In U.S. v. White, 365 B.R. 457 (Bankr. M.D. Pa. 2007), the U.S. Bankruptcy Court for the Middle District of Pennsylvania addressed the issue of whether the Internal Revenue Service (“IRS”) may setoff the entire pre-petition debt against pre-petition claims that have been declared exempt, or whether the IRS is only allowed to setoff up to the amount of the priority claim. The court held that the IRS may setoff the entire debt and is not limited to the amount of the priority claim.
The proper treatment of the IRS’ setoff right in bankruptcy is unclear because of a possible conflict between sections 522(c) and section 553 of the Bankruptcy Code. Outside of bankruptcy, the IRS may normally offset tax overpayments (tax refunds) against a debtor’s outstanding tax liability. See 26 U.S.C. § 6402(a) (2006). This right is typically protected in bankruptcy by the operation of section 553, which provides that Title 11 “does not affect any right of a creditor to offset a mutual debt” that arose before the commencement of the case against a claim that also arose before the commencement of the case. See 11 U.S.C. § 553 (2006). However, in an effort to ensure that a debtor in a bankruptcy proceeding has the ability make a fresh start, section 522 provides that certain assets may be declared exempt, protecting them from the reach of creditors. See 11 U.S.C. § 522 (2006). In order to protect these exempt assets from creditors, section 522(c) provides that exempt assets may not be “liable” during or after the bankruptcy proceedings for any debt that arose before the case, with some limited exceptions. Id. One of these exceptions “specifically subjects these exemptions to prepetition, priority claims,” White, 365 B.R. at 459, which is why priority debt is not barred from setoff by section 522.
The source of the conflict is that it is unclear how these two statutes work together when there is a pre-existing right to setoff against assets the debtor has declared exempt. If the IRS would have a valid right to offset the debt outside bankruptcy, but the debtor has declared the overpayment exempt, section 522(c) dictates that the IRS could not take more than the amount of priority debt. However, section 553 dictates that the bankruptcy code cannot alter the IRS’ right to setoff. Whether the right of setoff of exempted assets is limited to the amount of the priority debt or whether it is allowed up to the full amount of overpayment is dependant on whether the court gives preference to section 553 or to section 522.