SETOFFS

(COMMISSION TRACK NUMBER 215)

Present Law

Bankruptcy Code Section 553 generally preserves a creditor's right to setoff a prepetition obligation of that creditor against such a creditor's prepetition claim against the debtor. However, section 362 imposes an automatic stay of the setoff of any prepetition debt owing to the debtor against any claim against the debtor (fn. 82). The creditor must seek relief from stay to make the setoff. These provisions apply to governmental and nongovernmental creditors alike. Although section 362(b) contains exceptions to the automatic stay, none of the exceptions permits setoffs of prepetition tax liabilities against prepetition tax refunds (fn. 83). In other words, if a debtor files a bankruptcy petition at a time when he or she owes taxes for a prepetition year but is entitled to a refund for another prepetition year, the IRS cannot, in most jurisdictions, presently apply that refund against the liability (without seeking relief from stay).

Proposals Before the Commission

Commission Track Number 215. The IRS has requested the Commission to propose permitting such setoff by adding a new subsection (b) (19) to section 362 as follows:

(19) under subsection (a) of this section, of the setoff by a governmental unit of a tax refund that arose before the commencement of the case against a tax liability that arose before the commencement of the case.

Government Working Group Proposal No. 13 would adopt this rule

The IRS estimates that it could obtain approximately $24 million in potential setoffs annually pursuant to this change. See IRS Proposal, p. 14. The Department of Justice makes a similar recommendation. See Report of the Justice Proposal, p. 100.

The IRS makes a separate proposal to extend the right of setoff to post-petition refunds. See IRS Proposal, p. 15.

Task Force Position

The Task Force opposes these proposals and recommends that no change be made to present law.

Reasons for Position

The IRS already has adequate means to ensure that it will receive the tax refund. The debtor is required to disclose the tax refund (or potential tax refund) on Schedule B of the petition as it is "property" of the debtor. If the IRS has a valid prepetition claim and is entitled to the setoff, it will ultimately keep the refund.

The IRS is not without remedy. Section 362(d) permits a creditor to request relief from the stay and upon notice and a hearing the relief shall be granted for cause or if the debtor does not have an equity in the property and the property is not necessary to an effective reorganization. Thus, the IRS may choose to request relief from the stay to setoff the prepetition refund against the prepetition liability. The notice and hearing requirements are essential to protect the rights of the other creditors that may be entitled to the funds under the priority rules contained in section 507. If the IRS is permitted to automatically setoff a refund against a tax liability, the other creditors will not be aware of the setoff and will not have a forum to protest the setoff. Also, the tax refund may be an asset of the debtor that is exempt from creditors. By permitting an automatic setoff, the debtor may be deprived of the ability to retain the exempt asset. There is no policy justification for depriving the debtor of an exempt asset merely because the asset happens to be a tax refund.

Finally, the rules as to setoffs apply to all creditors. With respect to this procedural matter, there is no justification for giving the IRS rights that are not enjoyed by other creditors. If the setoff rules are faulty, the Commission ought to deal with themgenerally.

Other Institutional Positions

The Association of the Bar of the City of New York opposes expanded setoff rights. A focus group of the American College of Bankruptcy takes the same position.

*************************FOOTNOTES**********************************

fn. 82: Bankruptcy Code Section 362(a)(7).

fn. 83: Local rules and standing orders in some districts allow taxing authorities to make some such setoffs without a motion. See Justice Proposal, p. 100; IRS Proposal p. 16

Questions, comments or suggestions? kbercik@taxcounsellor.com

Last updated June 1, 1997