In re Alexander
| Decision Date | 01 April 1998 |
| Docket Number | Bankruptcy No. 97-31085(3)7,Adversary No. 97-3126. |
| Citation | 225 BR 145 |
| Parties | In re Maurice Len ALEXANDER, Debtor. Maurice Len ALEXANDER, Plaintiff, v. COMMISSION, INTERNAL REVENUE SERVICE, Defendant. |
| Court | U.S. Bankruptcy Court — Western District of Kentucky |
Anne Marie Regan, Legal Aid Society, Inc., Louisville, KY, for debtor.
John Wilson, Louisville, KY, trustee.
The Plaintiff/Debtor, Maurice Alexander ("Debtor"), filed for Chapter 7 Bankruptcy on March 5, 1997. In his Petition, Debtor claimed an exemption in his anticipated federal income tax refund for tax year 1996, in an amount of $3,450.31. Thereafter, he received notice from the Defendant, the Internal Revenue Service (the "IRS"), that it had applied, or "set-off," the full amount of Debtor's 1996 refund against a dischargeable tax debt owed by Debtor for tax year 1991.
Debtor subsequently filed this Adversary Proceeding to recover from the IRS that portion of his 1996 tax refund which he claimed exempt. There are no material facts in dispute. This case turns on a question of law that has never before been addressed by the Sixth Circuit or by the Bankruptcy Courts sitting in the State of Kentucky: i.e., whether a creditor may exercise a right of set-off against exempt property of the Debtor.
The parties filed Cross-Motions for Summary Judgment, each party having extensively researched and briefed the question of law at issue. The Court has fully reviewed the numerous briefs filed by both parties, including all Response and Reply briefs and all of the case law cited by both sides. For the reasons set forth below, the Court will join with the majority of courts which have considered this issue, in holding that a debtor's exempt property may not be subject to set-off. Accordingly, Debtor's Motion for Summary Judgment will be sustained, and the IRS's Motion for Summary Judgment will be overruled.
Debtor filed his Chapter 7 Bankruptcy action on March 5, 1997. Debtor listed the IRS as a priority creditor holding a debt for federal income taxes for tax year 1991 in the amount of $660.00. Thereafter, the IRS notified Debtor of additional federal income taxes owed for tax years 1991, 1992, 1994 and 1995. Debtor subsequently amended his Bankruptcy Schedules to reflect the debt owed to the IRS as being in the amount of $6,110.00.
Debtor's tax liability for tax year 1991, the year that is of significance to this case, was incurred in the following manner. Debtor originally received an Earned Income Tax Credit for tax year 1991, in the amount of $1,722.00. Several years later, in 1994, the IRS notified Debtor that both his filing status as "Head of Household" and his Earned Income Tax Credit for 1991 had been disallowed. This had the consequential effect of reducing Debtor's exemptions and standard deductions. As a result of these adjustments, Debtor was notified that he owed the IRS $2,659.00 for tax year 1991. By the time Debtor filed for bankruptcy, this amount had grown to $3,477.00.
While Debtor owed a tax liability for tax years 1991, 1992, 1994 and 1995, Debtor was entitled to receive a federal income tax refund for tax year 1996. Debtor qualified for an Earned Income Tax Credit in the amount of $2,742.00, and expected to receive a tax refund based on his withholding in the amount of $735.00. Debtor listed these refunds in his Bankruptcy Petition as property in which he possessed an ownership interest, and claimed an exemption with regard to both. Debtor claimed the $2,742.00 Earned Income Tax Credit as exempt under K.R.S. 205.220(3),1 and claimed $708.31 of the $735.00 tax refund based on withholding under K.R.S. 427.160.2 Debtor was unable to claim the full amount of the $735 .00 tax refund as exempt, as he used the balance of his $1,000.00 exemption under K.R.S. 427.160 to exempt his otherwise non-exempt earnings. Consequently, Debtor was able to claim all but $26.29 of his 1996 Federal tax refund as exempt. No objections were filed thereto.
Shortly after Debtor filed his bankruptcy action, the IRS notified Debtor that the full amount of his 1996 refund, totaling $3,477.00, had been applied to the taxes Debtor owed for tax year 1991. Counsel for Debtor contacted the IRS and was advised that the IRS would not release the funds to Debtor. It is undisputed that Debtor's tax debt for tax year 1991 is dischargeable. Nevertheless, it is the IRS's position that the interception of Debtor's 1996 tax refund was a valid set-off under 11 U.S.C. § 553.
The issue which must be resolved by this Court is whether the IRS was entitled to exercise its right to set-off against property in which Debtor claimed an exemption; i.e., his 1996 tax refund.
The United States Supreme Court has addressed the application of set-off in the context of bankruptcy proceedings in the case of Citizens Bank v. Strumpf, 516 U.S. 16, 116 S.Ct. 286, 133 L.Ed.2d 258 (1995). "The right of set-off (also called `offset') allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding `the absurdity of making A pay B when B owes A.'" Id., 516 U.S. at 16, 116 S.Ct. 286. The Bankruptcy Code does not create a federal right of set-off. Id. However, if a party possesses a right of set-off outside of bankruptcy, 11 U.S.C. § 553(a) preserves that right when certain conditions are met. Id.
Section 553(a) reads:
Except as otherwise provided by this section and in sections 362 and 363 of this title, this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case.
(emphasis added). Thus, to offset a debt under § 553, there must not only be a mutuality of parties, but also a mutuality of obligations. In re A.J. Nielson, 90 B.R. 172, 175 (Bankr.W.D.N.C.1988); In re Pyramid Indus., Inc., 170 B.R. 974 (Bankr.N.D.Ill.1994), aff'd., 210 B.R. 445 (N.D.Ill.1997); In re Julien Co., 136 B.R. 784 (Bankr.W.D.Tenn. 1992).
The Court notes that the language of § 553(a) has been construed as being permissive in nature, rather than mandatory. Cumberland Glass Mfg. Co. v. De Witt, 237 U.S. 447, 455, 35 S.Ct. 636, 59 L.Ed. 1042 (1915); Internal Revenue Service v. Norton, 717 F.2d 767, 772 (3rd Cir.1983); In re Miel, 134 B.R. 229, 234 (Bankr.W.D.Mich.1991); In re Cabrillo, 101 B.R. 443, 448 (Bankr.E.D.Pa. 1989). Section 553(a)'s "application, when properly invoked before a court, rests in the discretion of that court, which exercises such discretion under the general principles of equity." Norton, 717 F.2d at 772 quoting 4 Collier on Bankruptcy ¶ 553.02, at 553-11 (15th Ed.1983).
In this case, the non-bankruptcy law upon which the IRS relies for its right to set-off is Section 6402 of the Internal Revenue Code. That provision permits the IRS to set-off any existing tax deficiencies against any tax refunds due to the taxpayer. 26 U.S.C. § 6402(a). There is no dispute in this case that there is a mutuality of parties, a mutuality of obligations, and both obligations arose prepetition. Thus, the general requirements necessary to set-off a debt under § 553 of the Bankruptcy Code have been met. What distinguishes this case, however, is the fact that the property against which the IRS attempts to exercise its right to set-off is exempt property of the Debtor.
Debtor properly claimed his 1996 tax refund as exempt pursuant to § 522 of the Bankruptcy Code, governing exemptions. While § 522 sets forth federal exemptions permitted under the Bankruptcy Code, the section also contains an opt-out provision, permitting states to substitute their own exemption provisions. § 522(b). Kentucky is an opt-out state, and in this case, Debtor claimed his 1996 Earned Income Credit as exempt under K.R.S. 205.220(3). That provision exempts all public assistance benefits from levy or execution. Federal Earned Income Credit benefits have been determined to be public assistance benefits within the meaning of K.R.S. 205.220(3), and therefore, are exempt from all claims of creditors in bankruptcy. In re Brown, 186 B.R. 224 (Bankr.W.D.Ky.1995).
With regard to Debtor's 1996 tax refund based on an overpayment of withheld taxes, Debtor claimed $708.31 of that refund as exempt under K.R.S. 427.160. That Statute provides a $1,000.00 general exemption that can be applied by a debtor in bankruptcy to property of any nature.
As no objections were filed to Debtor's claimed exemptions, his 1996 federal tax refund became exempt under § 522(a). Taylor v. Freeland, 503 U.S. 638, 643, 112 S.Ct. 1644, 118 L.Ed.2d 280 (1992) (); In re Monteith, 23 B.R. 601, 602 (Bankr.N.D.Ohio 1982). As a result, § 522(c) comes into play.
Section 522(c) provides in relevant part that property exempted from the bankruptcy estate shall not be liable for any debts arising before the bankruptcy was filed, unless such debt falls into one of the exceptions specified in § 522(c)(1) through (3). Sections 522(c)(1) and (3) except certain nondischargeable debts from § 522(c)'s application, while subsection (c)(2) excepts debts secured by a lien. There is no dispute in this case that Debtor's tax obligation for tax year 1991 was not secured by a lien. Additionally, the parties have both conceded that Debtor's 1991 tax year obligation was dischargeable in nature. Thus, the exceptions to § 522(c) do not apply.
As the exceptions to § 522(c) are not relevant, it is clear from the language of that Section that the tax refund owed to Debtor for tax year 1996 cannot be used to satisfy Debtor's prepetition tax debt for tax year 1991....
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