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Is IRS Offset of Tax Refund a Violation of Automatic Stay?

Here is the issue:  Debtor files for bankruptcy on February 1, 2016 but expects a tax refund for tax year ending in December 31, 2015 from the IRS.  Debtor owes tax to the Internal Revenue Services for prior tax years.  Can the IRS offset the tax refund for 2015 for the tax debts for prior years when Debtor filed for bankruptcy in 2016?  Is IRS offset of tax refund a violation of automatic stay?  It does not matter whether it is a Chapter 13 Bankruptcy or Chapter 7 Bankruptcy.

The Tax code gives the IRS the power to first credit an overpayment to other federal tax liabilities. 26 U.S.C. 6402.  Since debtor had an outstanding tax liability, the overpayment did not ripen into a refund under 26 U.S.C. 6411.  Therefore, debtor do not have a right to the tax refund.  The IRS's setoff rights existing under law independent of bankruptcy code were preserved under 11 U.S.C. 553.  IRS's setoff rights is based on statute.  Bad news for debtor.

Does filing for Bankruptcy in February 1, 2016 before debtor files her tax return for tax year 2015 creates an automatic stay that prevents IRS from offsetting debtor's tax refund?

Upon filing bankruptcy, "automatic stay" comes into effect to stop all collection activities including the IRS.  However, there are some exceptions to the automatic stay.  Although automatic stay prevents a creditor from offsetting a debt incurred prior to bankruptcy filing under 11 U.S.C 362(a)(7), 11 U.S.C. 362(b)(26) carves an exception for the IRS:  "setoff under applicable non-bankruptcy law of an income tax refund, by a governmental unit, with respect to a taxable period that ended before the date of the order for relief against an income tax liability".  Another bad news for debtor.

Debtor might argue that the tax refund is property of the estate and is a protected asset under the California state exemption law.  However, when 11 U.S.C. 522(c) conflict with 11 U.S.C. 553, 11 U.S.C. 553 controls over 11 U.S.C. 522(c) but this does not foreclose a bankruptcy court from considering whether any state policy of protecting the rights of a debtor is present in the case.  However,the IRS's right of setoff is not based on equitable principles but on 26 U.S.C. 6402, which is a federal statute that does not recognize state exemptions.  Arguably, the Supremacy Clause of the United Stated Constitution prevents state exemption laws from defeating federal setoff rights provided under IRC 6402.  United States v. Gould, 401 B.R. 415, 428 (B.A.P. 9th Cir. 2009).  In other words, the IRS setoff rights trump the exemption statute.  This is tough to swallow for debtor.

As a consolation, debtor is getting rid of tax liabilities quickly so that it will not continue to accumulate interests and penalties.  In the long run, debtor would get out of debt quicker unless these tax liabilities are dischargeable debt under the Bankruptcy Code (loss of tax refund would be terrible news here).

This website is for informational purpose only and is not a substitute for retaining a bankruptcy attorney.

For more information, schedule a consultation with an experienced Bankruptcy Attorney in Sacramento, Stockton, or Fairfield, California.