We represent business owners and individuals in bankruptcy and commercial litigation frequently. On March 31, 2019, in Wood v. Dept. of Housing & Urban Development (In re Wood), 18-5006 (Bankr. S.D. W.Va. Mar. 31, 2019), the court addressed the issue concerning whether a debtor’s tax overpayment was protected by the automatic stay and was an asset that the debtor could exempt. The U.S. Treasury had offset a deficiency owed to the Department of Housing and Urban Development, or “HUD”, with a federal tax overpayment after a bankruptcy was filed. Typically, if one department of the federal government is a creditor of a taxpayer, and another is a debtor, the government will offset the payments. The Court held that in bankruptcy, such offsets are not allowed.
In Wood, the debtor, Larry Wood, defaulted on a loan to purchase a mobile home in July 2014. The loan was insured by HUD, so HUD paid the deficiency on the loan in November 2015. HUD issued Mr. Woods a “Notice of Intent to Collect by Treasury Offset,” which stated that the U.S. Department of Treasury could offset the deficiency with any of the Woods’ tax overpayments and remit those funds to HUD.
Mr. Woods and his wife filed for Chapter 7 bankruptcy protection in March 2018 and filed their tax returns later that month. Mr. Woods claimed an exemption in a scheduled 2017 federal tax overpayment of about $6,000. The U.S. Treasury, however, proceeded to offset the debt to HUD on April 4, 2018, with the federal income tax overpayment.
The debtor commenced an adversary proceeding to recover and exempt the overpayment the U.S. Treasury had offset. The court was confronted with a split in the case law on two matters: (1) whether a debtor’s tax overpayment becomes property of the estate and is protected by the automatic stay; and (2) whether the debtor may exempt the overpayment and defeat a governmental creditor’s right of setoff under 11 U.S.C. § 553.
A right of setoff is governed by 11 U.S.C. § 553, which provides that a creditor may exercise its right of setoff without violating the Bankruptcy Code in certain situations permitted by applicable nonbankruptcy law. Here, the nonbankruptcy law authorizing the Treasury to intercept tax overpayments and apply them to debts owed to federal agencies is 26 U.S.C. § 6402 (the “Tax Offset Program”).
The court ultimately agreed with other courts in his circuit: setoff rights under 26 U.S.C. § 6402 are subject to the automatic stay. The Woods’ right to a tax overpayment vested in them at midnight on December 31, 2017. They properly exempted their anticipated federal tax refund on their bankruptcy schedules. Thus, the exempted overpayment was property of the bankruptcy estate, protected by the automatic stay, and not available for setoff by HUD after the bankruptcy petition was filed.
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