Anthony S. Gould

OCR transcription for search; preserved printed pages are authoritative

UNITED STATES BANKRUPTCY COURT

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GPO

Entered on Docket
April 01, 2008

GLORIA L. FRANKLIN, CLERK
U.S BANKRUPTCY COURT
NORTHERN DISTRICT OF CALIFORNIA

UNITED STATES BANKRUPTCY COURT
NORTHERN DISTRICT OF CALIFORNIA
In re Case No. 05-50292-ASW
Anthony S. Gould, Chapter 13

Debtor.

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MEMORANDUM DECISION
ON MOTION FOR RELIEF FROM STAY BY IRS

Before the Court is the Motion by United States for Relief
from Stay to Set Off Tax Refund (the “Motion”) brought by the
United States of America, for itself and on behalf of the Internal
Revenue Service (collectively, the “IRS”). The IRS requests that
the automatic stay of Bankruptcy Code § 362! be modified to permit
it to offset pre-petition income tax liabilities owed by debtor

Anthony S. Gould (“Debtor”) against pre-petition income tax

* Unless otherwise provided, all references to code sections

shall mean the Bankruptcy Code, codified in Title 11 of the United
States Code, 11 U.S.C. § 101, et seq., including all amendments
thereto.

MEMORANDUM DECISION ON MOTION
FOR RELIEF FROM STAY BY IRS

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1 || refunds’? claimed by Debtor.
2 Debtor is represented by David A. Boone, Esq. and Leela V.
3 ]}/Menon, Esq. of the Law Offices of David A. Boone. Special
4]/ Assistant United States Attorneys John W. Strate and Rex K. Lee
5 || represent the IRS.
6 This Memorandum Decision constitutes the Court’s findings of
7) fact and conclusions of law, pursuant to Rule 7052 of the Federal
8 || Rules of Bankruptcy Procedure.
9
10 I.
11 FACTS
12 Debtor is a divorced father with two teenage dependent
13 | children.’ He earns $3,100 per month working as a mechanic,‘ and
14} his monthly expenses are $3,025.5 He has very few assets and very
15 | few liabilities, other than tax liabilities and refunds. Debtor’s
16 || only significant assets are a 1987 Jeep Cherokee, a state income
17 || tax refund in the amount of $3,217.00, and the federal income tax
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1 * While the Motion primarily refers to “tax refunds,” it also
uses the term “tax overpayment.” The Court notes that these terms,
97 |J at least as used in some of the relevant caselaw, are not
interchangeable. The use of the term “tax overpayment” has certain
23 | built-in analytical assumptions. For this reason, the Court shall
use the more neutral term “tax refund.”
24
3 ee Schedule I.
25
* Schedule I shows Debtor earns $3,100.00 per month working
26 | as a mechanic for Railway Distributing. This is his only source of
income.
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28 ° See Schedule J.
MEMORANDUM DECISION ON MOTION
FOR RELIEF FROM STAY BY IRS 2

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refund in the amount of $6,852.00 currently at issue.®

Debtor’s only significant debts are for income taxes.’ Prior
to the filing of his bankruptcy case, Debtor failed to file federal
tax returns for 1999 through 2004. Pre-petition, Debtor owed
roughly $28,000 to the Franchise Tax Board (the “FTB”) and roughly
$10,000 to the IRS for unpaid income taxes stretching back to 1991.

On January 20, 2005 (the “Petition Date”), Debtor filed his
Voluntary Petition under Chapter 13 of the Bankruptcy Code, his
Chapter 13 Plan (the “Original Plan”) and his Schedules.

The IRS filed its initial proof of claim against Debtor on
February 24, 2005, which included estimated income taxes due for
1999-2004.® On March 2, 2005, the IRS filed an objection to
confirmation of the Original Plan on the basis of Debtor’s failure
to file tax returns and the Original Plan’s failure to provide full

payment for the IRS's priority claim as required by Bankruptcy Code

° See Amended Schedule A and Amended Schedule B. Debtor's
Amended Schedule B lists personal property with a current market
value of only $15,964.00 -- of which, $11,047.00 is attributable to
federal tax refunds and $3,217.00 is attributable to state tax
refunds.

7 The only secured claim noted on Amended Schedule D is a tax
lien by the FTB securing a claim of $28,122.57. Amended Schedule E
only lists priority claims by the FTB in the amount of $4.00 and by
the IRS in the amount of $255.00 -- both for 2001 income taxes.
Schedule F shows six general unsecured claims totaling $32,822.62
-- the largest being a $27,078.55 debt to the FTB for 1993-1998
income taxes. The Claims Register shows seven proofs of claim have
been filed in this case -- five by the IRS, one by the FTB
asserting a secured claim of $28,122.57, and one by Wells Fargo
Bank asserting a general unsecured claim of $447.38.

8 United States’ (IRS‘s) Supplemental Brief in Support of
Motion for Relief from Stay, filed May 15, 2006, 3:15-18.

MEMORANDUM DECISION ON MOTION
FOR RELIEF FROM STAY BY IRS

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§ 1322(a)(2).?

On May 26, 2005, Debtor filed Amended Schedules B, C, D and E
(the “Amended Schedules”). On his Amended Schedule B, Debtor lists
claims for federal income tax refunds for tax years 2002, 2003 and
2004 totaling $11,047.00.?° On his Amended Schedule C, Debtor

claimed the following exemptions:

Property Basis in CCP Value
Household furniture, 703.140 (b) (3) $500.00
appliances, etc.

Clothes, shoes and 703.140 (b) (3) $300.00
accessories

Checking account 703.140 (b) (5) $400.00
1987 Jeep Cherokee 703.140(b) (2) $500.00
2002, 2003, 2004 Fed 703.140 (b) (5) $6,852.00
Income Tax Refunds

2002, 2003, 2004 FTB 703.140 (b) (5) $3,217.00
Refunds

° On March 15, 2005, the Chapter 13 Trustee also filed an
objection to the Original Plan on the basis of Debtor’s failure to
file his federal income tax returns for 2001-2004. This objection
was withdrawn on September 13, 2005, after Debtor filed said tax
returns.

10 Debtor has subsequently acknowledged that this amount is
incorrect. The tax refunds claimed as exempt by Debtor actually
total $6,852. See Declaration of Debtor as to Facts Re Opposition
to Internal Revenue Service’s Motion for Relief from the Automatic
Stay, filed January 18, 2006, at 2:14-17 (“I have exempted a total
of $11,047.00 in tax refunds in the Amended Schedule C filed with
the Court based upon an expected refund of $4,1950.00 [sic] for
2003. However, the Amended return filed for that year, 2003,.
indicates a liability due in the amount of $2,314.00.”)

11 Amended Schedule C incorrectly states the amount of this
claimed exemption to be $11,047.00. See footnote 10 supra.

MEMORANDUM DECISION ON MOTION
FOR RELIEF FROM STAY BY IRS

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No party, including the IRS, filed a timely objection to the
exemptions claimed by Debtor in his Amended Schedule C.

At the time Debtor filed the Amended Schedules, Debtor had not
yet filed his tax returns for the years 1999 through 2004. In
June and July of 2005, Debtor filed these tax returns. The

balances indicated on these tax returns by Debtor are as follows:

Year Refund Claimed Deficiency Owed
1999 $2,226.00
2000 $2,291.00
2001 $255.00
2002 $2,414.00
2003 $2,314.00
2004 $4,438.00
$11,369.00 $2,569.00

Declaration of Debtor as to Facts Re Opposition to Internal Revenue
Service’s Motion for Relief from the Automatic Stay (“Debtor’s
Decl.”), filed January 18, 2006, 2:7-17.

After Debtor filed his Amended Schedules and his tax returns
for 1999 through 2004, the IRS filed several subsequent amended

Proofs of Claim."

12 The IRS could have objected to the exemptions on the basis

that Debtor had not filed these tax returns, but the IRS did not do
so.

13 The 1999 and 2000 claims for refund are presumably barred
by the statute of limitations to seek such refunds. 26 U.S.C.

§ 6511(a). This issue was not addressed by the parties. However,
the Court notes this potential bar, as those amounts might
otherwise impact the IRS’s claim of setoff.

14 The IRS filed its first amended Proof of Claim on July 8,
2005, which was objected to by Debtor on August 19, 2005. On
August 26, 2005, the IRS filed its second amended Proof of Claim,
asserting a priority claim of $307.51 and an unsecured claim of
$9,664.93, for a total of $9,972.44 -- including penalties and
interest.

MEMORANDUM DECISION ON MOTION
FOR RELIEF FROM STAY BY IRS

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Debtor filed his First Amended Chapter 13 Plan on May 26, 2005
(the “Amended Plan”). No objections were filed to the Amended
Plan. The Amended Plan was confirmed on October 5, 2005. The
Amended Plan provides that Debtor will pay the sum of $75 per month
to the Chapter 13 Trustee for a term of 37 months. This results in
a distribution to general unsecured claims of approximately 2 cents
on the dollar.

The IRS filed this Motion on October 25, 2005 seeking to
exercise certain alleged setoff rights under Bankruptcy Code § 553.
Specifically, the Motion asked that the automatic stay be modified
to allow the IRS to “offset the tax refunds totaling $8,733 owed by
the IRS to the debtor against the IRS’ claim of $9,972.44 against
the debtor.” Motion, 4:2-4.

While this Motion was pending before the Court, the IRS filed
two subsequent amended proofs of claim. Or May 22, 2006, the IRS
filed its third amended Proof of Claim, asserting a priority claim
of $2,709.93 and an unsecured claim of $9,780.63, for a total of
$12,490.56. On July 10, 2006, the IRS filed a fourth and final
amended proof of claim, in the total amount of $9,972.44 (the

“TRS’s Final Proof of Claim”), divided as follows:

Secured Claim pursuant to “Right to setoff”

$2,702.17 Deficiency owed for 1991 tax period
$2,488.72 Penalty on 1991 deficiency to Petition Date
$1,661.11 Interest on 1991 deficiency to Petition Date
$6,852.00

1S Under the Amended Plan, there are no secured claims.

MEMORANDUM DECISION ON MOTION
FOR RELIEF FROM STAY BY IRS

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Unsecured Priority Claim under 507(a) (8)?°

$255.00 Deficiency owed for 2001 tax period
$52.51 Interest on 2001 deficiency to Petition Date
$307.51
General Unsecured Claim
$2,679.78 Balance of Pre-petition interest for 1991
deficiency
$133.15 Interest to Petition Date Priority Claim for

===s==5=5=== 2001 deficiency
$2,812.93
The balances owing between the parties are unclear. The

amounts of the income taxes or refunds owing, as asserted by both
parties, have repeatedly changed in the course of the case and the
pendency of this Motion. In addition, the amount of the “wild
card” exemption asserted by Debtor has -- at least in the body of
the pleadings relating to this Motion, although not in the Amended
Schedule C itself -- been reduced from $11,047.00 to $6,852.00.
Correspondingly, the IRS reduced its request for setoff from $8,733
to $6,852 ~- the total of the 2002 and 2004 refunds Debtor alleges
is owed to him.'® The IRS’s alleged right of setoff is the sole
basis for the $6,852.00 secured portion of the IRS’ Final Proof of
Claim. Debtor disputes the secured status of the $6,852.00 portion

of the IRS’s Final Proof of Claim, and has reserved his right to

16 Even though Debtor has stated that he owes a deficiency in

the amount of $2,314.00 for tax year 2003, the IRS has not included
such an amount in the amounts the IRS asserts as owing. See
Debtor’s Decl. at 2:7-17. Indeed, the IRS’s Final Proof of Claim
indicates “$0.00” tax due for 2003.

17 Debtor’s Decl. at 2:14-17.

18 United States’ (IRS’s) Supplemental Brief In Support of
Its Motion for Relief from Stay (“IRS’s Supp. Brief”), filed May
15, 2006, at 4:20.

MEMORANDUM DECISION ON MOTION

FOR RELIEF FROM STAY BY IRS 7

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object thereto pending this decision by the Court.’ For the
purposes of this Motion, the parties agree that the amount the IRS

now seeks to set off is $6,852.00.?°

Il.
ANALYSIS
The issue before the Court is whether the IRS should be

granted relief from stay, pursuant to Bankruptcy Code § 362, to
allow the IRS to offset, pursuant to § 553, Debtor’s pre-petition
income tax liabilities against Debtor’s pre-petition income tax
refunds.** The total amount of the IRS’s Final Proof of Claim is
$9,972.44, for taxes owing for tax years 1991 and 2001 and pre-
petition interest and penalties thereon. Debtor has asserted a
claim for an income tax refund for tax years 2002 and 2004 totaling
$6,852. By the Motion, the IRS seeks to apply the entire $6,852
owing by the IRS to Debtor against the $9,972.44 tax liability owed

by Debtor. If the Motion is granted, the IRS will receive roughly

8 Debtor's Statement Regarding Claim Amount in Set-off

Request by Motion for Relief from Stay (“Debtor’s Statement”),
filed February 28, 2007, at 2:20-25.

20 See Debtor’s Statement at 2:26-27; IRS’s Final Proof of
Claim; and IRS’s Supp. Brief at 4:17-20.

*. The Court notes that, for cases filed after October 17,
2005, the newly added Bankruptcy Code § 362(b) (26) provides that
the setoff by the IRS of a pre-petition tax refund is not stayed.
This new section was added by the Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005, Pub.L. No. 109-8, 199 Stat. 23
§ 418 (Apr. 20, 2005). While this provision eliminates the need
for the IRS to bring a motion for relief from stay, it does not
resolve the issue of whether the IRS may set off against tax
refunds after the debtor has exempted such funds under § 522,
without objection.

MEMORANDUM DECISION ON MOTION
FOR RELIEF FROM STAY BY IRS

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$7,159.51 or slightly over 71% of the $9,972.44 total of the IRS’s
Final Proof of Claim plus a pro rata distribution on the $2,812.93
balance under the Amended Plan.” If the Motion is denied, the IRS
will receive $307.51 as a priority claim and a pro rata
distribution on the balance of $9,664.93.

While this difference in the potential recovery on the IRS’s
Final Proof of Claim is significant, this case presents a much more
significant issue than whether, on the facts here presented, the
IRS can establish a right of setoff under § 553, thereby
establishing cause for relief from the automatic stay under § 362.
This larger issue arises from Debtor’s opposition to the Motion.
Debtor has opposed the Motion on the basis that the IRS is not
entitled to set off against the 2002 and 2C04 refunds because
Debtor has already fully exempted the refunds pursuant to
Bankruptcy Code § 522 and CCP § 703.140(b) (5). Debtor argues that
such exemption gives him a superior right to the $6,852. The
primary issue presented by the Motion, therefore, is whether the
setoff should be allowed against property the debtor has already
fully exempted -- without challenge by the IRS or any other party.
A. The Applicable Statutory Provisions

1. The Automatic Stay of Bankruptcy Code § 362

Bankruptcy Code § 362 imposes an automatic stay against
certain acts by creditors against the debtor or property of the
estate. Included among the acts prohibited by the automatic stay

is “the setoff of any debt owing to the debtor that arose before

22 The $7,159.51 payment is comprised of the $6,852 setoff

amount plus $307.51 owed as a priority claim under § 507(a) (8).

MEMORANDUM DECISION ON MOTION
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the commencement of the case under this title against any claim
against the debtor[.]” 11 U.S.C. § 362(a)(7). No exception is
made under § 362 -- at least as written prior to the Bankruptcy
Abuse Prevention and Consumer Protection Act of 2005 (the
“BAPCPA”)-- for setoffs by the IRS.”? Therefore, the unambiguous
language of § 362(b)(7) stays any right the IRS might otherwise
have to set off tax refunds against tax liabilities owing by
Debtor.

Even though the IRS’s right to set off is stayed by the
automatic stay, the IRS, like any other creditor, may ask the court
to lift the stay to allow it to exercise a right of setoff. As

explained by the Ninth Circuit BAP in In re Pieri, 86 B.R. 208, 210

(9th Cir. BAP 1988):

Under the Code, the allowance of setoff is not automatic
but is instead permissible at the discretion of the
bankruptcy court, applying general principles of equity.
[citations omitted] . . . In order to insure that
questions concerning setoff are presented to the court
for determination, Section 362(a)(7) specifically stays
setoff. The automatic stay does not defeat the right of
setoff. Rather, it merely stays its enforcement pending
an orderly examination of the debtor’s and creditor's
rights. [citations omitted]

*3 The Petition Date was January 20, 2005. The BAPCPA was

enacted on April 20, 2005. A few of its provisions became
immediately effective, but the majority of the BAPCPA’s amendments
became effective on October 17, 2005 -- 180 days after its
enactment. Because Debtor’s bankruptcy case was commenced prior to
the effective date of the BAPCPA, the provisions added by the
BAPCPA are inapplicable to Debtor’s case. See footnote 21 supra
and section II(C) (4) infra.

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2. Setoff Under Bankruptcy Code § 553 and Internal
Revenue Code § 6402(a)

Bankruptcy Code § 553 addresses a creditor’s right of setoff
in the bankruptcy context. It provides, in pertinent part, as
follows:

Except as otherwise provided in 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[.]

11 U.S.C. § 553(a). Section 553 does not create a federal right of

setoff, but preserves existing rights under applicable non-

bankruptcy law. Citizens Bank of Maryland v. Strumpf, 516 U.S. 16,
18, 116 S.Ct. 286, 289, 133 L.Ed.2d 258 (1995); In re De Laurentiis
Ent. Group Inc., 963 F.2d 1269, 1277 (9th Cir. 1992).

The IRS’s ability to offset tax liabilities against tax
refunds is found at Internal Revenue Code (“IRC”) § 6402(a), which

provides:

In the case of any overpayment, the Secretary, within the
applicable period of limitations, may credit the amount
of such overpayment, including any interest allowed
thereon, against any liability in respect of an internal
revenue tax on the part of the person who made the
overpayment and shall, subject to subsections (c), (d)
and (e), refund any balance to such person.

26 U.S.C. § 6402(a) (emphasis added).

In addition to the requirements for setoff under the
applicable non-bankruptcy law -- in this case, the elements of IRC
§ 6402(a) set forth above -- § 553 imposes certain additional
requirements in the bankruptcy context. To establish a valid

setoff right under § 553, the IRS must prove: (1) a debt owed by

MEMORANDUM DECISION ON MOTION
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the creditor to the debtor arising pre-petition; (2) a claim of the
creditor against the debtor arising pre-petition; and (3) the debt

and claim are mutual obligations. In re Verco Industries, 704 F.2d

1134, 1139 (9th Cir. 1983).

There is no dispute that the tax debts and requests for
refund in question are mutual pre-petition obligations between
Debtor and the IRS. It is undisputed that, but for Debtor’s
bankruptcy filing, the IRS would be able to exercise its right
under IRC § 6402(a) to apply the refunds in this case to Debtor’s
unpaid tax liabilities.*4 The IRS argues that, pursuant to § 553,
it retains the same rights in bankruptcy, and, therefore, should be
permitted to set off Debtor’s unpaid tax liabilities against his
tax refunds, as provided for by IRC § 6402(a).7> Absent the
exemption by Debtor of the refunds in dispute, there would be no
question that the IRS should be allowed to exercise its right of
setoff under Bankruptcy Code § 553 and Internal Revenue Code

§ 6402 (a).

*4 See De Laurentiis, 963 F.2d at 1276 (Chapter 11 discharge
did not bar a creditor from raising a pre-petition claim as a
setoff against an action brought by the debtor); In re Buckenmaier,
127 B.R. 233, 239 (9 Cir. BAP 1991) (creditor’s setoff of its
contingent claim for contribution was not enjoined by Chapter 7
discharge).

*5 While it is true that, even within the Bankruptcy Code,
there is a strong policy of encouraging the payment of taxes by
individuals, the Bankruptcy Code does, nonetheless, provide rights
to individuals, vis-a-vis their taxes, that they would not have
outside of bankruptcy. For example, non-priority tax debts can be
discharged under 727, 1141 and 1328. In addition, in a Chapter 13
case, a debtor has the ability to discharge even priority tax debts
upon the completion of plan payments under § 1328(a). Further,
plans in bankruptcy cases allow debtors to pay tax debts over time,
without the risks of garnishment or attachment.

MEMORANDUM DECISION ON MOTION
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Setoff rights in bankruptcy are “'‘generally favored,’ anda
presumption in favor of their enforcement exists.” De Laurentiis,
963 F.2d at 1277 (quoting In re Buckenmaier, 127 B.R. 233, 237 (9
Cir. BAP 1991)). Setoff is, however, permissive, rather than
mandatory, and the decision ultimately rests within the discretion

of the court. In re Cascade Roads, Inc., 34 F.3d 756, 763 (9th

Cir. 1994). In exercising its discretion, the Bankruptcy Court is
to apply the general principles of equity. Setoff, even where
otherwise authorized, should not be allowed when it would be
inequitable or against public policy to do so. FDIC v. Bank of

America Nat’l Trust and Savings, 701 F.2d 831, 836-37 (9th Cir.

1983), cert. denied, 464 U.S. 935 (1983).

3. Debtor’s Exemptions under § 522 and CCP § 730.140(b)
To help provide a bankruptcy debtor with a “fresh start” after
bankruptcy, the Bankruptcy Code allows the debtor to exempt certain

property. United States v. Security Industrial Bank, 459 U.S. 70,

72 n.1, 103 S.Ct. 407, 409 n.1, 74 L.Ed.2d 235 (1982). In enacting
§ 522, Congress noted “[t]he historical purpose of these exemption
laws has been to protect a debtor from his creditors, to provide
him with the basic necessities of life so that even if his
creditors levy on all of his nonexempt property, the debtor will
not be left destitute and a public charge.” H.R. Rep. No. 95-595,
95" Cong., 18* Sess. at 126 (1977), as reprinted in 1978
U.S.C.C.A.N. 5963, 6087. Section 522(c) bars exempt property from
being liable for any debt that arose before the commencement of the
case, with certain enumerated exceptions not present here. A

debtor has the ability to remove property from, or acquire property

MEMORANDUM DECISION ON MOTION
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of, the estate by claiming exemptions. Owen v. Owen, 500 U.S. 305,

308, 111 S.Ct. 1833, 1835, 114 L.Ed.2d. 350 (1991).

Property cannot be exempted unless it first falls within the
bankruptcy estate. Owen, 500 U.S. at 308; In re Heintz, 198 B.R.
581, 586 (9th Cir. BAP 1996). The bankruptcy estate is comprised
of all legal and equitable interests owned by the debtor as of the
commencement of the case. 11 U.S.C. § 541(a)(1). Even if claims
held by the debtor are contingent and/or unliquidated, they still
become property of the estate as of the commencement of the

bankruptcy case.?®

It is well established that unliquidated claims
for tax refunds for pre-petition taxable years are included within
the property of the estate.?’

Section 522(b) permits a debtor to “exempt (1) property under

the federal exemptions contained in Section 522(d), unless State

law does not so authorize, or (2) property exempt under State or

local law, or other federal law.” In re Higgins, 201 B.R. 965, 966
(9? Cir. BAP 1996). Because California has opted out of the

federal exemption scheme, State law governs the right to an
exemption in this case. 11 U.S.C. § 522(d); CCP § 703.130. Under

California law, a bankruptcy debtor may choose between two sets of

26 Sierra Switchboard Co. v. Westinghouse Electric Corp., 789

F.2d 705, 708 (9™ Cir. 1986) (unliquidated emotional distress
claim); In re Ryerson, 739 F.2d 1423, 1425 (9** Cir.

1984) (contingent contractual provisions); In re Bronner, 135 B.R.
645, 647 (9 Cir. BAP 1992) (unliquidated bad faith lawsuit); In re
Wischan, 77 F.3d 875, 877 (5*° Cir. 1996) (unliquidated personal
injury causes of action).

27 Kokoszka v. Belford, 417 U.S. 642, 648, 94 S.Ct. 2431,
2435, 41 L.Ed.2d 374 (1974); Mueller v. Commissioner, 496 F.2d 899,
903 (5%* Cir. 1974); In re Barowsky, 946 F.2d 1516 (10° Cir. 1991).

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\o oo ~~ ON in oS Go N

10
il
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28

exemptions: (1) the exemptions available under CCP § 703.140(b) or
(2) regular state law exemptions. CCP § 703.140(a). The
exemptions afforded by CCP § 703.140(b), which were elected by
Debtor in this case, are substantially similar to those under
Bankruptcy Code § 522(d).

Debtor scheduled his claims for income tax refunds as exempt
under CCP § 703.140(b) (5), which closely mirrors Bankruptcy Code
§ 522(d)(5). These sections are commonly referred to as the “wild
card” exemption because they can be used to protect any kind of

property whatsoever. In re Goswami, 304 B.R. 386, 390 (9% Cir. BAP

2003). The wild card exemption, as in effect at the Petition Date,
permits the exemption of $925 plus any unused portion of the
$17,425 homestead exemption afforded by CCE § 703.140(b) (1). The
unused portion of the homestead exemption is commonly referred to
as the “spillover.” 2 David G. Epstein, Steve H. Nickles and James
J. White, Bankruptcy Practitioner Treatise Series at § 8-20 (West
1992). Congress noted that the availability of the wild card
exemption ~- and particularly the spillover component -- was very
important “in order not to discriminate against the nonhomeowner.”
H.R. Rep. No. 95-595 at 361.

Because of the spillover component, the wild card exemption is
often the most significant exemption afforded to a non-homeowner
debtor. This is clearly the case under the facts at hand. Debtor
does not own a home, so he cannot otherwise benefit from the
homestead exemption. For Debtor, the wild card exemption -- and
his claim of exemption as to his tax refunds in particular -- is
the only significant source of funds “to provide him with the basic

necessities of life” as Congress recognized exemptions were

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UNITED STATES BANKRUPTCY COURT

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\o oo ~ n oT - Ww nN =

ie) ho No nN No N i) bo N —_ — — —= — — = — —_ —
(oe) ~~] fon Nn as GO iS) — © Ke] [oe] ~] nN Na os W No — )

designed to do. H.R. Rep. No. 95-595 at 126. Debtor’s exempted
federal and state income tax refunds total $10,069. The combined
value of all other items that Debtor has exempted -- which includes
household furnishings, clothing, a 1987 Jeep Cherokee and $400 ina
checking account -- is only $1,700. Without his income tax
refunds, the balance of the exempt funds left to Debtor would
represent roughly half of one month’s living expenses for Debtor

and his family.

B. Effect of IRS’s Failure to Object to Exemptions
Bankruptcy Code § 522(1) provides the following procedures for
claiming exemptions and objecting to claimed exemptions:
The debtor shall file a list of property that the debtor
claims as exempt under subsection (b) of this section.

Unless a party in interest objects, the property
claimed as exempt on such list is exempt.

Federal Rule of Bankruptcy Procedure 4003(b), in turn, provides in
pertinent part as follows:

A party in interest may file an objection to the list of
property claimed as exempt only within 30 days after the
meeting of creditors held under § 341(a) is concluded or
within 30 days after any amendment to the list or
supplemental schedules is filed, whichever is later. The
court may, for cause, extend the time for filing
objections if, before the time to object expires, a party
in interest files a request for an extension.

The Supreme Court has directed that this 30-day limit for
objections to exemptions must be strictly applied. Taylor v.
Freeland & Kronz, 503 U.S. 638, 112 S.Ct. 1644, 118 L.Ed.2d 280
(1992).

In Taylor, the debtor disclosed an employment discrimination

lawsuit in her schedules, listed its value as “unknown,” and

claimed the expected proceeds as exempt. Id. at 640. While the

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UNITED STATES BANKRUPTCY COURT

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\o oo ~ On Nm - ies) N —_

i) N i) N NO N ie) nN No — — = —_ —_ —_ = — — —
[oo aes ©) Or) © OO Oo oe ©) ©) i ~ O° RE N° EE

Chapter 7 trustee wrote a letter to the debtor telling her he
considered the potential proceeds of the lawsuit to be property of
the bankruptcy estate, he decided not to object to the claimed
exemption, incorrectly assuming that the case would likely “wind up
settling far within the exemption limitation.” Id. at 641. After
the debtor settled the lawsuit for $110,000, the Chapter 7 Trustee
objected to the debtor’s exemption. Id.

The trustee made three principal arguments in support of his
untimely objection to the exemption of the lawsuit: (1) § 522(1)
and Rule 4003(b) “serve only to narrow judicial inquiry into the
validity of an exemption after 30 days, not to preclude judicial
inquiry altogether”;?% (2) barring his objection as untimely would
create improper incentives for a debtor to claim meritless
exemptions on the chance that no party will object, thereby making
his claimed exemptions valid;*? and (3) requiring debtors to file
exemptions in good faith would eliminate this otherwise improper
incentive. *°

The Supreme Court rejected all of the trustee’s arguments and
held that he could not contest the validity of an exemption after

the 30-day deadline, “whether or not [the debtor] had a colorable

28 Taylor, 503 U.S. at 643.

*9 The Eighth Circuit described the practice as “exemption by
declaration.” In re Peterson, 920 F.2d 1389, 1393 (8% Cir. 1990),
abrogated by Taylor, 503 U.S. 638.

39 Taylor, 503 U.S. at 644. Prior to Taylor, this broad “good
faith” review of exemptions had been adopted by the Fifth, Sixth
and Eighth Circuits. See In re Sherk, 918 F.2d 1170, 1174 (5 Cir.
1990); Peterson, 920 F.2d at 1393-94; In re Dembs, 757 F.2d 777,
780 (6 Cir. 1985).

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\o oo ~ nN NA oe Qo No =

bo nN N No bo bo bo bdo NO —_ — — —_ — — _ — _ _—
[oe] ~] fon) AN aS Ww bo — (-) \O (70) ~] an N - Ow N — Oo

oY

statutory basis for claiming it.” Id. at 644. The Supreme Court
reasoned:

Deadlines may lead to unwelcome results, but they prompt

parties to act and they produce finality. In this case,

despite what [debtor’s counsel] repeatedly told him, [the

trustee] did not object to the claimed exemption. If

[the trustee] did not know the value of the potential

proceeds of the lawsuit, he could have sought a hearing

on the issue, see Rule 4003(c), or he could have asked

the Bankruptcy Court for an extension of time to object,

see Rule 4003(b). Having done neither, [the trustee]

cannot now seek to deprive [the debtor and her attorneys]

of the exemption.
Id. at 644. The Court noted the trustee’s concerns that this
ruling would provide improper incentives to debtors to claim
meritless exemptions, but found that “[t]his concern . . . does not
cause us to alter our interpretation of § 522(1).” Id. at 644.
The Court noted that bad-faith claims should be limited by existing
provisions in the Bankruptcy Code that impose penalties for
improper conduct by debtors or their attorneys.?!. The Court
reasoned that to the extent these other provisions do not curtail
meritless claims by debtors, “Congress may enact comparable
provisions to address the difficulties that [the trustee] predicts
will follow our decision” but the courts “have no authority to
limit the application of § 522(1) to exemptions claimed in good
faith.” Id. at 644-45.

Here, as in Taylor, no party objected to the exemptions

asserted by Debtor in his Amended Schedule C. This rendered the

* See, e.g., 11 U.S.C. § 727(a) (4) (B) (denial of discharge
for presenting fraudulent claims), Fed. R. Bankr. P. 1008
(requiring filings to be signed to verify the truthfulness under
penalty of perjury), Rule 9011 (authorizing sanctions for signing
meritless documents), and 18 U.S.C. § 152 (imposing criminal
penalties for fraud in bankruptcy cases).

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\o oo ~] ON ws - os) N —

ie] N NO NO i) i) N NO N — — — — i —_ — — — —
fore) ~ n wi aS Go bo = ro) \o (oe) ~~ an Nn - Ww i) bn an)

exemptions valid and unassailable under Taylor. The merits of
Debtor’s exemption claim can no longer be argued by the IRS or
considered by this Court. The IRS failed to object to the claimed
exemption within the applicable time period, and the IRS is,
therefore, barred from challenging its validity now. Id. at 642.
The Ninth Circuit Bankruptcy Appellate Panel has held that “[t]he
bankruptcy court’s broad equitable power does not enable it to
carve out an exception to Taylor’s strict construction of § 522(1)

and Fed.R.Bankr.P. 4003[.]” In re Canino, 185 B.R. 584, 595 (9th

Cir. BAP 1995) (finding that the Bankruptcy Court could not exercise
its equitable authority to recognize informal or de facto

objections to debtor’s exemption claims); see also In re Boyd, 243

B.R. 756, 766 (N.D. Cal. 2000) (finding “that § 105 cannot cure the
trustee’s failure to file a timely objection” to debtor’s
exemptions).

The only case this Court has found, from all the courts within
the Ninth Circuit, which provides even the slightest qualification
of the strict rule of Taylor is In re Clark, 266 B.R. 163 (9 Cir.
2001). In Clark, the debtor described property claimed as exempt
as “five lots listed in qualified retirement plan[.]” Id. at 165.
In fact, there was no such retirement plan and the property was
owned by an entity other than the debtor. Id. at 170-71. The
Ninth Circuit found that because the debtor’s exemption claim was
“ambiguous and imprecise”, the subject property was not
automatically exempt under Taylor when no timely objection was
filed. Id. at 170-71.

Clark is not applicable to the case at hand. Debtor specified

the taxable years for the refunds he exempted. While the amounts

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UNITED STATES BANKRUPTCY COURT

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Oo Oo JN HN wn FP WO HO

No N iw) bdo bo nN No N NO om — _ — — — — — — —
oo NN MN FF WO NY FK§ OF OO DO NDT DA F&F WO NY KF OS

feb}

of these refunds may not have been established at the time the
exemptions were made -- since Debtor had not yet filed the relevant
tax returns -- it was clear from the list of exemptions which
years’ refunds Debtor was exempting. The IRS could have objected
to the exemption of the tax refunds on the basis that Debtor was
not entitled to a “refund” under IRC § 6402(a) -- as argued in the
current Motion -- and the exemption was, therefore, without merit.
If the IRS needed additional time to sort out whether, in
accordance with its interpretation of IRC § 6402(a), Debtor was
entitled to any refunds, or what the value of such refunds might
be, the IRS “could have sought a hearing on the issue, see Rule
4003(c), or [it] could have asked the Bankruptcy Court for an
extension of time to object, see Rule 4003(b).” Taylor, 503 U.S.
at 644. The IRS had, in fact, been active in Debtor’s case, and
had filed an objection to confirmation of the Original Plan on the
basis of Debtor’s failure to file his tax returns and provide for
payment in full of the IRS’s priority claims. The IRS certainly
was aware that Debtor had failed to file tax returns for the years
1999-2004. For whatever reason, the IRS chose not to object to the
exemption of the tax refunds. Under Taylor, the tax refunds are
exempt and can no longer be subject to the IRS’s subsequent efforts
to assert a claim of setoff.
Cc. Caselaw Cited by the Parties

While the Court is compelled by Taylor to deny the IRS’s
Motion on the basis of the IRS’s failure to object timely to the

exemption of the refunds, neither party addresses the impact of

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UNITED STATES BANKRUPTCY COURT

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Ko) lo9) ~] nN nN -& Ww N =

bo WN No No bo bdo do N No —_ — — — — = — —_ — —_
[ove] ~] nN mn & Ww ie) —_ fam) \o [oe] ~] an an a ww N — So

Taylor.** Instead, the arguments presented by Debtor and the IRS
highlight a conflict of authority relating to the interplay of
setoff under § 553 and exemption under § 522.

Debtor’s claim of exemption and the IRS’s claim of setoff --
both significant and compelling in their own right -- appear to
conflict such that both cannot be given simultaneous effect. This
conflict has been noted by the Ninth Circuit BAP:

When Section 522(c) is viewed against Section 553, we see

that they present us with apparently conflicting

provisions. Section 553 allows setoff of mutual debts

owed between a creditor and the debtor which arose before

the commencement of the case. Yet Section 522(c) bars

exempt property from being liable for any debt, with

certain enumerated exceptions, that arose before

commencement of the case.

Pieri, 86 B.R. at 212.

In this Motion, the parties discuss cases that are part of a
larger body of caselaw, from which three, very different, lines of
reasoning have developed. This Court could not find, and the
parties have not provided any citations for, any controlling
caselaw relating to the interplay of §§ 522 and 553 under the
specific facts presented. Several courts outside the Ninth Circuit
have considered the IRS’s ability to set off tax refunds in light
of a bankruptcy debtor’s claim of exemption with respect to such
tax refunds. From those decisions, the three-way split of

authority has developed. One line of cases holds setoff cannot be

made against assets exempted under § 522 on the basis that to do so

*@ In oral arguments, Debtor’s counsel did raise the 30-day

period for objections to exemptions under Bankruptcy Rule 4003(b),
but not Taylor specifically. The Court brought Taylor to the
attention of the parties at the January 31, 2007 hearing on the
Motion.

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21

OQ
—O).,.

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UNITED STATES BANKRUPTCY COURT

For The Northern District Of California

oO fo SN DBD OH FF WD LH =

NO NO NO WN NH NP NO NO NO KF Ff KF Ff KF FOO Ee |
ao ST DN OF FF WY NY KF CO CO DO I DR A BP WHO YP K CO

C

would nullify the purpose of § 522, which is to protect a minimal
amount of assets necessary to assure a fresh start for the debtor.
A second line of cases holds that setoff rights under § 553 always
prevail over an exemption under § 522 relying on those courts’
reading of various sections of the Bankruptcy Code. Finally, a
third line of cases has argued, as the IRS has done in this Motion,
that a debtor’s estate has no interest in any tax “overpayment” --
and, therefore, the debtor cannot claim any amount as exempt --
until the IRS has determined that a refund is owing after “netting”
the tax liabilities pursuant to IRC § 6402(a).

1. Cases Allowing Exemption Over Setoff

As noted above, a significant line of cases has held that a
debtor’s claim of exemption under § 522 trumps the IRS’s right of
setoff under § 553. In re Sharp, 286 B.R. 627, 629 (Bankr. E.D.
Ky. 2002); In re Pace, 257 B.R. 918, 920 (Bankr. W.D. Mo. 2000); In
re Jones, 230 B.R. 875, 880 (M.D. Ala. 1999); In re Alexander, 225
B.R. 145, 149 (Bankr. W.D. Ky. 1998); In re Monteith, 23 B.R. 601,
603 (Bankr. N.D. Ohio 1982); In re Tubbs, No. 99-33506-PB7, 2000 WL
1203508, at *1 (Bankr. S.D. Cal. 2000) (“{T]o the extent the

debtors’ pre-petition tax liabilities are dischargeable, the IRS’s

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UNITED STATES BANKRUPTCY COURT

For The Northern District Of California

\o oo ~ nN GN a Go N —

iw) N N N iw) No N NO No — — — — — — — —e — —
(oe) ~l (ony nN & ies) N — OQ \o [oe] ~l nN Nn > WwW No _ Oo

right to setoff does not trump the debtors right of exemption”) .*?
Alexander explains the reasoning behind this approach as follows:

If the rule were otherwise, § 522({c) would simply have no
meaning. [citations omitted] A debtor would completely
lose the ability to exempt property from the reach of
creditors possessing a right of offset under § 553.
[citations omitted] It is a basic tenet of statutory
construction that ‘when two provisions of a statute are
in conflict they should be interpreted in such a fashion

as to give meaning to the whole.’ [In re Miel, 134 B.R.
229, 235 (Bankr. W.D. Mich. 1991); In re Monteith, 23
B.R. 601, 603 (Bankr. N.D. Ohio 1982).] Thus, where one

construction of a statute will nullify a provision of
that statute, while an equally plausible construction
will give effect to the statute as a whole, the latter
construction is preferred. [citations omitted] In this
case, if § 553 and § 522 are construed so as to allow the
IRS to exercise its right of set-off against the Debtor’s
exempt property, § 522(c) will be rendered without effect
or meaning. On the other hand, construing the provisions
to mean that a right of set-off under § 553 is limited to
property not claimed exempt under § 522, gives effect to
both provisions.

Alexander, 225 B.R. at 149.

In addition to the statutory construction argument noted
above, these cases also emphasize that favoring exemptions over
setoff rights furthers the chief policy behind the Bankruptcy Code
-- providing the debtor with a fresh start. Pace, 257 B.R. at 920,

Jones, 230 B.R. at 880, Alexander, 225 B.R. at 149.

33. Outside the context of a tax liability, many other cases

have also found that exemptions under § 522 trump setoff under

§ 553. See In re Tarbuck, 318 B.R. 78 (Bankr. W.D. Pa. 2004) (bank
could not set off deficiency judgment against funds in bank account
that the debtor claimed as exempt); In re Killen, 249 B.R. 585
(Bankr. D. Conn. 2000) (debtor’s claim of exemption in her tax
refund precluded government from setting debtor’s refund off
against her dischargeable, pre-petition debt to the Department of
Housing and Urban Development); In re Haffner, 12 B.R. 371 (Bankr.
M.D. Tenn. 1981) (bank not entitled to setoff against certificate of
deposit claimed by debtor as exempt).

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UNITED STATES BANKRUPTCY COURT

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\o oo ~l ON a > uo N —

NO bdo bho NO No No bdo bdo nN _ — — — — — — — _ —
fo.) ~l nN an ow Ww i) — oO \o [oe] ~] nN Nn & (es) i) —_ jo)

ey

Finally, these cases hold that the legislative history of
§ 522 supports their position. One of the versions of § 522(c)
considered by Congress, but which was never enacted, would have
allowed the IRS to set off tax debts against tax refunds a debtor
claimed as exempt.** By rejecting that version of § 522(c),
“Congress did not intend that exempt property be liable to the
payment of dischargeable tax debts, whether by set-off or
otherwise.” Monteith, 23 B.R. at 604; see also Jones, 230 B.R. at
880-81; Alexander, 225 B.R. at 150. This position, that exemptions
trump setoff rights, has been identified by many courts as the
“majority rule” on the issue of whether § 553 must yield to § 522.

Pace, 257 B.R. at 920; Jones, 230 B.R. at 879; Alexander, 225 B.R.

at 149.

*4 In relevant part, the legislative history from the report

of the Senate Judiciary committee on Senate Bill 2266, which was
not ultimately passes, states:

Subsection (c) (3) permits the collection of dischargeable
taxes from exempt assets. Only assets exempted from levy
under Section 6334 of the Internal Revenue Code or under
applicable state or local tax law cannot be applied to
satisfy these tax claims. This rule applies to pre-
petition tax claims against the debtor regardless of
whether the claims do or do not receive priority and
whether they are dischargeable or nondischargeable. Thus,
even if a tax is dischargeable vis-a-vis the debtor's
after-acquired assets, it may nevertheless be collectible
from exempt property held by the estate.

S. Rep. No. 95-989, 95th Cong.2nd Sess. at 76 (1978), reprinted in
1978 U.S.C.C.A.N. 5787, 5862.

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Oo CO AJ BDA WA BR WH PO

Do wo NO NH NY NO NN HP NO He eRe EF Fr OOF EEUU le
ao ~~ BO UAT FF WO NY KF OO Oo CO HS DH rH FP WH YP KS OC

2. Cases Allowing Setoff Over a Claimed Exemption
While it may have been the “majority” view that exemptions
should prevail over a claim of setoff by the IRS, several cases
have found the opposite.*> This second line of cases holds that
§ 553 can only be given effect if exemptions remain subject to

setoff. IRS v. White, 365 B.R. 457 (M.D. Pa. 2007); United States

v. Luongo, 255 B.R. 424 (N.D. Tex. 2000), aff'd on different

grounds, 259 F.3d 323 (5th Cir. 2001); In re Martinez, 258 B.R. 364
(Bankr. W.D. Tex. 2000); In re Glenn, 2000 WL 33364195 (Bankr. W.D.

Wis. 2000); Posey v. IRS, 156 B.R. 910 (W.D.N.Y. 1993); In re

Eggemeyer, 75 B.R. 20 (Bankr. S.D. Ill. 1987).*® In rejecting the
position taken by the majority of cases favoring exemption over
setoff, the Bourne court explained this second line of reasoning as

follows:

This court disagrees with the majority’s conclusion that
allowing exemption rights under § 522(c) to supersede a
creditor’s setoff rights under § 553 gives effect to both
provisions and prevents the nullification of § 522(c).

To the contrary, by giving primary effect to the
exemption rights of a debtor, the offset right of a
creditor is often completely nullified, as would be the
result in the instant case. It is just as logical to
give effect to both provisions by holding that a debtor
may claim an exemption which is valid as to all creditors
except one having a right of offset.

3° In re Pigott, 330 B.R. 797, 799 (Bankr. S.D. Ala. 2005)
notes this was considered the majority view, “at least until 2001”,
when IRS v. Luongo, 259 F.3d 323 (5™ Cir. 2001) and In re Bourne,
262 B.R. 745 (Bankr. E.D. Tenn. 2001) were issued.

3® Outside the tax liability context, see also In re Junio,

2002 WL 32001412 (E.D.N.Y. 2002) (allowing bank to set off checking
account funds against loan balance claimed as exempt); Bourne, 262
B.R. 745 (allowing setoff of debt owed to HUD against tax refund
claimed as exempt); In re Wiegand, 199 B.R. 639 (W.D. Mich.

1996) (allowing credit union to set off debt against debtor's credit
union account claimed as exempt).

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\o io“) ~l ON oa) a Oo i) _

i) ho No bdo bo i) i) bo do —_ —_ _ — — — — — — —
[oe] ~] fon Nn & O iS) — So \O CO ~ nN Nn - ie) bo = oO

In re Bourne, 262 B.R. 745, 756 (Bankr. E.D. Tenn. 2001). This
approach holds that a debtor can still exempt property under § 522
from the reach of all other creditors -- just not those holding a

valid right of setoff. In re Wiegand, 199 B.R. 639, 642 (W.D.

Mich. 1996). These cases point to the language of § 553 --
specifically, that “this title does not affect any right of a
creditor to offset a mutual debt” -- and argue that it is clear and
unambiguous.

In further support of their interpretation of the
Congressional intent with respect to a creditor’s right of setoff,
some of these cases*’ cite the language of § 542(b) regarding
turnover of property of the estate which provides:

Except as provided in subsection (c) or (d) of this

section, an entity that owes a debt that is property of

the estate and that is matured, payable on demand, or

payable on order, shall pay such debt to, or on the order

of, the trustee, except to the extent that such debt may

be offset under section 553 of this title against a claim

against the debtor.

11 U.S.C. § 542(b) (emphasis added). The courts in these cases read
this provision as unequivocally allowing any creditor with a right

of setoff to retain the property -- even if the debtor properly

exempted the property. ?®

7 White, 365 B.R. at 462, citing Eqqemeyer, 75 B.R. at 22,
Posey, 156 B.R. 910, Wiegand, 199 B.R. at 643 and Bourne, 262 B.R.
at 754.

38 This cannot be an accurate interpretation of 542(b) since

creditors do not have an absolute right to retain property just
because they assert a right of setoff. As noted by the Ninth
Circuit BAP in Pieri, for example, California state law does not
allow setoff against exemptions that are designed to ensure payment
of daily living expenses, such as wages and unemployment or
disability benefits. Pieri, 86 B.R. at 210-11. See also footnote
48, infra. Further, within the Ninth Circuit, it is well settled
that the allowance or disallowance of a setoff is ultimately within

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In response to this argument, the pro-exemption cases have
countered that § 542(b) does not apply to property that has been
exempted by the debtor because it is no longer “property of the
estate.” Jones, 230 B.R. at 881-82; Alexander, 225 B.R. at 150-51.
“In this case, the IRS simply does not have a valid right of set-
off. Debtor has properly exempted his tax refund; consequently,
the refund is no longer property of the estate. Rather, it is
property belonging to Debtor.” Alexander, 225 B.R. at 151
(citations omitted). Such property is then subject to turnover
pursuant only to § 542(a), which requires an entity that possesses
property that the debtor may exempt, to deliver such property to
the trustee. Bourne, 262 B.R. at 755. Section 542(a) does not
contain an express exception for a creditor with a right to set
off.

Pro-setoff cases respond that a debtor’s claim to a refund is
a “debt” owed to the debtor by the IRS, rather than funds belonging
to the debtor. Accordingly, any turnover request is covered by
§ 542(b), not § 542(a), and is therefore subject to setoff rights,
as preserved by § 553. Bourne, 262 B.R. at 756.

This debate is somewhat circuitous. If a court assumes a tax
refund can be exempted, then § 542(a) is the applicable provision.

If, however, the court starts with the assumption that a mere right

the discretion of the trial court. Cascade Roads, 34 F.3d at 763.
Accord 5 Collier on Bankruptcy @ 553.02[3] (15*® ed. rev. 2003);
Bohack Corp. V. Borden, Inc. (In re Bohack, Corp.), 599 F.2d 1160,
1165 (2d Cir. 1979); U.S. v. Norton, 717 F.2d 767, 772 (3d Cir.
1983); Cohen v. Savings Bldq. & Loan Co. (In re Bevill, Bresler &
Schulman Asset Management Corp.), 896 F.2d 54, 57 (3d Cir. 1990);
DuVoisin v. Foster (In re Southern Indus. Banking Corp.), 809 F.2d
329, 332 (6 Cir. 1987); In re Myers, 362 F.3d 667, 672 (10% Cir.
2004); Dayton Sec. Assocs. V. Securities Group 1980 (In re The Sec.
Group 1980), 74 F.3d 1103, 1114 (11°° Cir. 1996).

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of setoff (as distinguished from the situation where the creditor
has already exercised a setoff before the debtor exempted the
property) prevents a claim of exemption, then § 542(b) would
control. The Court finds that this debate is not supportive of
either position at least when, as here, there is both property that
has already been fully exempted, and a subsequent claim of setoff
as to the same property. Only after the court determines whether
setoff or exemption should prevail is the question resolved of
whether § 542(a) or § 542(b) is triggered.

In response to the “fresh start” policy argument raised in
favor of exemptions, some decisions favoring setoff note that “this
policy is not always paramount and is often subordinated to other
social and economic concerns and objectives.” Bourne, 262 B.R. at
757. These countervailing objectives include the common law rights
of creditors to set off mutual debts. Martinez, 258 B.R. at 367.
The pro-setoff cases argue that not upholding setoff rights in
bankruptcy would provide incentives to creditors to set off debts
earlier, rather than risking the loss of the setoff right in a
later bankruptcy. Recognition of the setoff right “removes an
incentive that might otherwise lead a creditor to take precipitous

action.” Bourne, 262 B.R. at 758, quoting, 5 Collier on Bankruptcy
@ 553.02[2] (15th ed. rev. 2000) .%9

39

5 Collier on Bankruptcy { 553.02[2], as quoted by Bourne,
discusses the policy reasons for the preservation of rights of
setoff under § 553. This section of Collier does not address the
interplay between §§ 522 and 553 or even mention exemptions under
§ 522.

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In response to the arguments offered by the pro-exemption
cases relating to the legislative history of § 522(c), the pro-
setoff cases counter:

[T]he conclusion that exempt property is not liable for
discharged taxes does not necessarily preclude offset
against property claimed exempt. As the Wiegand court
recognized, there is a distinction between collecting on
a unilateral debt and offsetting a mutual obligation. In
re Wiegand, 199 B.R. at 642. The majority courts relying
on legislative history may have been persuaded by the
fact that the IRS was seeking an offset against the
debtor’s discharged tax liability. See In re Jones, 230
B.R. at 876; In re Alexander, 225 B.R. at 147; In re
Monteith, 23 B.R. at 602. If debts other than tax
obligations had been involved, the legislative history
would have provided no basis for denial of offset.

In re Bourne, 262 B.R. at 757. Stated another way, just because
Congress chose not to permit the collection of dischargeable taxes
from exempt assets -- as was proposed in the Senate’s version of
§ 522(c) -- does not necessarily mean that that decision by
Congress was meant to address the interplay of exemptions under
§ 522 and setoff under § 553. The pro-setoff cases argue that the
legislative history at issue only dealt with the issue of
exemptions standing alone, not in combination with § 553.

3. Cases Allowing “Netting” of Liabilities by the IRS

A third, distinct line of reasoning has gained support in the
last few years. These cases draw a clear distinction between a tax
“overpayment” and a tax “refund.” They hold that a debtor’s estate
has no interest in any tax overpayment until the IRS has determined
that a refund is owing after “netting” the tax liabilities pursuant

to IRC § 6402(a).*° If the estate has no interest in a tax

*° Pettibone Corp. v. United States, 34 F.3d 536 (7™ Cir.
1994); United States v. Midway Indus. Contractors, Inc. (In re

Midway Indus. Contractors, Inc.), 178 B.R. 734, 737 (N.D. I11.
1995) (IRS did not violate the automatic stay when it offset a tax

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overpayment until after the IRS’s netting, then the debtor cannot
even claim the overpayment/refund as exempt. Therefore, under this
third line of reasoning, a claim of exemption by a debtor with
respect to an anticipated tax “refund” does not preclude the IRS
from offsetting pre-petition tax liabilities against such pre-
petition “overpayment. ”*

The case most cited as supporting this “netting” argument is
the Fifth Circuit’s decision in In re Luongo, 259 F.3d 323, 335 (5
Cir. 2001). In Luongo, after a discharge had been entered in favor
of a Chapter 7 debtor and her bankruptcy case had been closed, the
IRS set off the debtor’s discharged pre-petition income tax
liability for 1993 against a pre-petition tax refund owing to the
debtor for 1997. The debtor then reopened her bankruptcy case,
filed amended schedules listing the tax refund as exempt, and
brought an adversary proceeding to compel turnover of the 1997
refund. Both the debtor and the IRS brought motions for summary
judgment on the debtor’s turnover action. The Bankruptcy Court
granted the debtor’s motion, specifically adopting the pro-

exemption reasoning of Alexander, 225 B.R. 145. U.S. v. Luongo,

liability against a tax refund on the ground that “netting” of the
obligation was not a “setoff” within the meaning of the Code); Lyle
v. Santa Clara Co. Dept. of Child Support (In re Lyle), 324 B.R.
128, 131-32 (Bankr. N.D. Cal. 2005); Security Pac. Nat’l Bank v.
U.S. (In re Siebert Trailers), 132 B.R. 37, 40 (Bankr. E.D. Cal.
1991); IRS v. Luongo (In re Luongo), 259 F.3d 323, 335 (5™ Cir.
2001).

‘t This reasoning is contrary to the well-established

principles that property of the estate, which may be exempted by a
debtor, includes: (1) contingent and/or unliquidated claims held by
the debtor; and, more specifically, (2) unliquidated tax refunds
for pre-petition taxable years. See footnotes 26 and 27 supra.

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255 B.R. 424, 427 (N.D. Tex. 2000). The IRS appealed this decision
to the District Court. The District Court reversed the Bankruptcy
Court’s decision, and granted the IRS’s cross-motion for summary
judgment, following the pro-setoff line of cases noted above and
holding that the “clear and unambiguous language of § 553(a)”
dictates that “the IRS’s right of setoff is unaffected by Luongo’s
claims that (1) the tax refund is exempt property and (2) that the
tax liability was discharged in the bankruptcy proceeding.”

Luongo, 255 B.R. at 427-28. The debtor then appealed to the Fifth
Circuit. The Fifth Circuit affirmed the District Court’s decision,
but on very different grounds.

While both the District Court and the Fifth Circuit in Luongo
came down in favor of the IRS, the Fifth Circuit rejected the pro-
setoff reasoning adopted by the District Court and, instead, relied
upon the “netting” provisions of IRC § 6402(a). Specifically, the
Fifth Circuit held:

A debtor’s claim to a tax refund is property of the

estate. Mueller v. Commissioner, 496 F.2d 899, 903 (5™

Cir. 1974). However, under 26 U.S.C. § 6402(a) the

debtor is generally only entitled to a tax refund to the

extent that her overpayment exceeds her unpaid tax

liability. . . . Section 6402(a) grants the IRS

discretion whether to offset against a debtor’s unpaid

tax liability or to refund the overpayment to the

taxpayer. The IRS elected to exercise that discretion to

apply the overpayment to Appellant’s past liability.

Because the prior unpaid tax liability exceeded the

amount of the overpayment, the debtor was not entitled to

a refund and the tax refund did not become property of

the estate. Absent an interest in the estate to the

refund, it could not properly be exempted by the debtor
under § 522.

Luongo, 259 F.3d at 335. The unusual, but crucial, factual
circumstance in Luongo, is that the IRS set off the pre-petition
tax liability against the pre-petition tax refund before the debtor

reopened her bankruptcy case and amended her Schedules to claim the

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tax refund as exempt. The Fifth Circuit held that because the IRS
had elected to set off the tax liability, there was no longer a
balance to be refunded to the debtor. If no refund existed after
the setoff, then it could not have become property of the estate
and could not have been properly exempted by the debtor. Because
the debtor “could not properly exempt the overpayment at issue’,
the Fifth Circuit did "not reach the exemption issue decided below
-that is, whether § 522(c) prevents a creditor from exercising its
right to setoff preserved in § 553.” Id. at 328. Therefore, the
balance of the Fifth Circuit’s opinion in Luongo relating to the
netting argument is reduced to dicta. Luongo stands for the simple
proposition that when a setoff occurs prior to the exemption, there
is nothing left to exempt -- not that the IRS has some superior
right to exempt funds through netting under IRC § 6402. Unlike in
the present case, Taylor was not controlling in Luongo since the
setoff occurred prior the claim of exemption.

It is important to note that Luongo arose in the context of a
motion by the debtor to compel the turnover of a tax refund which
had been set off by the IRS before the debtor reopened her
bankruptcy case. Luongo, and its discussion of the netting
argument, would not support a motion for relief from stay -- as is
currently pending before this Court. In Luongo, the IRS did not
need relief from stay to offset the tax liability against the tax
refund, because the debtor’s bankruptcy case was closed at the time
of the setoff.

The problem is that several, more recent decisions have taken
the Fifth Circuit’s discussion of netting under IRC § 6402 out of

context and have ignored the unique fact that, in Luongo, the

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netting occurred prior to the claim of exemption by the debtor. In
some instances, these newer decisions have used the Fifth Circuit
discussion of netting under IRC § 6402(a) to validate post-petition
setoffs by the IRS.** Following the reasoning of these cases, since
IRC § 6402 defines whether a refund exists, the IRS may set off
debts -- pre-petition or post-petition -- and thereby remove a
potential refund from the property of the estate.** Some of these
cases have used the Fifth Circuit’s Luongo decision as a basis for
granting relief from stay in favor of the Federal government to
effectuate a post-petition setoff pursuant to IRC § 6402, even after
the tax refund in question had been fully exempted by the debtors.

See, e.g., Shortt, 277 B.R. 683.

However, this is a complete misapplication of Luongo. Luongo

does not stand for the proposition that the IRS has an absolute

right to set off pursuant to IRC § 6402(a) at anytime. Rather,

42 In re Lyle, 324 B.R. 128 (Bankr. N.D. Cal. 2005) (denying

Chapter 13 debtor’s motion to compel turnover of tax refunds and
for damages for violation of the automatic stay resulting from
IRS’s setoff of pre-petition support obligations against
anticipated pre-petition tax refund pursuant to IRC § 6402(c)); In
re Baucom, 339 B.R. 504, 507 (Bankr. W.D. Mo. 2006) (denying
debtor’s motion to reopen case and compel turnover of tax refund
against which IRS offset debt owed to Rural Housing Department);
Beaucage v. IRS, 342 B.R. 408, 411 (D. Mass. 2006) (dismissing
adversary proceeding challenging post-petition setoff of tax
liability); In re Jones, 359 B.R. 837, 841 (Bankr. M.D. Ga.

2006) (granting summary judgment in favor of IRS in adversary
brought by debtor to recover anticipated tax refunds against which
IRS set off pre-petition tax liability); In re Shortt, 277 B.R.
683, 692 (Bankr. N.D. Tex. 2002) (annulling stay to validate setoff
of pre-petition debt owed to Army and Air Force Exchange Service
against tax refund under IRC § 6402(d)); In re Pigott, 330 B.R.
797, 800 (Bankr. S.D. Ala. 2005) (upholding objection by IRS to
Chapter 7 debtor’s claim of exemption as to anticipated refund).

“3 See Lyle, 324 B.R. 128; Pigott, 330 B.R. 797; Shortt, 277
B.R. 683.

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Luongo held that where the IRS has properly exercised its setoff -—-
outside the pendency of the bankruptcy case -- there no longer is a
“refund” which may, thereafter, become property of the estate. This
Court agrees with Luongo on this point. As noted above, the Fifth
Circuit’s decision in Luongo specifically states that it did “not
reach the exemption issue decided below -- that is, whether § 522(c)
prevents a creditor from exercising its right of setoff preserved in
§ 553.” Luongo, 259 F.3d at 328. Therefore, it is inaccurate for
these more recent cases to cite the Fifth Circuit’s decision in
Luongo as authority for the proposition that, because of the netting
allowed by IRC § 6402(a), the IRS’s setoff claim under § 553 trumps
an exemption asserted by the debtor, without opposition, under

§ 522.

Although the netting argument has been frequently cited
favorably in recent setoff cases, as if it represented a new,
important insight on the setoff issue, it is not at all new. Long
before Luongo and the later cases which greatly expanded the netting
argument, the Seventh Circuit espoused the netting theory in

Pettibone Corp. v. United States, 34 F.3d 536 (7 Cir. 1994).

Pettibone even went so far as to suggest in dicta that netting of
pre-petition tax liabilities by the IRS does not constitute a
“setoff” within the meaning of Bankruptcy Code and, therefore, the
IRS would not be subject either to the automatic stay under § 362 or

the requirements for setoff under § 553.‘ This position was then

“4 After explicitly setting forth this position, the Pettibone

court then said it did not reach the issue of whether the IRS’s
setoff “would have been permissible as a setoff under the
Bankruptcy Code[,]” because the plan permitted the setoff.
Pettibone, 34 F.3d at 539-40.

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interpreted as the holding of Pettibone by many courts and Pettibone
was cited as authority for the position that “no setoff [occurs]

when the IRS [nets] the debtor’s underpayments and overpayments in

arriving at the amount of the debtor’s refund.” United States v.
Midway Indus. Contractors, Inc. (In re Midway), 178 B.R. 734, 737
(N.D. Ill. 1995). Unlike the more recent netting cases, however,

Pettibone and the litany of cases that followed it did not deal with
a conflict between §§ 522 and 553 -- Pettibone solely addressed the
issue of setoff by the IRS.

Pettibone’s proposition that netting by the IRS does not
constitute a setoff under § 553 is echoed in the reasoning of the
more recent pro-setoff cases, which hold that this netting removes
the refund from the property of the estate. If IRC § 6402 simply
defines whether a refund exists, as these recent cases argue, the
post-petition netting of pre-petition tax liabilities would not
constitute a “setoff” within the meaning of the Bankruptcy Code. If
refunds do not become property of the estate unless there are funds
left after the IRS nets liabilities -- assuming, of course, the IRS
chooses to do so under IRC § 6402(a)** -- then there would be no
need for the IRS to seek relief from stay to effectuate such a

netting. The IRS would not be taking any action against property of

45 The setoff of tax liabilities against tax refunds under IRC

§ 6402(a) is discretionary. Setoffs for other types of debts are
governed by other sections of § 6402 -- past due support
obligations are governed by § 6402(c), obligations to other federal
agencies are governed by § 6402(d) and obligations on state income
tax are governed by 6402(e). The setoffs under §§ 6402(c), (d) and
(e) are mandatory in nature, not at the discretion of the IRS.

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the estate since, per this line of reasoning, there is no refund to
be property of the estate.

After Pettibone, several other courts rejected the notion that
the IRS’s netting under IRC § 6402 does not constitute a setoff
within the meaning of the Bankruptcy Code, thereby eliminating the
need for the IRS to seek relief from stay. Rather, those courts
specifically held that the IRS did need relief from stay to allow a
setoff in order to net refunds owed by the IRS against taxes owed by
the taxpayer. The predominant case rejecting Pettibone and the

netting argument is the Second Circuit's decision in Aetna Casualty

and Surety Co. v. LTV Steel Co., Inc. (In re Chateaugay Corp.), 94

F.3d 772, 780-82 (2d Cir. 1996).**° Chateaugay unequivocally held

that the “netting” of an “overpayment” to extinguish an
“underpayment” is a classic setoff within the meaning of the

Bankruptcy Code. Therefore, the IRS, like any other creditor with a

“6 See also 5 Collier on Bankruptcy, @@ 553.06{3][{b] (15th ed.
rev. 2007), fn. 26, citing United States v. Norton, 717 F.2d 767,
772, 9 C.B.C.2d 336, 344 (3d Cir. 1983); United States v. Reynolds,
764 F.2d 1004, 1006-1007 (4 Cir. 1985); United States v. Johnson
(In re Johnson), 136 B.R. 306, 308-11 (Bankr. M.D. Ga. 1991); In re
Hackney, 20 B.R. 158, 159 (Bankr. D. Idaho 1982); Rozel Indus.,

Inc. v. Internal Revenue Serv. (In re Rozel Indus., Inc.), 120 B.R.
944, 948 (Bankr. N.D. I11l. 1990); In re Franklin Sav. Corp., 177

B.R. 356, 359-60 (Bankr. D. Kan. 1995); In re Academy Answering
Servs., Inc., 20 C.B.C.2d 174, 177-78, 90 B.R. 294, 295-96 (Bankr.
N.D. Ohio 1988); rev'd on other grounds, 100 B.R. 327 (N.D. Ohio
1989); United States v. Perry (In re Perry), 26 B.R. 599, 600
(Bankr. E.D. Pa. 1983); In re Internal Revenue Service Liab. &
Refunds, 10 C.B.C.2d 609, 611, 30 B.R. 811, 812-14 (M.D. Tenn.
1983) (vacating as violating the automatic stay and the strictures
of section 553 an agreed order that would have permitted IRS to
exercise its Section 6402(a) setoff procedures in every chapter 13
reorganization case in the district without further judicial
inquiry); Runnels v. I.R.S. (In re Runnels), 134 B.R. 562, 564-65
(Bankr. E.D. Tex. 1991); In re Burrow, 36 B.R. 960, 963 (Bankr. D.
Utah 1984).

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setoff right that has not yet been exercised, is subject to the
provisions of §§ 362 and 553. The Chateaugay court held:

By arguing that the “accounting” procedure under 6402 (a)
is something other than an ordinary right of setoff, the
government in essence asks us to find that the bankruptcy
laws do not apply to the IRS. This we cannot do. For the
Supreme Court has quite clearly held that “(nJothing in
the Bankruptcy Code or its legislative history indicates
that Congress intended a special exception for the tax

collector.” United States v. Whiting Pools, Inc., 462
U.S. 198, 209, 103 S.Ct. 2309, 2316, 76 L.Ed.2d 515
(1983); see also United States ex rel. IRS v. Norton, 717

F.2d 767, 772 (3d Cir. 1983).
Chateaugay, 94 F.3d at 780-81.%’
This Court finds Chateaugay much more persuasive and better

reasoned than Pettibone. The problems noted in Chateaugay with the

netting approach, as set forth in the above quote, are well taken.
The setoff sought by the IRS is not unlike the setoff by any other
creditor. The tax refunds in dispute ceased being property of the
estate when Debtor exempted them, without opposition by the IRS.
Taylor, 503 U.S. 638. At that point, the exempt tax refunds were no
longer subject to any possible setoff against debts owed by the

estate.
4. Analysis of Three Lines of Cases
The interplay between §§ 522 and 553 is clearly a difficult

issue. While the three lines of cases noted above provide extensive

*” Indeed, even the IRS has interpreted a setoff under IRC
§ 6402(a) as a “collection activity” and not merely an accounting
procedure. See Hall v. Commissioner of Internal Revenue, 2004 WL
1616382, at *2 (U.S. Tax Ct. 2004), citing Campbell v.
Commissioner, 121 T.C. 290, 292, 2003 WL 22765712 (2003) and secs.
1.6015-5(b) (2) (I), 1.6015-9, Income Tax Regs (defining an offset of
an overpayment against a liability pursuant to section 6402 asa
collection activity effective for requests for relief from joint
and several liability filed on or after July 18, 2002).

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\o oO ~ ON Nn - Ww i) —

nN N N iS) NO i) N bo dN — — — —_ — — — — — —
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fal!

justifications for the decisions reached, the strict application of
any of these three lines of reasoning is problematic. To adopt the
stringent reading of § 553, which dictates that § 553 always trumps
§ 522, as advocated by decisions such as Bourne, would necessarily
ignore the directives from within the Ninth Circuit to consider the
equities presented in each case. However, adopting an approach that
always favors exemption over setoff -- outside of the Taylor failure
to object context -- would be equally inappropriate.

The interpretation advocated by the cases adopting the netting
approach -- and primarily relied upon by the IRS in its Motion --
is, however, the most problematic. Luongo, as expressly stated by
the Fifth Circuit in its decision, does not address what should
happen when the IRS seeks to set off against a refund that is
already exempt. Those are the facts currently before the Court. In
addition, as discussed above, Luongo and the netting argument
clearly do not support the granting of a motion for relief from
stay, which is currently before the Court in this case. Rather, the
logical extension of the netting argument, as discussed in Pettibone
and rejected in Chateaugay, would be that the IRS could operate
entirely outside the Bankruptcy Code in netting pre-petition tax
refunds against pre-petition tax liabilities, and the IRS would not
need to seek relief under §§ 362 and 553.

While the BAPCPA provides that, in post-BAPCPA cases, the
automatic stay does not apply to setoffs by the IRS pursuant to
§ 6402(a), the new § 362(b) (26) did not exist at the time this case
was filed. Further, the new § 362(b) (26) recognizes that the
netting of tax liabilities under IRC § 6402 is, in fact, a “setoff”
within the meaning of the Bankruptcy Code -- it simply provides that

MEMORANDUM DECISION ON MOTION
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UNITED STATES BANKRUPTCY COURT

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\o (oe) ~] nN ~ - ee) N —

bdo bo No No ho i) No i) No pe — — —_ _ = be — — —
foe) ~l Nn Nn & Go No — So \o (oe) ~l Nn wa & Ww N — Oo

the automatic stay no longer applies to such setoffs. However, the
new § 362(b) (26) does not address the ability of the IRS to offset
pre-petition tax liabilities after a debtor has fully exempted pre-
petition tax refunds. This issue was not addressed by the BAPCPA
and is not presently before this Court. In the future, the conflict
between §§ 522 and 553 may arise either in the context of the IRS’s
objection to a claim of exemption with respect to a tax refund, or
in the context of a turnover action by the debtor under § 542 --
rather than, as here, in the context of a motion for relief from
stay to effect a setoff. See footnote 21 supra.

The crux of the IRS’s Motion is that the IRS must be granted
relief from stay because there is no “refund” Debtor may exempt
after the IRS’s netting of the pre-petition tax debts pursuant to
IRC § 6402(a). This argument rests solely upon distinction between
a tax “overpayment” and a tax “refund” adopted by the cases
following the netting approach. However, this Court finds this
premise unworkable for largely the same reasons as expressed by the
Second Circuit in Chateaugay.

If the netting argument is accepted, then the IRS does not need
relief from stay to effectuate the “netting” under IRC § 6402(a),
since, under this view, the netting merely defines whether a
“refund” exists and does not constitute a setoff within the meaning
of § 553. For this reason, even if the Court were to adopt the
underlying basis for the Motion, i.e., that there is no property of
the estate until the IRS performs its netting operation, it would,
nevertheless, have to deny the Motion itself. The IRS has not
argued in the Motion that it can set off without relief from stay.

Therefore, that issue is not properly before this Court and is not

MEMORANDUM DECISION ON MOTION
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39

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\o ee) ~] ON in & Oo i) _

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oo ~ ON iw) - wo No aon j=) \o oo ~ ON a eS (es) i) = oo)

decided by this decision. The Court merely finds that Luongo and
the decisions adopting the netting approach do not support relief
from stay as requested by the Motion.

D. Alternative Holding - Balancing of Equities

If Taylor is not dispositive of the issue before the Court, the
Court also finds, as an alternative holding, that the Motion should
be denied on its merits. Perhaps contrary to the three lines of
cases noted above, the Ninth Circuit directs this Court to balance
the equities presented. See FDIC v. Bank of America, 701 F.2d at
836-37; Cascade Roads, 34 B.R. at 763; Pieri, 86 B.R. at 210. In
balancing those equities, there are several important factors that
weigh in Debtor’s favor.

First and foremost, the IRS did not object to the exemption of
the refunds by Debtor. The IRS could have easily objected to the
exemption on the basis that, as the IRS well knew, Debtor had not
yet filed his tax returns for 1999-2004. These tax returns were not
fully filed by Debtor until roughly two months after Debtor asserted
his exemptions. The IRS had been active in Debtor’s case early on
and had filed an objection to confirmation of the Original Plan on
this very basis. As also noted above, the IRS could have objected
to the exemption on the basis that Debtor was not entitled toa
“refund” under IRC § 6402(a) and the exemption was, therefore,
without merit.

Alternatively, the IRS could have also asked for an extension
of time, pursuant to Federal Rule of Bankruptcy Procedure 4003(b),
to object to the exemptions until it had an opportunity to review
the late-filed tax returns for 1999-2004 and to evaluate its

potential setoff claims under IRC § 6402(a). The IRS does not argue

MEMORANDUM DECISION ON MOTION
FOR RELIEF FROM STAY BY IRS

40

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\o oo ~] nN in - Ww N _

N N do N No N in NO bdo = = —_ — — — —_ — —_ —
[oe] | nN nn a ww N — oS Ne} foe] ~l N nN oN W bo = fom)

that it was somehow prevented from filing a timely objection to the
exemptions, or that to require the IRS to object to the exemptions
of tax refunds by debtors would present an undue burden.

The IRS simply chose not to file an objection. Therefore, the
merits of such potential objections and/or requests for an extension
of time to file an objection are not properly before this Court, and
this decision is not meant to address how the Court might have ruled
on such objections or requests. The fact that the IRS chose not to
file an objection to the exemption of the tax refunds prevented the
Court from addressing any such issues in a timely manner and weighs
in Debtor’s favor in a substantive balancing of the equities -- in
addition to the dispositive effect such failure to object has under
Taylor.

Second, IRC § 6402(a) does not confer upon the IRS any
extraordinary status or rights. It is merely a provision allowing
the discretionary setoff of debts owed to the IRS. Setoff is a
right held by many types of creditors under various non-bankruptcy
laws. Other subsections of IRC § 6402 do confer special rights and
status to other governmental agency creditors, if certain additional
requirements are met.‘

For example, in Lyle, the state agency to which dependent care
debts were owed intercepted the debtor’s future income tax refunds,
pursuant to IRC § 6402(c). Pre-petition, the state agency notified

the debtor that his delinquent child support obligations would be

“8 IRC § 6402(c) allows for the interception of tax refunds
for the payment of pay due support obligations. IRC § 6402(d)
allows for the interception of tax refunds for the payment of debts
owed to Federal agencies, other than the IRS. IRC § 6402(e) allows
the interception of tax refunds for the payment of state income tax
obligations.

MEMORANDUM DECISION ON MOTION
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\o oo ~ ON wa) > Oo bo —

NO NO iS) i) N i) N i) No —_ — —_ — _ — = _ = —_
oe) ~] aN — - Ww No — (on) Ne) [oo] ~] ON GN as to NO — ©

subject to collection through the federal tax intercept program, and
that if he wanted to dispute obligations he needed to contact the
state agency. The debtor did not dispute the obligations. This
satisfied the notice requirements of IRC 6402(c). When the tax
refund was due to the debtor post-petition in Lyle, the IRS was
already under a pre-existing statutory obligation to transfer the
funds to the intercepting state agency. The IRS had no discretion
to do anything else, and the Bankruptcy Court had no authority to
order otherwise.*’? Here, there is no such statutorily-mandated
interception in place by another governmental agency. This is
simply an attempt by the IRS to exercise its discretionary ability
to set off debts owed to itself. Under the facts at hand, the
setoff rights of the IRS under IRC § 6402(a) are just the same as
any other creditor’s setoff rights and the IRS is not afforded
special treatment.

Third, this discretionary right of setoff was not timely
exercised by the IRS in this case. Unlike Luongo, the IRS had not
set off the tax liabilities prior to Debtor’s claim of exemption.

In this case, Debtor’s exemption came first and was followed several

months later by the IRS’s motion for relief from stay to set off.

49 IRC § 6402(f£), which emphasized the non-discretionary
nature of the interception, provides, in pertinent part, as
follows:

No court of the United States shall have jurisdiction to
hear any action, whether legal or equitable, brought to
restrain or review a reduction authorized by subsection
{c), (d), or (e@). No such reduction shall be subject to
review by the Secretary in an administrative proceeding.

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0 Oo ND WwW BR WwW NY &

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(oe) ~~] ON a) & QW No — © \o loa) ~] nN ws > Oe i) bo (an)

Cap

Finally, the facts of this case relating to Debtor’s financial
position weigh heavily in favor of denying the IRS’s claim of
setoff. The Ninth Circuit has directed that setoff should not be
allowed when it would be inequitable or against public policy to do

so. FDIC v. Bank of America Nat'l Trust and Savings, 701 F.2d at

836-37.°° The facts presented by this case do not show a debtor
trying “to take unfair advantage” of an adversary by using a claim
of exemption to defeat a setoff. Pieri, 86 B.R. at 213.°* The
record shows a debtor who has absolutely nothing else but the tax

refunds in question to “provide him with the basic necessities of

50 California state law has also protected exempt property

against claims of setoff when necessary to further state policy.
See In re Ter Bush, 273 B.R. 625, 631-32 (Bankr.S.D. Cal.

2002) (finding California state law supportive of “the proposition
that exempt property will be protected from setoff when an
important public policy regarding the rights of the debtor is
involved, regardless of the statutory language granting the
exemption.”); see also Birman v. Loeb, 64 Cal.App.4th 502

(1998) (disallowing setoff of debt owed by debtor against non-
judicial foreclosure deficiency); Barnhill v. Robert Saunders &
Co., 125 Cal.App.3d 1 (1981) (disallowing setoff of employee’s
exempt wages against debts owed to employer); Kruger v. Wells Fargo
Bank, 11 Cal.3d 352 (1974) (disallowing setoff against debtor’s bank
account containing funds derived from unemployment compensation and
disability benefits); Williams v. Williams, 8 Cal.App.3d 636

(1970) (disallowing setoff against alimony or child support
payments).

51 See also In re Winnett, 97 B.R. 7 (Bankr. E.D. Cal.
1989) (finding attorneys had superior rights to funds held in an
attorney’s trust account subject to a pre-petition fee dispute with
the debtors notwithstanding debtors’ assigrment of their rights to
disputed funds as a down payment for a new home and the subsequent
claim of homestead exemption as to such disputed funds upon then
filing bankruptcy); In re Glaze, 169 B.R. 956 (Bankr. D. Ariz.
1994) (allowing setoff of damages awarded by state court arising
from the forced sale of debtors’ home even though debtors had
subsequently filed bankruptcy and asserted a homestead exemption as
to the proceeds in hopes of defeating the damages award).

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io.) ~] n an - Ww N

\o

10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
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life.” H.R. Rep. No. 95-595 at 126. Debtor’s schedules show a
positive monthly cash flow of only $75, which Debtor has dedicated
to payments under his confirmed Amended Plan. Debtor has virtually
no assets, other than his tax refunds, and he has two dependent
children. Allowing the IRS to set off the tax refunds would take
from Debtor his wildcard exemption -- the most important exemption
available to him as a nonhomeowner. This would be contrary to both
the interest of bankruptcy policy and California state exemption
policy.

There are factors weighing in the IRS’s favor. Debtor owes
pre-petition income taxes, both to the IRS and to the FTB.°? Debtor
failed to file tax returns for six consecutive years pre-petition.
Finally, there is a presumption in favor of allowing setoffs in
recognition of the long-standing common law right. In re Hal, 122
F.3d 851, 852 (9%» Cir. 1997). However, that presumption does not
withstand the countervailing equities weighing in the Debtor’s
favor, as discussed above, under the facts presented.

The Court notes that the IRS has argued that its setoff right
gives it a secured claim under § 506(a) which provides:

An allowed claim of a creditor .. . that is subject to

setoff under section 553 of this title, is a secured claim

. to the extent of the amount subject to setoff

and is an unsecured claim to the extent that .. . the

amount so subject to setoff is less than the amount of

such allowed claim.

Because the Court has determined that the equities weigh in favor of

Debtor’s exemption over the IRS’s claim of setoff, § 506(a) is no

longer applicable to the IRS’s claim. The Court is denying the

52 See footnote 25 supra.

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\O oo ~— nN mm - w i) _

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(oe) ~~] nN WN - (oS) i) — =) \o oo ~~ nN ws BS (oe) N bowen oS

IRS’s claim of setoff, not merely delaying it by treating it as a
secured claim under the Amended Plan. To delay, rather than deny,
setoff would be to eviscerate the purpose of this Debtor’s crucial
wild card exemption.

Finally, the Court notes that the IRS has suggested that the
Court only has the discretion to delay setoff rather than to deny it
entirely. Specifically, the IRS has argued:

[D]enying relief from stay serves no conceivable purpose

because the Court lacks jurisdiction to order a tax refund

and because Debtor is not entitled to have it turned over

to him. The tax overpayments will be permanently frozen

until the stay terminates or the statute of limitations
for a refund claim expires.

IRS’s Supp. Brief at 2:25-3:3. This argument was soundly rejected

by the Ninth Circuit BAP in Cascade Roads, 34 F.3d at 765-66.

Further, this argument fails to recognize that it is the Court --
not the IRS -- that is charged with the duty of evaluating setoff
claims under § 553. The caselaw is clear that it is within the
Court’s discretion to grant or deny a motion for relief from stay to
allow a party to effectuate a setoff. Cascade Roads, 34 F.3d at
763; FDIC v. Bank of America Nat’l Trust and Savings, 701 F.2d at
836-37. The Court is not bound by the netting argument espoused by
the Fifth Circuit in Luongo, which is the only support for the IRS’s
assertion that “Debtor is not entitled to have [the tax refund]

turned over to him.”

IV.
CONCLUSION
For the reasons set forth in this Memcrandum Decision, the

IRS’s Motion is denied and the IRS is not permitted to offset

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\o oe) ~] ON wa) - ioe) N

10
ll
12
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Debtor’s unpaid tax liabilities against the $6,852 owed to Debtor as
tax refunds for 2002 and 2004. The Court denies the Motion on two
separate bases: (1) Debtor’s exemption of the tax refunds is no
longer subject to challenge pursuant to Taylor and (2) the equities
require that the IRS’s setoff rights yield to Debtor’s wildcard
exemption on the facts of this case.

For the reasons stated above, the IRS is also not entitled to
have a portion of its claim treated as a secured claim pursuant to
§ 506(a).

Because the Court has determined that the IRS is not entitled
to set off, the IRS does not have a basis to retain the $6,852 owing
to Debtor as tax refunds for 2002 and 2004. Therefore, the IRS
shall promptly turn over these funds to Debtor.

Counsel for Debtor shall submit a proposed form of order after

review by counsel for the IRS as to form.

ARTHUR S. WEISSBRODT
UNITED STATES BANKRUPTCY JUDGE

Dated:

Mark 31, 200%

MEMORANDUM DECISION ON MOTION
FOR RELIEF FROM STAY BY IRS

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\o oo ~] nN way -& Go NO _

NO N NO NO No N NO No No — — — — — — — — —_ —
oe) ~] nN Nn a OO bo _ fan) Nes} (ove) ~l] an wa & wo iw) = jm)

Court Service List

John W. Strate, Esq.

Special Assistant U.S. Attorney
55 S. Market Street, Suite 505
San Jose, CA 95113

David A. Boone, Esq.

Law Office of David A. Boone
1611 The Alameda

San Jose, CA 95126

Anthony S. Gould
872 Leigh Ave.
San Jose, CA 95128

Devin Derham-Burk
P.O. Box 50013
San Jose, CA 95150-0013

Office of the U.S. Trustee
U.S. Federal Bldg.

280 S Ist St. #268

San Jose, CA 95113-3004

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