Court Blesses Offset Before Pandemic When Later Filed Return Would Have Been Treated Differently

In Seto v United States the Court of Federal Claims held that it was permissible to apply a taxpayer’s 2019 federal income tax refund to offset defaulted student loans dating back nearly 30 years. In the case, Seto argued that Treasury unlawfully offset the refund because if he had filed his 2019 return later in the filing season, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) financial relief provisions would have precluded offsets. The case offers a relatively rare judicial consideration of the Treasury Offset Program, and illustrates how some taxpayers who filed returns prior to the pandemic were left worse off than those who filed after Congress and federal agencies administering debts subject to offset provided financial relief.

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The opinion discusses how Seto had approximately $170,000 in student debt, with about $95,000 of that principal, stemming from loans that began in the early 1980’s. The opinion details Soto’s struggles to make payments, leading eventually to a default notice that identified the possibility that any future tax refunds would be applied or offset to the delinquent education debt. In late 2018, the Department of Education informed Soto that it had referred the delinquent debt to the Treasury’s Offset Program, which applies federal payments to differing debts owed to federal and state agencies, including delinquent student loan debt.

In January of 2020, Seto filed his 2019 tax return, and that return reflected an overpayment of $9,228, with almost $8,000 of that due to a claimed Investment Tax Credit for the purchase and installation of a solar energy system.

The IRS processed that return in mid-February 2020, BC (Before COVID).  After the IRS processed the return, it authorized the refund which passed through the IRS filters since Seto had no outstanding federal tax debt.  The refund then moved from the IRS to the Bureau of Fiscal Services for payment which required it go through the TOP filters prior to payment.  Because of the outstanding student loan on the books at TOP, Treasury (aka the Bureau of Fiscal Services) applied the refund to the delinquent student loan debt.

A month or so after, Congress passed CARES. CARES provided taxpayers relief from offsets of CARES payments other than those attributable to delinquent child support. The problem for Seto was that CARES did not go into effect until the President signed the bill into law on March 27, 2020, two months after he filed and about a month after the IRS processed his return.  He also had a problem that the offset by TOP resulted from a regular tax refund and not a CARES economic impact payment.  Nothing in the legislation protected regular tax refunds though neither Seto nor the court focused on this distinction.

Not surprisingly, when Seto heard about the CARES offset relief, he responded by asking for his money back. When that did not happen, he sued, claiming that the offset violated his due process rights. The Court of Federal Claims considered his pro se complaint as an illegal action case, as the due process clause is not money-mandating and thus is generally outside its jurisdiction.

Why was this not a refund suit? From a tax procedure standpoint, when IRS reviews a return and applies an overpayment, no basis exists for a refund suit.  Subsequent to the application, the IRS either applies the refund to a past due federal tax debt or approves the refund for payment causing it to go through the TOP filters where it is applied to the myriad other federal and state debts that qualify for the Treasury Offset Program (for more on this you can check out Keith’s article on offsets here  or an extensive subchapter in Saltzman and Book, IRS Practice & Procedure Chapter 14A.)  The offset to a separate debt after allowance of the refund causes the refund to lose its relationship to the year where the overpayment arose. 

What about when someone is unhappy with the offset? IRC 6402(g) generally insulates Treasury and IRS from legal actions to restrain offsets. 

Despite that protection, the court addressed whether it was appropriate for the offset to occur, especially given that Seto would have been entitled to receive his money if he had simply filed his return two months later.

The IRS processed his return and applied his refund to offset a portion of his outstanding student loan debt on or before February 20, 2020, when Mr. Seto was formally notified of the government’s action. Nothing in the CARES Act states or clearly suggests that the student loan temporarily relief provisions applied retroactively. Absent such statutory language, courts cannot construe laws and implementing regulations to have retroactive effect. Hicks v. Merit Sys. Prof. Bd. ,819 F.3d 1318, 1321 (Fed. Cir. 2016) (“Retroactivity is not favored in the law and congressional enactments and administrative rules will not be construed to have retroactive effect unless their anguage requires this result. Accordingly, we will construe a statute to avoid retroactivity unless there is clear evidence that Congress intended otherwise.”) (cleaned up). Consequently, the enactment of the CARES Act has no bearing on Mr. Seto’s illegal exaction claim.

Conclusion

I have not dug deeply into the file, but the CARES relief provisions the court refers to were directed at Economic Impact Payments and not all claimed overpayments on taxpayers’ 2019 returns.  Barbara Heggie discusses this, and the March 25, 2020 Department of Education’s decision to halt requests for offset, in her April 2020 post Refunds, Offsets & Coronavirus Tax Relief. There are two different offset relief provisions at play and Seto needs the Department of Education relief to protect him and because of the timing of his refund it did not.  So I do not think that CARES has much direct bearing on the legality of the offset, but the Education policy came into effect only two days before then-President Trump signed CARES into law. The opinion notes as well that Seto did receive a couple of thousand dollars of the claimed overpayment due to a processed innocent spouse claim; I suspect that the court means injured spouse, with some of the overpayment likely attributable to Seto’s spouse.

Diving Beneath the Surface of In re Webb

We welcome back Ken Weil to help us parse a technical bankruptcy issue impacting taxes.  Ken has his own practice in Seattle that focuses on representing individuals with tax debt and resolving that debt through administrative action with the IRS or through bankruptcy. He has written a book on his specialty area, Weil, Taxes and Bankruptcy, (CCH IntelliConnect Service Online Only) (3d ed. 2014). He is one of the top experts at the crossroads of personal bankruptcy and taxes. We are fortunate to have him back with us again. Keith

In Webb v. Internal Revenue Service (In re Webb), Bankr. N.D. W.Va. Adv. Proc. No 21-00014 (November 8, 2021), a Chapter 13 debtor brought an adversary proceeding to hold the IRS in contempt for an improper setoff of a tax refund against a tax debt.  On the IRS’s Rule 12(b)(6) motion to dismiss, the court held for the IRS. 

The court stated that “[a]n order of contempt is a serious reprimand and is appropriate only in the case of a deliberate violation in the face of succinct directions to the contrary.”  Id. at p.3.  Because the debtor’s Chapter 13 plan did not explicitly prevent tax setoffs, the court found that the high standard necessary to hold the IRS in contempt was not met.  In note 2, the court stated that it “need not discuss the legality of the IRS’s actions because the Debtor only alleges the [IRS’s] actions constituted contempt of the confirmation order.”

Because contempt was the only issue before him, Judge Bissett decided the case without diving into the more complicated issues lurking beneath the surface.  What makes this case blog-worthy are the issues that would or could have been before the court if the case had been presented differently.  In particular, because of the IRS’s implicit election to treat its 2019 tax debt to Ms. Webb as a prepetition debt, there are multiple opportunities to discuss an analytical tool that I call deemed versus defined, which I first learned from Professor Harvey Dale almost 40 years ago.

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   1.   Factual background.

          In November 2019, Marie Webb (the Debtor) filed a Chapter 13 petition.  In her schedules, she listed taxes owed for 2013 and 2018.  In April 2020, the IRS filed its proof of claim, which it amended subsequently.  It listed the 2013 tax owed as an unsecured general claim, i.e., nonpriority claim.  It listed the 2018 tax owed as an unsecured priority claim.  In addition to the taxes scheduled by the Debtor, the IRS’s proof of claim listed the 2019 tax year as an unsecured priority claim and estimated the tax due. 

          In her Chapter 13 plan, the Debtor agreed to pay the 2019 tax debt as a priority obligation.  Corrective Order Confirming Chapter 13 Plan, Webb Docket No. 45, p.5, ¶ 10 (February 19, 2021) (Corrective Order).  The Debtor’s Chapter 13 plan left all property the Debtor acquired postpetition in the bankruptcy estate.  Corrective Order p.8, ¶ 10.

          In March 2021, the IRS set off the Debtor’s 2020 tax refund (IRS’s debt) against the 2019 tax obligation (IRS’s claim). In the Bankruptcy Code, setoffs are viewed from the creditor’s perspective.  Thus, the IRS’s refund owed is the debt, and the taxpayer’s unpaid tax obligation is the claim.  The Tax Code and 11 U.S.C. § 553 use the word “offset.”  I use “setoff” when used as a noun or adjective and “set off” when used as a verb. The Debtor objected to the setoff by filing an adversary proceeding seeking to hold the IRS in contempt.

     2.   Applicable law and its application in Webb.

          This paragraph discusses the law that would have been applicable if some of the underlying issues had been raised and argued by the parties.

          a.   I.R.C. §§ 1398-1399. 

          Tax Code §§ 1398 and 1399 provide rules for when a debtor’s tax year in the year of filing can be bifurcated.  The only time an individual’s tax year can be bifurcated is in an asset, Chapter 7 case. Assuming a calendar year-end, if the tax year of filing is bifurcated, a prepetition tax year runs from January 1 to the day before the petition is filed.  A second, postpetition year runs from the day of filing to December 31. See I.R.C. § 1398(d) (rules for taxable years of individual debtors); I.R.C. § 1399 (“Except in any case to which section 1398 applies, no separate taxable entity shall result from the commencement of a case under title 11 ….”); and Hall v. United States, 566 U.S. 506, 516 (2012) (Chapter 13 postpetition taxes are not incurred by the estate; they are a liability of the debtor).

          The Debtor filed for bankruptcy in November 2019.  This means the 2019 tax year ended after the bankruptcy filing and was a postpetition tax year.  The IRS’s proof of claim treated 2019 as a prepetition tax year.

          b.   11 U.S.C. § 1305.

          This paragraph discusses the things we know and do not know about 11 U.S.C. § 1305, and it looks at Webb through a § 1305 lens.

               i.   What we know about § 1305.

          Under 11 U.S.C. § 1305, a governmental unit can elect to file a proof of claim for taxes that [first] become payable while the case is pending.  11 U.S.C. §§ 1305(a)(1) and 1322(b)(6); and see Joye v. Franchise Tax Board Cal. (In re Joye), 578 F.3d 1070, 1075-1077 (9th Cir. 2009) (payable means first becomes payable); and In re DeVries, Bankr. D. Id. No. 13-41591 (April 28, 2015), 2015-1 USTC ¶ 50,287 (only governmental entity may file § 1305 claim).  Internal Revenue Manual guidance is found at IRM 5.9.10.9.2 (08-07-2018).

          Beyond the proof of claim, no special form is needed for a governmental unit to elect § 1305.  The IRM states that IRS personnel should file a proof of claim and add to the proof of claim language stating that the proof of claim is being filed under the authority of § 1305.  IRM 5.9.10.9.2(6) (08-07-2018).  The IRS’s proofs of claim in Webb did not have this language. 

          If the governmental unit so elects and the proof of claim is accepted as filed, the governmental unit’s postpetition claim is treated as if it were a prepetition claim.  In other words, a postpetition claim is deemed to be a prepetition claim.  Beyond this point, the applicable law is murky.

               ii.  The confusing world of § 1305.

          The election to use § 1305 raises a number of confusing issues.

                     I.  Are § 1305 claims entitled to priority?

          The argument that § 1305 claims do not receive priority is based on 11 U.S.C. § 507(a)(8), which has no provision for priority treatment of a deemed prepetition claim under § 1305.  In re Jagours, 236 B.R. 616, 619-620 (Bankr. E.D. Tex. 1999) (postpetition claim treated as filed prepetition but not entitled to priority because such a claim does not fit within the language of § 507(a)(8)(i)).  Cases that allow priority rely on § 1305(b), which states that a § 1305 claim shall be allowed or disallowed the same as if such claim had arisen prepetition.  In re Jagours, 236 B.R. at 616 n.3.  The IRM straddles the fence.  Compare IRM 5.9.10.9.2(8) (08-07-2018) (benefit of filing § 1305 claim is that “Service will be paid as a priority creditor”), with IRM 5.9.10.9.2(9) (08-07-2018) (risk of filing § 1305 claim is that “§ 1305 claims may not be accorded priority status”).

                     II.  Is a § 1305 claim dischargeable?

          In dicta, Jagours stated that § 1305 claims are not dischargeable.  In re Jagours, 236 B.R. at 620 (“rights of the creditor to collect are not impaired by the Chapter 13 plan”).  The IRM appears to disagree.  IRM 5.9.10.9.2(9) (08-27-08) (“Once provided for in the plan, the tax liability may be dischargeable.”)

                     III. Is postpetition interest paid on § 1305 claims? 

          Assuming funds are insufficient to pay interest to unsecured creditors, postpetition interest will not run on a discharged § 1305 claim, regardless of whether the § 1305 claim is paid-in-full.  If the § 1305 claim is not discharged or if it is deemed a postpetition claim, postpetition interest will continue to run.  See Ward v. Bd. of Equalization of Cal. (In re Artisan Woodworkers), 204 F.3d 888 (9th Cir. 2000) (postpetition interest payable on nondischargeable tax debt fully paid through a Chapter 12 plan).

                     IV.  Are penalties paid on § 1305 claims?

          In Webb, what happens to the failure-to-pay penalty (assuming the Debtor filed her 2019 return timely)?  If a prepetition claim, during the bankruptcy, the penalty does not accrue.  I.R.C. § 6658.  If a prepetition claim, the portion of the penalty that accrued prepetition is dischargeable in the bankruptcy, regardless of age.  See 11 U.S.C. § 1328(a)(2) (by omission from the listed exceptions, all penalties discharged regardless of age; this rule is one of the last vestiges of the old Chapter 13 superdischarge that disappeared with the 2005 revisions to the Bankruptcy Code).  If a postpetition claim, the penalty accrues.  

               iii. Webb and § 1305.

          With its proofs of claim in Webb, the IRS implicitly filed a § 1305 claim and took the position that it was entitled to priority.  The Debtor agreed to that treatment.  If the plan is completed, the tax would be paid-in-full.  At that point, only the payment of interest would turn on the dischargeability issue. 

          If postpetition interest and penalties are not paid, this is a sweet deal for the Debtor, as a postpetition tax is paid interest-free over the life of the plan.

          c.   11 U.S.C. §§ 541, 1306, and 1327(b).

          Bankruptcy Code §§ 541 and 1306 tell us what property is included in the bankruptcy estate.  Section 541 broadly defines bankruptcy estate property.  Section 1306(a)(1) provides that property of the estate includes all property that the Chapter 13 “debtor acquires after the commencement of the case but before the case is closed, dismissed or converted ….”  Upon plan confirmation, all property of the estate vests in the debtor.  11 U.S.C. § 1327(b).  Section 1327(b) does not override § 1306.  In re Shay, 553 B.R. 412, 417-418 (Bankr. W.D. Wash. 2016) (Lynch J.).  A priori, it applies to prepetition property that is returned to the debtor upon confirmation.

          The Debtor’s Chapter 13 plan included all property acquired postpetition in her bankruptcy estate, which means it included any potential tax refund in her bankruptcy estate. Whether the refund could even be estate property is also debatable.  Because the right to overpayment arose before the IRS made its setoff, it was most likely estate property.  Copley v. United States, 959 F.3d 118, 122-123 (4th Cir. 2020).  West Virginia is in the Fourth Circuit.  Otherwise, under I.R.C. § 6402(a), a “debtor is generally only entitled to a tax refund to the extent that her overpayment exceeds her unpaid tax liability.”  IRS v. Luongo (In re Luongo), 259 F.3d 323, 335 (5th Cir. 2001); and United States v. Gould (In re Gould), 401 B.R. 415, 424-425 (B.A.P. 9th Cir. 2009) (citing Luongo with approval), aff’d, Gould v. United States (In re Gould), 603 F.3d 1100 (9th Cir. 2010) (adopting BAP opinion).

          d.   11 U.S.C. §§ 327(a), 362(a)(3), (b)(26), and (c)(1).

          The automatic stay protects the debtor from collection action by creditors while a bankruptcy case is pending and before discharge is entered.  In particular, the creditor may not act to obtain possession of estate property.  11 U.S.C. § 362(a)(3).  An exception is that a governmental unit may set off postpetition a prepetition debt (a tax refund) against a prepetition claim (a debtor’s unpaid tax debt).  11 U.S.C. § 362(b)(26).  Here, the 2020 tax refund is a postpetition debt.

          The Debtor’s plan kept all property in the bankruptcy estate, and § 362(a)(3) stayed collection as to that property.  The automatic stay remained in place as long as the property remained bankruptcy estate property.  11 U.S.C. § 362(c)(1); and see also 11 U.S.C. § 362(c)(2) (if property had been returned to debtor, stay would have remained in place until the case was closed, dismissed, or the debtor received a discharge.)

          Judge Bissett stated correctly that the Debtor’s plan failed to address explicitly whether the setoff of a postpetition tax refund was permissible.  Consistent with § 1306, the plan did state that all property acquired postpetition would be property of the bankruptcy estate.  It also provided that the Debtor could keep the first $1,500 of any tax refund and the remainder should be sent to the Chapter 13 trustee.  Corrective Order p.2, ¶ 3.

          Pursuant to 11 U.S.C. § 1327(a), all creditors, including the IRS were bound by the terms of the plan, and the Debtor’s complaint so alleged.  Webb v. Internal Revenue Service (In re Webb), Bankr. N.D. W.Va.Adv. Proc. No. 21-00014, Docket No. 1, Complaint ¶ 23 (June 21, 2021).

          e.   Setoffs, mutuality of obligation, and deemed versus defined.

          This paragraph discusses when setoffs are allowed in bankruptcy and the concept of mutuality of obligation.  It then applies the analytical tool of deemed versus defined to ask whether mutuality of obligation existed when the IRS made its setoff in Webb. For a thorough analysis of setoffs and taxes, see K. Fogg, “The Role of Offset in the Collection of Federal Taxes,” added to SSRN on February 26, 2021 and forthcoming in the Florida Tax Review.

               i. Setoffs and mutuality of obligation.

          As a general rule, the Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose” prepetition against a claim of the debtor that arose prepetition. One exception is the improvement-in-position test that a bankruptcy trustee can use to claw back into the bankruptcy estate setoffs made in the 90-day prepetition period. 11 U.S.C. § 553(b).11 U.S.C. § 553(a).

          Valid setoffs require a mutual debt, i.e., mutuality of obligation.  The debt and claim must be between the same persons.  Because a bankruptcy filing creates a new entity, i.e., the postpetition debtor, the mutual debt requirement may be flunked while a bankruptcy case is active.  For example, a setoff of a postpetition debt (IRS refund owed to the debtor in bankruptcy) against a prepetition claim owed by the prepetition debtor (IRS’s right to unpaid tax) is not a mutual debt.  After a bankruptcy case closes, this issue disappears.  There is no longer an existing bankruptcy case to force a division between events arising pre and postpetition.

               ii.  Did mutuality of obligation exist in Webb?

          The combination of the IRS’s implicit § 1305 election and its setoff of the 2020 refund against the 2019 claim also puts the deemed versus defined concept in play.  If the IRS’s 2019 tax claim is treated as defined, mutuality of obligation exists because the IRS set off a postpetition obligation against a postpetition claim.  This must be how the IRS viewed the world.  Yet, as long as the Debtor has rights in the overpayment, see n.3, supra, this setoff would violate the automatic stay.  11 U.S.C. §§ 1306 and 362(c)(1).  If the 2019 tax refund is treated as deemed, i.e., prepetition treatment under the Debtor’s Chapter 13 plan, mutuality of obligation does not exist.  The IRS set off its postpetition debt against its prepetition claim.   

     3.   Conclusion.

          Judge Bissett is a wise man.  He found the straight-forward answer to the issue at hand.  He wisely and successfully avoided the difficult issues that were lurking beneath the surface. See Webb at n.2 (“the court need not discuss the legality of the IRS’s actions”).

          In lieu of filing an adversary proceeding alleging contempt and depending on the legal analysis one thinks is correct, the Debtor might have sued the IRS for (i) turnover under 11 U.S.C. § 542(b) for failing to pay the tax refund to the bankruptcy estate, (ii) violation of the automatic stay for exercising control over estate property, or (iii) making a setoff without mutuality of obligation.

2021 Year in Review – Administrative Matters Part 1

The job of my dreams from 15 years ago has just come open.  The University of Florida, home to one of the best LLM programs in tax in the country, has decided to make it even better by starting a low income taxpayer clinic.  When I was preparing for retirement from Chief Counsel back in 2007, I looked around for a teaching position and especially wanted one in Florida or somewhere in the South if I could not find one in Virginia.  I applied for a couple of positions in Florida but the schools had no interest in me, which was fortunate because I ended up at Villanova where I could not have been happier except that the weather in PA could have been warmer.  Then I moved even further North, reversing the path of most elderly folks, but again was very fortunate to land at the Legal Services Center of Harvard Law School.  Some lucky person will now have the opportunity to teach and to help taxpayers from a nice warm location.  The announcement:

The University of Florida Levin College of Law seeks a non-tenure-track Legal Skills Professor to serve as the instructor and director for our newly funded Low Income Taxpayer Clinic (“LITC”). This is a wonderful opportunity for a licensed attorney with substantial experience representing clients in disputes with the IRS and a passion for clinical legal education. We welcome applications from licensed attorneys already working in legal academia as well as practicing lawyers seeking to transition to legal academia.

Here’s the link to the position: https://explore.jobs.ufl.edu/en-us/job/519429/lecturer-legal-skills

Lots of administrative matters this year as the IRS pushed out a third Economic Impact Payment (EIP) and pushed out the Advance Child Tax Credit payments.  Congress put a lot of burden on the IRS asking it to shoulder these tasks while the IRS sought to dig itself out from two difficult filing seasons with lots of backlogs.

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ID Verification

Among other things that made the last two filing seasons difficult was the high number of ID verification requests the IRS made to taxpayers.  These requests came at an unprecedented scale.  I had the opportunity to ask Wage & Investment Commissioner Ken Corbin about the volume of these requests in a panel I moderated at the annual conference for Low Income Taxpayer Clinics.  He explained why the volume increased so dramatically and why it would probably go down significantly in the future.  Perhaps the IRS has explained this in other settings, but I had not seen an explanation previously.  His explanation made perfect sense.  The EIPs caused a high number of individuals to file a return who had not previously filed a return or who had not filed a return in a long time.  The returns of taxpayers not in the system generate a much higher level of potential fraud, particularly when filed for the purpose of obtaining a refund in one of these payment programs.  Consequently, the IRS sought to verify the ID of many more taxpayers than normal.  Unfortunately, it was unprepared for the call volume.  Fortunately, it has now developed a system rolled out in late November 2021 that should make the process go much smoother.

Misdated Notices

The IRS regularly sends out mail on a date other than the date on the correspondence.  I don’t condone the practice, but it’s been going on for quite some time.  In 2020, however, the IRS sent out millions of letters with the wrong dates and the wrong instructions, creating more confusion than necessary.  You can find our posts on these notices here and here.  During the pandemic, the IRS held off on sending out some of the notices that would have gone out on a regular cycle.  It did so both because it wanted to give taxpayers a break during the pandemic and because it could not staff the phone lines for the calls that would have inevitably resulted from the notices.  The problem continued in 2021.  As she did in 2020, the NTA blogged on the problem, providing a window into IRS action not otherwise available.  The 2021 correspondence problem does not implicate statutory time frames the way the 2020 misdated notices did.  Instead, the new problem involved the IRS sending 109,000 taxpayers a notice with incorrect information.  The notice not only wrongly told taxpayers of action the IRS did not take but contains a typographical error that compounded confusion.  See our posts here and here.

Cases for the Taxpayer Advocate

The Taxpayer Advocate issued guidance regarding the cases it would accept.  It needed to limit the cases it would take both because of case inventories and because it could do nothing about one of the biggest issues facing taxpayers – finding out what had happened to their return.  Because of significant and continuing delays in processing returns due to the pandemic, an unprecedented number of returns sat at IRS Service Centers waiting for someone to process them.  The delays especially impacted taxpayers who filed paper returns, amended returns and late returns.  These taxpayers turned to TAS when calls to the IRS proved unavailing or went unanswered; however, TAS cannot locate unprocessed returns sitting on a trailer outside of a Service Center.  The inability to turn to TAS for assistance provided further frustration for taxpayers, but the decision not to accept these types of cases seemed only logical given the inability to do much with these cases. 

In TAS-13-0521-0005: Interim Guidance on Accepting Cases Under TAS Case Criteria 9, Public Policy (05/06/2021), the National Taxpayer Advocate (NTA) put out guidance on the public policy cases that the Taxpayer Advocate Service (TAS) will accept.  The guidance regarding case acceptance expires on May 5, 2023. Under Code Sec. 7803(c)(2)(C)(ii), Congress listed several types of cases in which TAS will assist taxpayers and gave the NTA the authority to determine additional matters in which TAS will assist taxpayers. We discussed the issue here.

Updates from Independent Office of Appeals

Good news – Appeals has a customer service number: 559-233-1267.

Bad news – Appeals does not call you back if the case is unassigned, which would be my main reason for calling the number.

The update occurred as part of an event put on by the IRS for its stakeholders.  The executives from Appeals had a brief slide presentation which showed staffing and case levels in Appeals as of January 2021.

ITIN Acquisition

There have been changes made to processes at the ITIN unit related to issuing ITINs to dependents in Canada and Mexico.  Since the TCJA passed, the ITIN unit has begun to require proof of U.S. residency for dependents outside the U.S. prior to issuing an ITIN. These policies are not required by the statute or regulations and have perhaps some unintended consequences for vulnerable communities, particularly as they relate to the calculation of family size for the numerous federal and state agencies that use the tax return for this purpose. These policies also contradict the Form 1040 instructions which instruct taxpayers to include dependents from Mexico and Canada on the return.

Unfortunately for ITIN applicants, there is no easy way to appeal a rejection of an ITIN application, making these changes especially burdensome. Requesting an abatement of the math error notice that is issued after an ITIN rejection may provide the only way to appeal a rejected ITIN application. However, sometimes the IRS denies ITINs in situations where the inclusion of the ITIN applicant on the return does not change the amount of tax due, and no math error notice will issue. Creative litigators will have to figure out what remedies are available for a wrongfully denied ITIN application under these circumstances.

Exercise of Discretion Not to Offset Recovery Rebate Credits

The offset statute gives the IRS discretion to decide when to offset.  For the first two stimulus payments, Congress directed that the only offset would be for past due child support; however, it did not limit the IRS’ ability to offset when it passed the final stimulus payment.

A post by the NTA sets out some of the history on what the IRS did as it moved into the 2020 filing season. 

Congress prohibited offset of the first two stimulus payments (EIP), except against past due child support, which were made in 2020.  In passing the third stimulus payment (RRC), Congress did not create the same offset restriction.  Nonetheless, the IRS decided to exercise its discretion under 6402(a) with respect to the offset of federal tax refunds to federal tax liabilities.  The IRS allowed refunds based on RRC to pass through to taxpayers without being offset to satisfy prior federal tax debts.  Great news for persons with only federal tax debts in their portfolio of debts subject to offset under the Treasury Offset Program (TOP), but less good news for taxpayers with other outstanding obligations.  For a detailed discussion of offset and an explanation of TOP, you can read an article by me forthcoming in the Florida Tax Review found here.

The NTA points out two problems with the otherwise good news regarding the IRS decision to forego offset of refunds based on RRC.  First, the decision happened in the middle of the filing season after many taxpayers had already filed and already had their refunds offset.  A similar offset decision occurred in 2020 when the Department of Education decided during the middle of the filing season not to exercise its right to offset federal tax refunds (and other federal payments) against outstanding student loan debts.  Individuals who filed early (i.e., those most likely to have substantial refunds) get treated differently than those who wait. 

A similar issue occurred during the 2021 filing season with unemployment benefits that Congress decided mid-filing season to exclude from income (although the IRS created a way to fix this for early filing taxpayers without the need for them to file a superseding or amended return).  So many problems are created for tax administrators when Congress makes changes during the filing season.  The IRS deserves much credit the past two years for adjustments it has had to make during the filing season while operating under pandemic restrictions.  These type of adjustments can contribute to the processing delays for which the IRS gets a black eye.

Innocent Spouse and the Administrative Record

We received correspondence from PT reader James Everett of DeFranceschi & Klemm, PC in Boston.  Mr. Everett represents the taxpayer in Sutherland v. Commissioner, which Christine blogged here and I blogged here in the 2020 year in review post because of the importance of this case.  For those who do not remember Sutherland, it involves the issue of IRC 6015(e)(7) which limits Tax Court review in innocent spouse cases to the administrative record, including cases pending at the time of enactment that had already gone through the administrative process prior to the legislation creating the limitation.  The case was rescheduled for trial in 2021.

The national office interjected itself into the case and the IRS objected to all documents the taxpayer wanted to include with the stipulation that weren’t part of the “administrative” record (i.e., documents not provided during the administrative stage).  Judge Lauber made it clear he was going to require the IRS to call the appeals officer as a witness at the trial to discuss the record.  A few days before the trial, the IRS dropped its administrative record objections.  Judge Lauber asked the respondent’s counsel if this reflected Service-wide policy (i.e., the IRS agreed that §6015(e)(7) didn’t apply to pending cases); respondent’s counsel candidly replied that this was above his paygrade to comment on – he could only speak to the case at hand.

The withdrawal of objection to the administrative record was great, but based on the record it is not possible to tell if this was specific to the case, a rethink of IRS position, or just a lack of desire to have the AO testify.  The administrative record rule presents significant problems for individuals who go through the administrative process pro se, since they often fail to develop the full record needed if litigation occurs.  We really appreciate the insights provided by Mr. Everett and encourage other readers to provide similar insights if their cases have a significant procedural development.

Major Change to Offer in Compromise Policy

The only bad thing about the change in IRS policy in Offers in Compromise (OIC) is that it comes too late for me to change a forthcoming law review article on offset.  The inability to update the article which is headed to press matters little.  The new policy regarding offset in OICs represents a significant shift in collection policy for the benefit of taxpayers with accepted offers.  Kudos to the decision makers behind this policy shift.  A recent blog post from the National Taxpayer Advocate sets out the shift in policy and does a nice job of providing background as well as summarizing the new policy.  This post seeks to complement the information provided by the NTA but is somewhat duplicative.  Christine wrote a two-part blog post on offers and refunds, here and here, if you want more background on this subject.

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Offsets after OICs

Section 7122 gives wide discretion to the IRS to enter into an OIC with taxpayers when the IRS finds that doing so serves the best interest of the government.  As we have discussed previously, the IRS generally declined to enter into OICs until a shift in policy three decades ago brought about by the lengthening of the statute of limitations on collection.  Once it decided to accept OICs as a regular part of its collection arsenal, it took the IRS some years to refine the process.  As it did so, it developed language in Form 656, the form on which the taxpayer submits the OIC itself, which committed taxpayers to foregoing the refund for the year in which the IRS accepted the OIC.  If you actually read the entire Form 656 you find it contains many provisions regarding the taxpayer’s commitment in accepting the OIC.

 The specific language developed by the IRS regarding the commitment of the taxpayer to give up their refund in the year of the OIC acceptance is found on page 5 of the form in section 7(e), which states:

The IRS will keep any refund, including interest, that I might be due for tax periods extending through the calendar year in which the IRS accepts my offer. I cannot designate that the refund be applied to estimated tax payments for the following year or the accepted offer amount. If I receive a refund after I submit this offer for any tax period extending through the calendar year in which the IRS accepts my offer, I will return the refund within 30 days of notification.

This provision surprises many taxpayers.  It has caused our clinic to carefully explain to taxpayers what to expect.  The offset sometimes comes a year or more after the acceptance of the offer if the IRS accepts an OIC early in a calendar year.  We would counsel clients to try to manage their taxes for the year of the offer acceptance so that they did not have a refund or, if they did, the refund was small.

Even though the IRS rarely accepted OICs prior to the change in its policy in 1992, it did have an OIC program.  In the Sarmiento case, discussed below, the clinic traced this language back to at least 1964.  At that time, however, refundable credits did not exist and the policy as originally designed would not have been intended to claw them back after OIC acceptance.

The policy fell hard on individuals receiving refundable credits as Congress pushed more and more benefits into the hands of individuals through the tax code.  For some individuals, the offset could take the earned income credit and child tax credit of several thousand dollars even though these refundable credits did not really constitute a tax refund as much as a benefit payment through the tax code.  Because of the way the offset operated in this situations, authors of this blog and others have criticized the taking of these refunds as part of the OIC process. 

Taxpayers have essentially no leverage to negotiate the terms of an OIC.  Even when aware of this provision in the offer contract and aware that it meant the taking of a large refund generated because of refundable credits, taxpayers could not negotiate their way out of the situation.

Now, for OICs accepted after November 1, 2021, the IRS will forego taking the post-OIC acceptance refund for the year of acceptance.  It will still take refunds for the periods leading up to the acceptance of the OIC (subject to the discussion of Offset Bypass Refunds (OBRs) discussed below.)  The benefit to taxpayers varies based on the amount of refund they might have received for the year of OIC acceptance.  The NTA’s blog has some statistics on this; however, the individuals receiving significant refunds based on refundable credits, usually among the poorest of the taxpayers receiving acceptances, will definitely benefit.

The new policy does make clear that the IRS expects to offset any refunds related to pre-OIC acceptance tax years.  This policy makes sense.  It prevents taxpayers from delaying the submission of amended returns until after an OIC acceptance in an effort to circumvent having the refund offset.  In this way, the policy operates similarly to the requirement that taxpayers disclose their interest in potential lawsuits and other claims not yet turned into a definite amount at the time of making the OIC.  The IRS should receive these monies or at least know about them and make a judgment.

Prior Litigation on This Issue

Carl Smith took on the language when he served as the director of the Cardozo Low Income Taxpayer clinic.  Through litigation, the clinic tried to limit the refund offset in the year of acceptance to refunds that were not from refundable credits in Sarmiento v. U.S., 678 F.3d 147 (2d Cir. 2012), and its companion case, Maniolos v. U.S., 469 Fed. Appx. 56 (2d Cir. 2012).  At the time, the OIC language stated that the IRS could keep “any refund, including interest, due to [the taxpayer] because of overpayment of any tax or other liability, for tax periods extending through the calendar year in which the IRS accepts the offer.” Carl and the clinic argued that, in the plain English in which the OIC was written (which they argued should apply instead of Codespeak), a refundable credit is not from any overpayment, and the policy reasons for the offset of refundable credits made no sense from both a history and policy perspective.  The clinic’s brief stated:

Support for this colloquial-English interpretation is found in the alteration that has happened in the particular language regarding “additional consideration” from the time of the 1964 OIC at issue in Robbins Tire & Rubber Co, Inc. v. United States, 462 F.2d 684 (5th Cir. 1972).  The Robbins Tire OIC provided that the United States could retain “any and all amounts of money to which the proponent may be entitled under the internal revenue laws, due through overpayments of any tax or other liability, including interest and penalties, made for periods ending prior to or during the calendar year in which this offer is accepted.”  Id., at 686.  This prior OIC language —“any and all amounts of money to which the proponent may be entitled under the internal revenue laws”—was later replaced in the version that each of the taxpayers signed with the more colloquial English words “any refund, including interest, due to me/us . . .”

Carl notes that the policy reasons for offsetting refunds from actual overpayments make sense as a means of stopping people from overpaying estimated tax payments in the year of OIC acceptance, just to get the excess back after an OIC is accepted based on assets lowered by the excess payments. 

While the policy surprisingly still allows this creative tax planning, the old policy allowed creating planning to avoid having a refund – unless your refund resulted from a refundable credit.  In that sense, the new policy just trades off on incentives and, in my experience, a relatively small number of individuals submitting offers engage in this type of planning. 

The Second Circuit ruled that the word overpayment in the OIC had to be read as defined in the Tax Code, which included refundable credits.  The litigation did cause the IRS to rewrite the OIC form to eliminate the words “because of overpayment”.  Carl says that during the litigation the IRS Director of Collection Policy told Carl he was curious about the cases and would be following them.  Carl felt the IRS sounded open to the ideas at issue in the litigation, though the IRS eventually did not change policy and in fact made the language more airtight to be able to keep all overpayments.

Offset Bypass Refunds

The NTA’s blog describes OBRs.  Something we have done before here in the most visited post of any every written by this blog.  The NTA’s blog announces a new policy regarding OBRs and OICs which appeared on the IRS website two weeks ago with little fanfare.  If a taxpayer files a return during the time an OIC is pending, the IRS will offset any refund generated by the return up to the amount of the outstanding liability.  Previously, a taxpayer with hardship who needed this refund to pay the rent or electricity could not take advantage of the OBR process while the OIC was pending.

OBRs have come under some criticism recently.  TIGTA criticized them in a report discussed by Les in a post here.  Les and I participated in an ABA Tax Section comment that focused on OBRs and made several suggestions seeking to make them more taxpayer friendly and accessible.

The new policy allows the taxpayer to submit a request for an OBR even while the offer is pending.  Like the policy of offsetting refunds described above, it is another step in the right direction for protecting taxpayers and especially low income taxpayers.  Under the new policy, the IRS will process the OBR just as if the taxpayer had not filed an OIC.  This does not mean that the taxpayer will necessarily receive the refund, or the full amount of the refund, but does give the taxpayer a fighting chance to receive at least a part of the refund during a time of real need.

The NTA’s blog gives an example of how OBRs work.  The blog does not cite to IRM provisions regarding the new policy because those have yet to be written.  It notes that this process is not well known and not easy to find.  The post concludes by saying that TAS is trying to prod the IRS to be more forthcoming about this process:

We continue to encourage the IRS to provide educational material on IRS.gov explaining the benefits of OBRs, the economic hardship requirements, and what taxpayers need to do to timely request an OBR. With the upcoming filing season, we encourage the IRS to get the OBR message out by leveraging its relationships with the public.

No doubt improvements could occur, but I applaud the IRS for acknowledging that taxpayers who have submitted an OIC may need an OBR just as much as those who have not made such a submission.  Because the OBR process itself remains difficult and somewhat opaque, I do not expect that this policy change will open the floodgates.  It will, however, allow some taxpayers in need to find relief.

Limitation on Offset When the Government Seeks to Collect Restitution

The case of United States v. Taylor, No. 2:06-cr-00658 (E.D. PA 2021) brings out a limitation on the right to offset when the Government is collecting on a court-ordered restitution amount.  Here, the Government, specifically the Department of Justice, gets its hand slapped for levying on the social security of a convicted criminal.  The levy here is the 15% on social security that regularly arises with respect to outstanding federal tax obligations.  There is no indication in the opinion that the IRS made a restitution based assessment in this case or any kind of assessment.  This appears to be a case involving the payment of the court ordered restitution payment and not a derivative liability stemming from the restitution order.  The court does not mention the IRS other than in relation to the crime committed by the petitioner.

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Ms. Taylor and others were convicted of conspiracy to defraud the IRS.  The federal district court that sentenced her and then ordered her to pay a restitution judgment of $3.3 million.  The court, however, failed to take into account her financial resources and the Third Circuit vacated the restitution order and remanded the case so that the district court could make an appropriate determination of her ability to pay as well as her culpability.

On remand, the court determined her ability to pay was $100 per year and noted that the government could come back to the court for an increase if her circumstances changed.  This happened in 2012.  Between 2012 and 2019 when Ms. Taylor became eligible for aged-based social security benefits, the government did not return to the court to seek an increase, although it did make a preliminary determination that she could pay $25 a month.

The restitution payments were listed with the Bureau of Fiscal Services as available for offset pursuant to the Treasury Offset Program (TOP) because they were delinquent federal debts.  When the social security payments began, TOP began offsetting 15% of her social security (about $235 a month) and applied the funds taken from her monthly social security check to her outstanding restitution obligation.  She continued to comply with the court order to pay $100 a year.

When Ms. Taylor initially brought the action complaining of the TOP offset, she did so pro se.  The district court appointed Peter Hardy, one of the top white collar criminal defense attorneys in Philadelphia who also taught as an adjunct professor at Villanova when I was there and has guest posted for us in the past (for example, see this terrific post on the crime fraud exception to the attorney client privilege).  Undoubtedly, Ms. Taylor benefited from his appointment.

The court provides some background on the TOP program which we have discussed previously here and here

Ms. Taylor argued that she was in compliance with the restitution order, making the TOP offset inappropriate.  She also argued that her restitution debt was not delinquent, meaning it was not one the government should refer to TOP.  The Government argued that the referral to TOP was appropriate because she had a large outstanding debt.  The court finds that the debt is not delinquent:

“[U]nlike a civil judgment, the restitution order is the product of a ‘specific and detailed [statutory] scheme addressing the issuance . . . of restitution orders arising out of criminal prosecutions.’” Id. at 1204 (quoting United States v. Wyss, 744 F.3d 1214, 1217 (10th Cir. 2014)). Section 3572(d) states that “[a] person sentenced to pay a fine or other monetary penalty, including restitution, shall make such payment immediately, unless, in the interest of justice, the court provides for payment on a date certain or in installments.” 18 U.S.C. § 3572(d)(1). This subsection provides that the full payment of restitution is not due immediately if a court establishes a payment plan for restitution. See Martinez, 812 F.3d at 1205. Thus, “a defendant subject to an installment-based restitution order need only make payments at the intervals and in the amounts specified by the order.” Id. Section 3572 also explicitly defines when a payment of restitution is delinquent or in default. See 18 U.S.C. § 3572(h)-(i). A “payment of restitution is delinquent if a payment is more than 30 days late.” Id. § 3572(h). A “payment of restitution is in default if a payment is delinquent for more than 90 days. Notwithstanding any installment schedule, when a fine or payment of restitution is in default, the entire amount of the fine or restitution is due within 30 days after notification of the default.” Id. § 3572(i). These provisions “would be unnecessary, even meaningless, if the total restitution amount were already owed in full under an installment-based restitution order.” Martinez, 812 F.3d at 1205. It is evident from the structure and language of § 3572 that under an installment-based restitution order, the restitution debt only becomes delinquent when a defendant’s installment payment is more than 30 days late.

The court tells the government that if it wants more from Ms. Taylor it needs to come back to the court and request more.  It cannot simply offset at a time when she has continued to comply with the court’s order.  The court orders the government to stop the offset and to return to her all the money taken through TOP.  Perhaps the government will come looking for her and seek to raise the amount she must pay from $100 a year to a larger number.  Because she became unemployed as a result of the pandemic, this might prove difficult.

It’s unclear if the conspiracy to defraud the IRS could turn into a tax assessment.  If the IRS made a tax assessment of the liability or some part of the liability, it could collect on the tax liability independent of the restitution order and through a tax assessment could potentially levy on her social security.  Ms. Taylor, as part of her defense to the taking of the social security funds, argued that the taking of these funds put her into a difficult financial situation.  If the IRS made a tax assessment, it could not levy, even through TOP, if doing so would create financial hardship as defined by IRC 6343(a)(1)(D).  Convicted tax criminals generally make difficult taxpayers from whom to collect.  Ms. Taylor appears to fit into that category.

Offsetting Stimulus Payments Due to a Taxpayer in Bankruptcy

The case of Lockhart v. CSEA, et al, No. 1:20-ap-00038 shows another facet of the offsetting of last year’s stimulus payments.  In this case the taxpayer owed past due child support, which was the one type of debt to which the stimulus payments could be offset; however, he argues that the offset in his situation violated the automatic stay of his bankruptcy case as well as the terms of the confirmed chapter 13 plan.  Though the court tosses certain claims, it leaves open the possibility that the offset of the refund violates the terms of the plan of reorganization.

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Before looking at the issues the court addressed regarding the offset, a couple issues deserve mention.  First, the offset took both the refund of Mr. Lockhart and his current spouse and applied it to his past due child support.  This issue was discussed in several posts last year collected here.  The court simply sends her to file an injured spouse form.  I am a little surprised the IRS did not just fix the problem without the need for that form.

Second, the IRS should not be a party to this case.  It gave Mr. Lockhart what he requested – the stimulus payment.  The IRS did not refuse to give him the payment or make the offset.  The offset occurred at the Bureau of Fiscal Services.  It seems to me that would be the appropriate focus of any wrong activity at the federal level and not the IRS.  Maybe it doesn’t really matter, but by focusing on the IRS, Mr. Lockhart, and perhaps the court, focus on the wrong point in time.  This is a common mistake for taxpayers subject to offset.  They often see the IRS as the source of their problem, but when the offset goes to an agency outside of the IRS, the offset occurs once the funds have been approved by the IRS.

The first issue the bankruptcy court addresses is sovereign immunity.  Both the IRS and the state agency assert sovereign immunity in seeking dismissal of the action.  I was surprised by the IRS arguments regarding sovereign immunity as described by the bankruptcy court.  The court found that B.C. 106 waived sovereign immunity in matters of this type.  That decision seems consistent to me with the determinations regarding sovereign immunity that have developed over the last quarter century since the bankruptcy code was amended; however, I have not looked at the brief filed by the IRS and perhaps there is a nuance I am missing.  The court essentially lumped the state and federal sovereign claims together and found a waiver as to both.  The fact that sovereign immunity was waived does not win the case for the debtor, but it does allow the case to move forward.

The debtor seeks to hold the parties in contempt for taking the stimulus payment and applying it to the past due child support because he confirmed a plan that provided he would pay out the almost $20,000 of past due child support during the life of the plan. The state child support agency countered that it was not bound by the confirmation order, an argument I assume is grounded in the failure to include it as a named creditor, and that the stimulus payment was not property of the estate, an argument that would be grounded in the language of the chapter 13 plan itself. A common provision of chapter 13 plans revests all property in the debtor upon confirmation in return for the promise to pay.

The court refuses to hold anyone in contempt, stating that more facts are needed, especially since neither the IRS nor the state agency were served with the bankruptcy petition.  It also makes an interesting note that the debtor does not appear to be performing under the plan.  If the debtor is not actually making their plan payments which will resolve the child support issue or if the debtor is running up additional child support obligations post-petition, that could put the offset in a different light.

With respect to the automatic stay, the state child support agency asserted a defense based on one of the exceptions to the automatic stay, B.C. 362(b)(2)(F).  The automatic stay creates a stay of eight actions specified in B.C. 362(a), one of which is collection by a creditor of a pre-petition debt and another of which is offset.  In a chapter 13 case, the automatic stay lasts from the moment of filing the petition until the end of the case, which could be five years later.  The bankruptcy code, however, in B.C. 362(b) contains a list of 29 exceptions to the automatic stay. 

If a creditor fits under one of the 29 exceptions, it can take the collection action even though such action is barred by the provisions of B.C. 362(a).  I am most familiar with the exceptions that apply to taxes, most of which are found in B.C. 362(b)(9), and I was not familiar with B.C. 362(b)(2)(F).  It excepts “the interception of a tax refund, as specified in sections 464 and 466(a)(3) of the Social Security Act or under an analogous State law.”  Here, the debtor argued that the stimulus payment was not a tax refund but rather a credit.  The bankruptcy court sided with the government arguments that the stimulus payment is a tax refund.  This decision could have implications beyond bankruptcy cases but given the language of the application exception to the automatic stay provides sufficient cover for the action from the perspective of fending off a stay violation argument.

This case provides no remarkable revelations but does examine the taking of the stimulus payment under the only offset provision available.  If the debtor is not keeping current on his chapter 13 plan, he may face a difficult task in getting the return of the stimulus payment or a contempt charge against the state agency.  If the federal government did not know of the bankruptcy, it’s hard to fault it for making an offset where the state left a marker on the Treasury Offset Program database.  Removing the marker upon the filing of bankruptcy should fall on the state agency that knew of the bankruptcy, and not the TOP program.

The Fourth Circuit and the Primacy of Refund Offsets in Bankruptcy

We welcome guest blogger Michelle Drumbl. Professor Drumbl runs the tax clinic at Washington & Lee Law School and teaches tax there as well. She started as a clinician at almost the same time I did, and it has been a pleasure to work with her over the years. Starting later this summer she will take on the role of acting dean at the law school which is quite a testament to her abilities. She is also the author of a relatively recently published book, Tax Credits for the Working Poor – A Call for Reform, quite a timely book given the recent boost in refundable tax credits authorized by Congress. She is also the co-author of the Examinations chapter of the 8th Edition of Effectively Representing Your Client Before the IRS. Today she writes on a recent 4th Circuit decision at the intersection of tax and bankruptcy and brings to our attention a forthcoming article she has written on the same intersection triggered by another 4th Circuit decision that came out last year. If you want a more in depth discussion of offset you can look at the article written by Michael Waalkes and me which will be published later this year in the Florida Tax Review. Keith

Income tax refund offsets have been a hot topic on Procedurally Taxing, especially of late. While there has been interest in offset bypass refunds and injured spouse relief since long before the pandemic, the CARES Act added some new wrinkles. As has been well documented on this blog, Economic Impact Payments generally were not subject to offset, with some limited exceptions such as past due child support. Offset questions came up again in the context of the Recovery Rebate Credit.

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As we followed the legislative and administrative changes and implementation, it sparked conversations about how and when the IRS should exercise its discretionary refund offset authority under section 6402. Nina Olson revitalized a proposal that she had made prior to the pandemic, urging the IRS to be more proactive in granting offset relief in cases of economic hardship. Along similar lines, the ABA Section of Taxation recommended that the IRS implement systemic offset bypass relief for three categories of taxpayers during the pandemic.

Meanwhile, the Fourth Circuit has also had occasion to think about section 6402 in the last year, not in the context of COVID or offset bypass refunds, but in the context of bankruptcy. Two recent decisions from the circuit underscore how powerful a collection tool section 6402 remains for the IRS, leaving no ambiguity as to where the circuit stands on a question that has divided lower courts.

Keith blogged about the first decision, Copley v. United States, 959 F.3d 118 (4th Cir. 2020). Anticipating an income tax refund for tax year 2013, the Copleys listed the refund as a homestead exemption on their bankruptcy schedule prior to filing their income tax return. The Copleys had outstanding federal income tax liabilities for tax years 2008, 2009, and 2010; the tax debt for 2008 and 2009 was dischargeable in bankruptcy, while the debt for 2010 was nondischargeable. Despite the Copleys’ exemption claim, the IRS used its discretionary authority under IRC 6402(a) to offset the refund, applying it to tax years 2008 and 2009. Of course, applying it to the dischargeable tax debt was in the best interest of the IRS while also the worst possible economic outcome for the Copleys: if the homestead exemption did not entitle them to keep the refund for their fresh start, presumably they would prefer that it be applied to reduce the nondischargeable tax debt.

The Copleys brought an adversary proceeding in bankruptcy court seeking turnover of their tax refund, asserting that they had properly claimed it as exempt under Virginia’s homestead exemption provision as allowed by BC 522. Ultimately the matter was decided by the Fourth Circuit, which held that the refund became part of the Copleys’ bankruptcy estate, but that BC 553(a) preserves the IRS’s right of offset notwithstanding the Copleys’ exemption rights under BC 522(c). I wrote a forthcoming article about Copley in which I traced the case law split on this issue and discussed the significance of the Fourth Circuit’s holding.

The lower court case law is mixed and at times confusing, in part because it includes cases in which the IRS offset tax refunds to tax debt and also cases in which the Treasury made TOP offsets to nontax debt. The Bankruptcy Code’s automatic stay rule generally prohibits offset against prepetition debts; however, in 2005, Congress enacted BC 362(b)(26),  an exception that allows the IRS to offset a prepetition income tax refund against a prepetition income tax liability. As Keith has discussed, this exception does not extend to TOP offsets – the automatic stay limits the government’s right to offset a tax refund against a nontax debt.

Copley is the first circuit court opinion to resolve the tension between BC 522 and 553 while also finding the tax refund was part of the bankruptcy estate. In the conclusion of my article, I queried whether courts might limit the Copley holding to offsets of tax refunds against tax debts, as distinguished from offsets of tax refunds against nontax debts. Last month, while the article was still in the editing stages with the South Carolina Law Review, the Fourth Circuit provided an answer.

In Wood v. U.S. Department of Housing &  Urban Development, 993 F. 3d 245 (4th Cir. 2021), the Fourth Circuit followed Copley, holding that the government’s right under IRC 6402 to offset a tax refund against a preexisting nontax debt prevails over the debtors’ right under BC 522(c) to claim an exemption in their tax refund.

The Woods defaulted on a HUD-backed loan, which was subject to the Treasury Offset Program. The Woods filed bankruptcy in March 2018 and a week later filed their 2017 income tax return. Pursuant to IRC 6402(d), the government offset the federal income tax refund against the outstanding debt to HUD. The Woods brought an adversary proceeding in bankruptcy court, asserting that the tax refund was part of their bankruptcy estate, was protected by the automatic stay, and was protected by exemption under BC 522. The government argued that the tax overpayment was not considered a tax refund under IRC 6402, was thus not part of the bankruptcy estate, and therefore was not subject to exemption and not protected by the automatic stay. At the time of the adversary proceeding, the Fourth Circuit had not decided Copley.

Keith blogged about Wood last year when the district court affirmed the bankruptcy court’s  finding that the exemption provision of BC 522 disallowed a setoff under BC 553. While acknowledging a split on the issue, the district court found that the tax refund was part of the bankruptcy estate; it then followed other bankruptcy courts within the Fourth Circuit in finding that “a properly-claimed exemption trumps a creditor’s right to offset mutual prepetition debts and liabilities.” However, as Judge Wilkinson noted in Wood, “those courts lacked the guidance of [the Fourth Circuit’s decision in] Copley.” Judge Wilkinson’s Wood decision refers to IRC 6402(a) (offset against tax debts) and 6402(d) (offset against TOP debts) as “sister provision[s].” Importantly, the Wood decision notes that an offset under section 6402(a)  is discretionary while an offset under 6402(d) is mandatory, with the result that “the case for a statutory setoff right is even stronger [in Wood] for § 6402(d) than it was in Copley for § 6402(a).”

But as the opinion notes, that “is not the end of the matter” because unlike in Copley, the Wood court still had to had to address the applicability of the automatic stay. The district court in Wood noted that BC 362(b)(26)’s automatic stay exception does not apply to a TOP offset, with the result that the Woods’ tax refund was protected by the automatic stay. The district court rejected the government’s argument for retroactive annulment of the stay. In his blog post, Keith expressed surprise that the DOJ lawyer representing HUD would argue that the United States had the right to seek a retroactive annulment of the automatic stay to allow the offset. Keith noted that other federal agencies would need to go to Congress and have 362(b)(26) expanded if they wanted to use TOP while an individual was in bankruptcy.

The Fourth Circuit in Wood did not find this problematic, however. While acknowledging that 362(b)(26) does not apply to an offset against a HUD liability, and that the government’s actions violated the automatic stay, the court also noted that the government can seek relief from the stay and that “barring exceptional circumstances, the government’s motion for relief from the automatic stay in cases of this kind should ordinarily be granted” (citing Cumberland Glass Mfg. Co. v. De Witt on this point).  In remanding Wood to the lower court to consider that question, the Fourth Circuit emphasized the Copley precedent and its finding that “the government’s statutory setoff rights under § 6402 trump the Woods’ right to exempt their overpayment.”

It remains to be seen whether other circuits will follow the Fourth Circuit’s holdings in Copley and Wood as to the primacy of IRC 6402. In the meantime, debtors and bankruptcy attorneys should take note. In my article I outline a few takeaways, each of which highlight the need for careful planning when a bankruptcy debtor has outstanding tax debt. While Keith and Nancy Ryan come to my mind as notable exceptions, it is my observation that tax lawyers are not typically also bankruptcy experts and bankruptcy lawyers are not typically also tax experts. These two Fourth Circuit cases, however, are a reminder that both types of lawyers must be cognizant of the ways in which the statutory worlds of bankruptcy and tax collide.

Offset of Rebate Recovery Credit and Some Innocent Spouse News

We have written several posts on offset over the past year and offset posts continue to be the most popular posts we write.  It might be possible to start an offset blog based on reader interest.  Some prior posts are here (injured spouse offset issues); here (CARES Act offset exceptions); and here (offset bypass rules – most heavily visited post on our site.)

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The issue of offset of stimulus payments took an interesting turn this past week.  As you probably remember last year, in passing the CARES Act Congress took the extraordinary step of excepting from offset all debts except for past due child support.  This meant that stimulus payments in the first and second rounds went directly into the hands of taxpayers who would ordinarily have simply received a letter notifying them that their refund was taken to satisfy some past due debt. 

It looked like individuals who did not receive their stimulus payment for the first or second round and who could claim it as a Recovery Rebate Credit (RRC) as they filed their 2020 return would have the disadvantage of having the payment subject to federal tax offset and all of the other available offsets.  A recent post by the National Taxpayer Advocate (NTA) sets out some of the history on what the IRS did as it moved into the 2020 filing season. 

The bottom line is that the IRS has now decided to exercise its discretion under 6402(a) with respect to the offset of federal tax refunds to federal tax liabilities.  The IRS will allow refunds based on RRC to pass through to taxpayers without being offset to satisfy prior federal tax debts.  Great news for persons with only federal tax debts in their portfolio of debts subject to offset under the Treasury Offset Program (TOP) but less good news for taxpayers with other outstanding obligations.  For a detailed discussion of offset and an explanation of TOP, you can read an article recently written by Michael Waalkes and me found here.

The NTA points out two problems with the otherwise good news regarding the IRS decision to forego offset of refunds based on RRC.  First, the decision happened in the middle of the filing season after many taxpayers had already filed and already had their refunds offset.  A similar offset decision occurred last year when the Department of Education decided during the middle of the filing season not to exercise its right to offset federal tax refunds (and other federal payments) against outstanding student loan debts.  Individuals who filed early (i.e., those most likely to have substantial refunds) get treated differently than those who wait.  A similar issue has occurred during this filing season with unemployment benefits that Congress decided mid filing season to exclude from income.  (Though yesterday the Commissioner in his testimony before Congress said that the IRS was working on a way to fix this for early filing taxpayers without the need for them to file a superseding or amended return.) 

Should the unfairness of the treatment of early filers versus later filers cause the IRS not to adopt a change like this in the middle of a filing season?  Should the IRS (can the IRS) reverse the offsets it has already made during this filing season and put everyone on equal footing?  The NTA says “For taxpayers who already have had their RRCs offset to repay federal tax debts, we will work with the IRS to try to identify a way to make them whole.”  So, perhaps a fix will come for early filers with RRC based refunds, similar to what will happen for early filers reporting unemployment income.  This is a lot of extra work for the IRS when it is already strained recovering from the pandemic and pushing out stimulus payments.  If it can make this happen, it will be impressive.

The NTA pointed out a second problem with the IRS decision to exercise its discretion to allow the RRC refunds to bypass the federal tax offset – the IRS does not have the ability to keep these refunds from offset through TOP.  IRC 6402(a) gives the IRS discretion to waive offset of federal tax refunds but does not give it authority to waive offset of the other offsets that occur when a taxpayer has a federal tax offset.  The NTA says “Therefore, there remains a significant disparity between the treatment of taxpayers who received advance payments and the treatment of taxpayers who did not receive advance payments and are claiming their benefits as RRCs.”

Fixing the second problem requires Congressional action and passage of a bill with language similar to the CARES Act legislation last year.  There is no indication that such legislation is coming.  When the IRS is considering offset bypass refunds (OBR) discussed in the post linked above and in the article, it does not exercise its discretion when it can see a debt indicator on the taxpayer’s account alerting the IRS that the exercise of discretion will not put the money in the taxpayer’s hands but simply send it to the Bureau of Fiscal Services to satisfy another federal or state outstanding debt.  Because of the blanket decision to exercise discretion made with respect to RRCs, the IRS will benefit other federal and state creditors in some instances rather than the taxpayer.  While not optimal, this is the most the IRS can do with the authority it has.  It also provides a model for IRS moving forward that could benefit recipients of certain types of refunds, such as those generated by the earned income tax credit or other programs designed to put money in taxpayers’ hands.

Innocent Spouse news regarding the administrative record

We received correspondence from PT reader James Everett of DeFranceschi & Klemm, PC in Boston.  Mr. Everett represents the taxpayer in Sutherland v. Commissioner which Christine blogged here and I blogged here in the year in review post because of the importance of this case.  For those who do not remember Sutherland, it involves the issue of IRC 6015(e)(7) which limits Tax Court review in innocent spouse cases to the administrative record, including cases pending at the time of enactment that had already gone through the administrative process prior to the legislation creating the limitation.  The case was originally set for trial on December 2, 2020 in Boston but continued and rescheduled for trial on St. Patrick’s Day in Phoenix.  Most Bostonian’s would welcome a trip to Phoenix during the winter.  Alas, this trip was a virtual one. 

Here is the news from Mr. Everett regarding the IRS position on the administrative record:

The national office interjected itself into the case and the IRS objected to all documents that we wanted to include with the stipulation that weren’t part of the “administrative” record (i.e. documents not provided during the administrative stage).  In other words, it looked like the IRS was setting this case up for an appeal.  There was really no way of telling what the AO or CISCO actually reviewed previously because records weren’t kept in that fashion (since it didn’t matter with a de novo review).  Judge Lauber was going to require the IRS to call the appeals officer as a witness at the trial to discuss the record.  A few days before the trial, the IRS dropped its administrative record objections.  Judge Lauber asked the respondent’s counsel if this was reflection of Service wide policy (i.e., the IRS agreed that §6015(e)(7) didn’t apply to pending cases), respondent’s counsel candidly replied that this was above his paygrade to comment on – he could only speak to the case at hand. Thought this might be helpful to the readers of your blog.  

The withdrawal of objection to the administrative record is welcome news but does not resolve the issue.  The administrative record rule presents significant problems for individuals who go through the administrative process pro se, since they often fail to develop the full record needed if litigation occurs.