Freezing Refund Did Not Violate The Automatic Stay

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In United States v. Waters (In re Waters), No. 21-1219, 2022 WL 17086310 (2d Cir. Nov. 21, 2022) the court sustains the decision of the lower court that holding onto the debtor’s refund did violate the automatic stay.  I thought this issue was settled almost three decades ago by the Supreme Court in Citizens Bank of Md. v. Strumpf, 516 U.S. 16, 21 (1995) but debtor’s arguments here put a slight twist to the matter.


When a taxpayer goes into bankruptcy owing money to the IRS, the IRS wants to collect the outstanding debt in a manner that provides the most certainty.  If the taxpayer has a pre-petition tax debt and a pre-petition refund, the most certain way to collect the money is to offset it.  Offsetting avoids the muss and fuss of filing a proof of claim and hoping the estate has sufficient assets to satisfy the claim.  Sending a refund to a taxpayer at a time when the taxpayer owes taxes does not sit well with the IRS nor with any creditor.

Prior to 2005 the automatic stay at BC 362(a)(7) specifically prohibited offset as part of the automatic stay.  The Strumpf case arose in the context of the statute as it existed prior to 2005.  Strumpf did not involve the IRS but rather a bank.  It came out of the Fourth Circuit which had previously held that the IRS violated the automatic stay when it froze a taxpayer’s refund after the filing of a bankruptcy petition.  In Strumpf the Supreme Court said that the bank could freeze a debtor’s account in the situation where the debtor had an outstanding liability to the bank.  It rejected the debtor’s argument that the freeze amounted to an offset which the automatic stay prohibited.  The Court stated:

In our view, petitioner’s action was not a setoff within the meaning of § 362(a)(7). Petitioner refused to pay its debt, not permanently and absolutely, but only while it sought relief under § 362(d) from the automatic stay. Whether that temporary refusal was otherwise wrongful is a separate matter-we do not consider, for example, respondent’s contention that the portion of the account subjected to the “administrative hold” exceeded the amount properly subject to setoff. All that concerns us here is whether the refusal was a setoff We think it was not, because-as evidenced by petitioner’s “Motion for Relief from Automatic Stay and for Setoff”-petitioner did not purport permanently to reduce respondent’s account balance by the amount of the defaulted loan.

That decision opened the door for the IRS to also freeze refunds.  The Strumpf case did not say, however, that a creditor could freeze the debtor’s money indefinitely.  It contemplated that the creditor freezing the funds would relatively promptly come to the bankruptcy court seeking a lifting of the automatic stay and showing the necessity to do so in order to adequately protect the interest of the creditor as a secured creditor in the amount of the debtor’s funds it held.

In 2019 a district court decision, Wells Fargo Bank, N.A. v. Weidenbenner (In re Weidenbenner), No. 15-CV-244 (KMK), 2019 WL 1856276, at *4 (S.D.N.Y. Apr. 24, 2019) showed the hazards facing creditors who froze funds and did not act promptly to resolve the account.

In the bankruptcy court, Mr. Waters argued that the freeze of his refund violated BC 362(a)(1)(2) & (6).  He did not argue that it violated BC 362(a)(7) perhaps because of Strumpf or for other reasons.  In a footnote the Second Circuit notes:

Here, the IRS never sought the bankruptcy court’s approval to put in place or maintain its approximately two-year freeze. On other facts, such a lengthy freeze — coupled with the IRS’s failure to seek court approval — might constitute a violation of the automatic stay. But we need not pursue that possibility here because, for the reasons stated in text, no such violation occurred in this case.

Maybe Mr. Waters could have succeeded in arguing for a stay violation had he pushed the issue under subparagraph (a)(7).  Instead, he correctly dropped his arguments about subparagraphs (a)(1) and (5) in the appeal before the Second Circuit.  His arguments on those subparagraphs could go nowhere because both of those subparagraphs needed the IRS to commence an action or proceeding against him or a lien creation.  That did not occur under these facts.

He moved forward arguing that the freeze violated subparagraph (a)(6).  Here the court finds that the freeze did not violate this paragraph saying:

The IRS’s administrative freeze also did not violate Section 362(a)(6) because, on the facts of this case, the freeze did not constitute an act to collect, assess, or recover a claim against Waters. To determine whether a creditor violates Section 362(a)(6), courts routinely look at two standards. Some, including the district court below, evaluate whether a creditor’s conduct was of a nature that “(1) could reasonably be expected to have a significant impact on the debtor’s determination as to whether to repay, and (2) is contrary to what a reasonable person would consider to be fair under the circumstances.”… Applying the first standard, the district court determined that the IRS’s conduct “merely maintained the status quo” and did not constitute an act to collect, assess, or recover a claim. In making this determination, the district court relied on undisputed facts that Waters’s amended tax return claiming refunds for most of the taxes he paid violated a 2002 bankruptcy court order and that the IRS’s freeze was necessary to prevent Waters’s circumvention of that order.

The Court’s decision makes sense and follows the finding in Strumpf.  The fact that Mr. Water’s violated a court order in filing his claim kept him from making something out of the delay by the IRS in seeking resolution of the freeze.  The violation of the order may also have been why the IRS did not feel the need to seek a speedy resolution of the freeze.

Today, the landscape is different.  In 2005 Congress amended the bankruptcy code.  It did not eliminate the automatic stay with respect to offset, leaving subparagraph (a)(7) in the code, but it added a subparagraph to 362(b) the section describing exceptions to the automatic stay.  BC 362(b)(26) now allows the IRS to offset a pre-petition refund against a pre-petition liability if the refund and the liability both result from the same type of tax, e.g., both derive from income taxes or both derive from employment taxes. 

In most cases today, the IRS does not need to freeze refunds because it can offset them.  Only where the refund results from a different type of tax does the IRS need to freeze it and go through the same type of steps it needed to follow prior to the changes to the bankruptcy code in 2005.  Because freezing is now relatively rare rather than routine, the possibility that the IRS would fail to move quickly to resolve the freeze would seem to be greater though I have not noticed cases suggesting that debtors have pursued the IRS for stay violations of this type.

The 2005 change does not allow the IRS to offset a post-petition refund against a pre-petition liability and neither would the Strumpf decision allow a freeze in this context.  So, there are still times where freezing could cause problems for the IRS but those situations occur much less frequently that the ones the 2005 change now permits.

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