U.S. on Behalf of I.R.S. v. Norton

• Citation: 717 F.2d 767,9 C.B.C.2d 336
• Decision Date: 12 September 1983
• Docket Number: 82-1837,Nos. 82-1836,s. 82-1836
• Parties: 83-2 USTC P 9583, 9 Collier Bankr.Cas.2d 336, 10 Bankr.Ct.Dec. 1337, Bankr. L. Rep. P 69,367 UNITED STATES of America on Behalf of its Agency INTERNAL REVENUE SERVICE, Appellant, v. William H. NORTON, Carrie W. Norton, f/k/a Carrie A. Woodward, Appellees.
• Court: United States Courts of Appeals. United States Court of Appeals (3rd Circuit)

Page 767

717 F.2d 767

83-2 USTC P 9583, 9 Collier Bankr.Cas.2d 336,

10 Bankr.Ct.Dec. 1337, Bankr. L. Rep. P 69,367

UNITED STATES of America on Behalf of its Agency INTERNAL

REVENUE SERVICE, Appellant, v. William H. NORTON, Carrie W. Norton, f/k/a Carrie A.

Woodward, Appellees.

Nos. 82-1836, 82-1837.

United States Court of Appeals, Third Circuit.

Argued July 21, 1983.

Decided Sept. 12, 1983.

Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, Wynette J. Hewett (argued), Bruce R. Ellison, Attys., Tax Div., Dept. of Justice, Washington, D.C., for appellant; Peter F. Vaira, Jr., U.S. Atty., Philadelphia, Pa., of counsel.

Mitchell W. Miller (argued), Philadelphia, Pa., for appellees.

Before ADAMS and HIGGINBOTHAM, Circuit Judges, and TEITELBAUM, District Judge ^*.

OPINION OF THE COURT

ADAMS, Circuit Judge.

Shortly after the debtors filed a petition for an adjustment of their debts under the Bankruptcy Reform Act of 1978, hereinafter referred to as the Code, the Internal Revenue Service (IRS) retained a portion of a tax overpayment that was due the debtors. The principal issue before us in this appeal is whether this action by the IRS violated the automatic stay provisions of the Code. We hold that it does.

I

On October 2, 1980, William and Carrie Norton, the appellees filed a petition for an adjustment of their debts under Chapter 13 of the Code. In their plan, the Nortons scheduled the IRS as the holder of a priority tax claim with respect to an income tax deficiency for 1978 in the amount of $762.00. ¹ The plan stipulated for payment in full of that claim over a three year period. ²

Before the plan was confirmed on April 23, 1981, the debtors filed an income tax return for the 1980 tax year, which showed that they were entitled to a refund of $2,052.78. The IRS refunded $1,314.81, but retained $737.97 on account of the Nortons' 1978 tax liability. Thereafter, on May 14, 1981, the debtors filed an application with the Bankruptcy Court seeking release of the $737.97 that had been retained by the IRS. The Bankruptcy Court found that the IRS was not entitled to retain the $737.97 and ordered that that sum be returned to the debtors. ³ The Bankruptcy Court also found that, in retaining the debtors' tax refund, the IRS had violated the automatic stay the Code imposes on creditors of a debtor who files a petition under Chapter 13. ⁴ Finally, because of the IRS policy of retaining the refunds of all taxpayers who have filed a petition under the Code, ⁵ the Bankruptcy Court held the IRS in contempt and imposed a fine of $150.00. ⁶ The IRS appealed from these judgments to the District Court which affirmed both the contempt citation and the Bankruptcy Court's order that the full refund be turned over to the debtor. United States v. Norton (In re Norton), 9 B.C.D. 1033, 32 B.R. 698 (E.D.Pa.1982). The IRS has filed a timely appeal.

II

The legislative history of the Bankruptcy Reform Act is replete with references to the effect the proposed legislation would have on the collection of taxes. See, e.g., S.Rep. No. 1106, 95th Cong., 2d Sess. (1978) (Committee on Finance); S.Rep. No. 989, 95th Cong., 2d Sess. (Judiciary Committee) reprinted in 1978 U.S.Code Cong. & Ad.News 5787. These references make clear that the Bankruptcy Code attempts to reconcile three sets of interests that usually co-exist in tension: the interests of general creditors who do not want a debtor's funds to be exhausted by accumulated back taxes; the interests of debtors whose "fresh start" should not be burdened by accumulated taxes; and the interests of the public in not losing taxes whose collection the law has restrained.

In balancing these interests, the Congress gave the IRS a priority claim on the assets of a debtor's estate for tax liabilities that had not grown so "stale" as to burden general unsecured creditors who may have extended credit after the liabilities arose. To avoid hampering the debtor's fresh start, Congress coordinated the priority and discharge provisions of the Code so that unpaid taxes accorded priority are nondischargeable, while tax claims that are not given priority are usually not collectible from the debtor's post-bankruptcy assets. S.Rep. No. 1106, supra at 5; S.Rep. No. 989, supra at 14-15.

The IRS, in the case at bar, is in the preferred position of holding a secured claim with priority. Section 506 of the Code declares that an allowed claim of a creditor subject to setoff under Sec. 553 is secured to the extent of the amount subject to setoff. The unsecured balance of a tax claim on income greater than the amount of the setoff is accorded priority under Sec. 507(a)(6). A Chapter 13 plan must provide for full payment of priority claims and must provide for payment to a holder of a secured claim of an amount not less than the allowed secured claim. 11 U.S.C. Secs. 1322(a)(2), 1325(a)(5) (1979). Tax claims entitled to priority under Sec. 507(a)(6) are not dischargeable in a Chapter 13 case, and there can be no composition of priority tax debts. Id. Secs. 523(a)(1)(A), 1322(a)(2). Finally, to the extent that the claim of the IRS for back taxes is secured, the debtor must provide "adequate protection" to insure that the government receives the "indubitable equivalent" of its claim; the debtor can do so by making "periodic cash payments" to the creditor. Id. Sec. 361(1) and (3).

The plan for the adjustment of their debts filed by the Nortons and confirmed by the Bankruptcy Court provided for payment in full of the Government's priority claim on the pre-petition tax liability. The debtors have been conscientious in conforming to the terms of that plan. Each time they make a scheduled payment, the IRS refunds the amount of the payment from the monies it withheld. Transcript of Oral Argument at 15. The IRS refuses to honor the turn-over order of the Bankruptcy Court and argues that its partial retention of the Nortons' tax overpayment does not violate the automatic stay that the Code imposes on attempts by creditors to satisfy their claims against petitioners in bankruptcy.

III

Typically, a debtor has already been sued or threatened with legal action by the time a voluntary petition is filed. To ease the financial pressures--legal and extra-legal--that forced the debtor into bankruptcy, the Code provides that the filing of a petition results in an automatic stay of most actions by creditors to satisfy their claims against the debtor. 11 U.S.C. Sec. 362 (1979).

The automatic stay has been described as one of the most fundamental protections accorded debtors under the bankruptcy laws. "It gives the debtor a breathing spell from his creditors. It stops all collection efforts, all harassment, and all foreclosure actions," while the debtor attempts to reorganize or develop a plan by which to satisfy the claims of his creditors. H.R.Rep. No. 595, 95th Cong., 1st Sess. 340 (1977), reprinted in 1978 U.S.Code Cong. & Ad.News 5787, 6296. These features of the stay mechanism are designed to protect creditors as well as debtors. As the Report by the House Committee on the Judiciary put it:

... without [the automatic stay], certain creditors would be able to pursue their own remedies against the debtor's property. Those who acted first would obtain payment of [their] claims in preference to and to the detriment of other creditors. Bankruptcy is designed to provide an orderly liquidation procedure under which all creditors are treated equally. A race of diligence by creditors for the debtor's assets prevents that.

Id.

The scope of the automatic stay is broad. It prohibits, among other things, any act to obtain possession of property belonging to the debtor's estate, any act to collect on a claim against the debtor that arose before the filing in bankruptcy, and any act to set off a debt owing to the debtor that arose before the filing. 11 U.S.C. Sec. 362(a) (1979).

This last prohibition restrains a creditor from setting off a claim of the debtor against a debt owing to the creditor. That right is generally preserved in the Bankruptcy Code, which "does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor...." 11 U.S.C. Sec. 553 (1979). However, by the very terms of Sec. 553, that right is limited by the automatic stay provisions of Sec. 362. ⁷ Thus, before a setoff can be made against the debts owed by a petitioner in bankruptcy, a creditor must seek relief from the automatic stay. Even setoffs effected before bankruptcy may be investigated and reviewed by the Bankruptcy Court. Id. Secs. 553(a)(3) and (b)(1).

The interaction of sections 553 and 362 and the precise meaning of the term setoff form the core issue of this case. The Nortons and the courts below agree that the IRS violated the automatic stay imposed by section 362 in withholding the Nortons' 1980 tax refund and setting it off against their pre-petition tax debts. The IRS maintains that, in withholding a portion of the Nortons' overpaid taxes, it has not violated the automatic stay. Rather it has simply "frozen" the debtors' account so as to preserve its setoff rights against the Nortons. The automatic stay does not extinguish setoff rights, according to the Government; it simply postpones their enforcement. In concluding that the retention of the debtors' funds by the IRS violated the automatic stay, the courts below, in the Government's view, erroneously equated the retention of funds and the exercise of a setoff and, thus, ignored the IRS's right to credit overpayments against tax liabilities as specified in the Internal Revenue Code and preserved in the Bankruptcy Code.

This is not the first time that the IRS's policy of retaining overpaid taxes has led to litigation in the bankruptcy courts, ⁸ although it appears to be the first time that a court of appeals has been called upon to review this apparently vexatious controversy that has arisen between the IRS and the bankruptcy bar.

A

The Government argues...