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IRS Can Offset Chapter 7 Debtor's Overpayment Against Preexisting Tax Liability

(Parker Tax Publishing May 2020)

In a case of first impression, the Fourth Circuit held that the IRS's authority under Code Sec. 6402(a) to offset a tax overpayment against the unpaid taxes of a taxpayer who later files for bankruptcy cannot be subordinated or otherwise affected by the taxpayer's claim that the overpayment is exempt property under 11 U.S.C. Sec. 522(c). The court found that Code Sec. 6402 applies to "any overpayment" and does not provide any exception for overpayments made by a taxpayer who later declares bankruptcy. Copley v. U.S., 2020 PTC 146 (4th Cir. 2020).


On May 29, 2014, Matthew and Jolinda Copley filed a bankruptcy petition under chapter 7 of the Bankruptcy Code. In their petition, the Copleys listed the IRS as a priority creditor and identified a preexisting tax debt in the amount of $13,547. The Copleys claimed as property exempt from collection their overpayment of taxes from 2013, which resulted from their withholdings exceeding their tax liability by $3,208. The government did not object to the Copleys' claim.

On June 6, 2014, the Copleys filed their 2013 tax return which reflected the overpayment. The IRS confirmed the amount of the overpayment but did not send the Copleys a refund. Instead, the IRS exercised its discretion under Code Sec. 6402 to set off the Copleys' 2013 overpayment against their preexisting tax liabilities. The Copleys filed an amended complaint in the bankruptcy court seeking to compel the government to remit the overpayment to them. The bankruptcy court determined that the Copleys' interest in their tax overpayment was property of the bankruptcy estate and, once claimed as exempt, could not be subject to set off by the government under Code Sec. 6402. After a district court affirmed the bankruptcy court's judgment, the government appealed to the Fourth Circuit.

The government argued that a taxpayer can only have a property interest in a tax refund, not an overpayment, and the taxpayer can only have an interest in a refund if the overpayment exceeds preexisting tax liabilities. Because the Copleys' overpayment did not exceed their preexisting tax liabilities, the government asserted that their interest in a refund was valueless and, therefore, did not become part of the bankruptcy estate. The Copleys responded that they should be entitled to their refund because the purpose of the Bankruptcy Code is to give debtors a fresh start. They also argued that the government's position would effectively nullify the exemption provision in 11 U.S.C. Sec. 522(c). Finally, the Copleys argued that bankruptcy courts have discretion to disallow a creditor's attempt to impose a setoff under 11 U.S.C. Sec. 553(a).


The Fourth Circuit vacated the district court's judgment and remanded the case to the bankruptcy court after finding that the government's right to offset the Copley's overpayment under Code Sec. 6402(a) could not be subordinated or otherwise affected by the Copleys' attempts to claim the overpayment as exempt property. The court noted that the case was one of first impression in the Fourth Circuit.

The Fourth Circuit did not agree with the government's position that the Copleys' interest in a refund did not become part of the bankruptcy estate. Rather, the Fourth Circuit found that the Copleys' interest in their overpayment was part of the bankruptcy estate because, as of the time the Copleys filed their bankruptcy petition, the government had not taken any steps to accomplish a setoff under 11 U.S.C. Sec. 553(a). The court explained that a setoff is not accomplished until three steps are taken: the creditor must (1) decide to effectuate a setoff; (2) take some action accomplishing the setoff; and (3) record the setoff. The Fourth Circuit said it was undisputed that the government had not taken any of these steps at the time the Copleys filed their petition. The court found that the "defense of setoff" under the Bankruptcy Code is just that, a defense, which allows a creditor to assert the value of the claim as a defense to a demand to pay a separate debt owed to the debtor. Thus, the court found that unless exercised, the debtor's own claim against the creditor remains valid and cannot be considered valueless. If the creditor's claim against the debtor is disallowed or the right of offset is otherwise not asserted, the debtor will recover fully.

Observation: The Fourth Circuit also noted that nothing in Code Sec. 6402 requires that the government exercise its right of offset. The court said that, if the IRS had not elected to offset the debtors' overpayment, there is no dispute that the debtors would have been entitled to the full amount of their tax overpayment as exempt property.

Next, the Fourth Circuit found that the IRS's right of offset superseded the Copleys' right to exempt the overpayment under 11 U.S.C. Sec. 522(c). The court noted that, on the surface, a potential conflict appeared to exist between 11 U.S.C. Sec. 522(c), which protects property claimed as exempt in bankruptcy from being used to satisfy "any" prepetition debts, and Code Sec. 6402(a), which allows the IRS to offset "any overpayment" against a taxpayer's preexisting tax liabilities. But the Fourth Circuit found that the plain language of 11 U.S.C. Sec. 553(a) resolved this apparent conflict.

Section 553(a) provides that no provision of the Bankruptcy Code affects any right of a creditor to offset a mutual debt that arose before the commencement of the bankruptcy. The court found that the broad scope of Section 553(a) necessarily includes the property exemption provisions in 11 U.S.C. Sec. 522(c). Therefore, the court said it had to interpret 11 U.S.C. Sec. 522(c) in a way that did not affect the right of a creditor to offset a mutual debt. The court further found that the source of the IRS's right of offset, Code Sec. 6402(a), is also unambiguous in permitting the IRS to set off any overpayment, and does not include an exception for overpayments made by a taxpayer who later declares bankruptcy. In the court's view, the plain text of 11 U.S.C. Sec. 553(a) prevented it from reading an implicit exception into Code Sec. 6402(a) based on the language in 11 U.S.C. 522(c).

The court rejected the Copleys' argument that finding in favor of the government would go against the "fresh start" policy of the Bankruptcy Code. The court noted that another goal of bankruptcy is to ensure fair payment to creditors. The court also disagreed with the Copleys' contention regarding the nullification of 11 U.S.C. Sec. 522. The court said that preserving the government's right of offset recognized an additional exception to the application of 11 U.S.C. Sec. 522(c), but did not render the statute wholly superfluous. Finally, the court found that, while bankruptcy courts have historically had discretion to disallow a setoff, that discretion has always been limited to circumstances where the validity of the setoff could be questioned under other laws outside the Bankruptcy Code. In the court's view, that discretion did not permit the bankruptcy court to disregard the plain language of Code Sec. 6402(a) and 11 U.S.C. Sec. 553(a).

For a discussion of the tax treatment of income, deductions, and credits of a bankruptcy estate, see Parker Tax ¶16,150. For the IRS's right to offset overpayments against unpaid taxes, see Parker Tax ¶260,520.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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