A recent district court case demonstrated the interesting interaction between a tax overpayment, bankruptcy, and a Treasury offset under the Treasury Offset Program. 

In the case, the taxpayers borrowed money for a home purchase; the loan was insured by the United States Department of Housing and Urban Development (HUD). The taxpayers later defaulted on the loan, and HUD paid the remaining balance, which it then demanded from the taxpayers. 

In 2018, the taxpayers filed for bankruptcy. On their income tax returns filed shortly after the bankruptcy, the taxpayers reported federal and state income tax overpayments. 

Under the Treasury Offset Program, the Treasury used the federal income tax overpayment to offset the debt owed to HUD (an earlier income tax offset was applied in 2017, too). 

The Treasury Offset Program basically allows the Treasury to use tax overpayments to satisfy preexisting debts to federal agencies. You can learn more about the Treasury Offset Program here (Treasury website). In short, instead of getting the tax overpayment refunded to you, the funds get applied to the outstanding debt. 

When a bankruptcy case is filed, a bankruptcy estate is created, which comprises all the legal or equitable property interests of the debtor. Relatedly, the automatic stay also arises, which protects the property of the estate; indeed, the automatic stay is a powerful protection provided to debtors. 

Thus, the court noted two issues. First, whether the tax overpayment was property of the bankruptcy estate (and, as such, was protected by the automatic stay). Second, whether the overpayments could be exempted (and thereby defeat the government’s right to offset/setoff as a creditor). Stated more simply, the interaction between the tax overpayment, bankruptcy, and the Treasury offset. 

Relying on previous cases, the court noted that the tax overpayment become property of the taxpayer at midnight on December 31 of the taxable year of the overpayment. As such, unless the offset was completed by that time, the property interest in the overpayment vested. 

Here, the government had not yet completed the offset by the time the bankruptcy case was filed, so the tax overpayment was a property interest that became part of the bankruptcy estate and entitled to its protection.  Consequently, the court noted that, to effectuate the offset, the government needed a relief from stay or other statutory exception (i.e., 11 U.S.C. § 362(b)). 

Now, the court did note that a circuit split exists on this particular issue. Some courts, for instance, have held that tax overpayments are “contingent property interests that do not become part of the bankruptcy estate if the tax overpayment is less than preexisting debt owed.” The reasoning here being that, if the prior tax debt was larger than the tax overpayment, then the debtor was not entitled to a refund—that is, no refund became property of the estate.

Nevertheless, the court noted that a majority of courts consider tax overpayments to become a part of the bankruptcy estate. Moreover, the court reasoned that, if Congress wanted to exempt tax overpayments from the estate, Congress could have done so, like it had done for other property interests in 11 U.S.C. § 541(b). 

The next wrinkle was the interaction between the bankruptcy exemption statute and the bankruptcy setoff provision. In bankruptcy, debtors are able to exempt certain property by statute, i.e., property that is protected from creditors. However, as noted by the court, another section of the bankruptcy code preserves a creditor’s right of setoff. Again, the court explained that courts have reached different conclusions on the result when a tax overpayment is at issue. 

The Fourth Circuit, the circuit in which the case was decided, had not yet decided the specific issue. But the court explained that other courts in the Fourth Circuit have held that exemptions trump the creditor’s right to setoff. After reviewing several statutory and policy concerns, the court concluded that the bankruptcy exemptions trumped the bankruptcy setoff provisions as applied to the Treasury Offset Program.

The court also rejected the government’s argument for a retroactive modification of the automatic stay. 

In sum, the District Court affirmed the Bankruptcy Court’s decision to return the tax overpayment to the debtors. 

The case is In re Wood, No. 5:19-cv-00302 (S.D.W. Va. Dec. 16, 2019).