Category Archives: refund intercept/refund

Can the IRS Intercept a Tax Refund to Pay Non-Tax Debts Owed to Other Federal Agencies?

Absent bankruptcy, the federal Treasury Offset Program (“T.O.P”) allows the IRS to offset a non-tax debt owed by a taxpayer to a federal agency against a federal income tax refund owed to the taxpayer.  See 26 U.S.C. §6402.  The right of offset (aka “setoff”) allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding the absurdity of making party A pay party B when party B owes party A.

The IRS’ Treasury Offset Program authorizes the Secretary of the Treasury to intercept a taxpayer’s tax overpayment and apply it to preexisting debts.  Section 6402(a) of the US Tax Code provides that the Treasury “may” credit a taxpayer’s income tax overpayment against any tax liability.  Whereas, §6402(d) provides that Treasury “shall” credit a taxpayer’s income tax overpayment against a non-tax debt owed to another federal agency other than the IRS.

However, a taxpayer objected to the IRS intercepting a tax refund in the bankruptcy case of In re Addison, 533 B.R. 520 (Bankr. W.D.VA 2015).  There, the taxpayer argued that the US Bankruptcy Code’s automatic stay provisions of 11 U.S.C. §362(a)(7) prohibited the IRS from offsetting the tax refund against the non-tax liability owed by the taxpayer to the US Department of Agriculture, which related to a mortgage foreclosure deficiency.  The IRS countered and argued that §362(a)(7) did not apply because it was superseded by 11 U.S.C. §362(b)(26)’s negation of the automatic stay for setoffs by the IRS.

The Addison court rejected the IRS’ argument and held that §362(b)(26) did not apply to the facts of this case because §362(b)(26) only applied when the IRS was setting off tax debts owed to the IRS.  In the Addison case, the IRS was setting off non-tax debts owed to the US Department of Agriculture.  Specifically, the court stated §362(b)(26) constrains the reach of the automatic stay by excepting from violating the automatic stay the setoff under applicable nonbankruptcy law of an income tax refund…against an income tax liability.  (emphasis added).

Practice Pointer:   The IRS has broad tax intercept powers to collect debt on behalf of the federal government.  However, these powers are not unlimited.  In the bankruptcy concept, the IRS has the power to intercept tax refunds to offset tax liability relating to a taxable year that ended before the bankruptcy filing date, but the IRS does not have the power to intercept tax refunds to offset non-tax liability owed to other departments of the US Government.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Can a Bankruptcy Trustee Force the IRS to Surrender Trust Fund Taxes Paid by a Bankruptcy Payroll Company?

It is not uncommon for a for-profit corporation to outsource payroll services to an independent payroll company (“Payroll Provider”) to help administer payroll tasks.  A corporation typically advance funds to the Payroll Provider near the end of a payroll cycle, which are in turn used by the Payroll Provider to pay wages to the corporation’s employees and pay corresponding trust fund obligations to the various taxing authorities.

But what happens when the Payroll Provider files bankruptcy within 90 days of paying trust fund obligations to the IRS?  The issue is one of “preferential transfer.”  This issue was addressed in Slobodian v. United States of America, 533 B.R. 126 (Bankr. M.D.PA 2015), where the Payroll Provider paid $32,297 to the IRS within the period 90 days prior to the Payroll Provider filing bankruptcy.

In Slobodian, The Chapter 7 trustee filed an adversary complaint against the IRS alleging that the IRS payment was a preferential transfer because it was made within 90 days of the bankruptcy filing.  The trustee sought disgorgement of the $32,297 so that the funds could be redistributed to all creditors according to their statutory rights.

The Slobodian court ruled that in order to disgorge a purportedly preferential transfer, a trustee must demonstrate a (1) transfer of an interest of the debtor in property (2) to or for the benefit of a creditor (3) for or on account of an antecedent debt owed by the debtor, and (4) made while the debtor was insolvent.  11 U.S.C. §547(b).

So the big issue for the Slobodian court to determine was whether the $32,297 payment constituted a “transfer of an interest of the debtor in property.”  The IRS argued that the Payroll Provider never possessed an interest in the property for preference action purposes, and instead held the transferred funds in trust, to be transmitted to the United States pursuant to the Payroll Provider’s payroll service agreement with the corporation that provided the funds to the Payroll Provider.  The IRS asserted that the funds were held in a special statutory trust for the United States pursuant to 26 U.S.C. §7501(a), which states “Whenever any person is required to collect or withhold any internal revenue tax from any other person and to pay over such tax to the United States, the amount of tax so collected or withheld shall be held to be a special fund in trust for the United States.”  The special trust applies to Social Security, Medicare, and income taxes that Congress requires employers to withhold from employees’ paychecks, commonly referred to as “trust-fund taxes.” Id. at 134, citing Begier v. Internal Revenue Service, 496 U.S. 53, 54 (1990).

The Slobodian court agreed with the IRS and found that corporation’s channeling of trust fund taxes through the third-party Payroll Provider did not dilute the protections of the 26 U.S.C. §7501(a) trust.  The corporation tendered the funds to the Payroll Provider which collected the funds pursuant to its payroll services agreement and withheld both trust fund and non-trust fund taxes from the collected funds before ultimately distributing employee paychecks.  Therefore, the Payroll Provider did not own an equitable interest in the property it held in trust for the corporation, and thus the $32,297 payment was not “property of the estate” for purposes of preferential transfers of 11 U.S.C. §547(b).

The IRS was allowed to retain the payment and the corporation received full credit for the trust fund payments.

Practice Pointer: Be careful when dealing with payroll providers.  Perform due diligence on the providers before tendering money to them.  Make sure the funds tendered by the corporation to the payroll service are made from a segregated trust fund account and not from the corporation’s general operating account.  The preferred method would be two separate payments being made to the payroll service: one payment for employees; and one payment for the taxing authorities.  This preferred method would buttress a corporation’s argument that the trust fund payments were tendered to the payroll service in trust as part of a 26 U.S.C. §7501(a) trust fund. It may not be “convenient” but it is following best practices.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Don’t Trust the IRS’ Advice, it May be Wrong!

What recourse do taxpayers have if they wrongly rely upon the IRS’ bankruptcy advice?  None according to In re Brown, 533 B.R. 344 (Bankr. M.D. FL 2015).  There, taxpayers followed the IRS’ inaccurate bankruptcy advice that resulted in unwanted tax collections, including levies against the taxpayers’ bank accounts and tax refund offsets after the taxpayers’ bankruptcy case concluded.  The Brown court rejected the taxpayers’ theories of laches and estoppel to stop the IRS  because these equitable doctrines could not thwart the clear mandate of the U.S. Bankruptcy Code.  11 U.S.C. §101 et seq. The opinion did not state whether the taxpayers were represented by counsel at the time the IRS gave the advice or, if represented, why the taxpayers did not rely on contrary advice given by the taxpayers’ attorney.

Originally, the Brown taxpayers sought bankruptcy protection for relief from the IRS’ collection efforts initiated prior to the bankruptcy filing.  The taxpayers’ confirmed repayment plan, as amended, provided for the repayment of 100% of the IRS’ non-dischargeable priority tax claims and only a small percentage of the IRS’ non-priority unsecured claims relating to tax penalties (hereinafter, “Penalty Claims”).

Later, the taxpayers experienced problems making the plan payments.  The IRS recommended a strategy urging the taxpayer to file for a “hardship discharge” pursuant to 11 U.S.C. §1328(b) and then resolve the remaining priority debt issue outside of bankruptcy through an offer in compromise.  According to the IRS, this strategy would have allegedly discharged the Penalty Claim.  The taxpayers took the IRS’ advice and concluded the bankruptcy early by obtaining a hardship discharge.

The post-bankruptcy events did not go as planned.  The taxpayers’ offer in compromise was rejected by the IRS and the IRS sought to collect both the priority claim PLUS the Penalty Claim.  After the bank levied the taxpayers’ bank accounts and offset their tax refund, the taxpayers filed action in the bankruptcy court alleging the IRS violated the bankruptcy discharge injunction.

The Brown court had to determine if a hardship discharge under 11 U.S.C. §1328(b) eliminated the IRS’ Penalty Claim since the IRS encouraged the taxpayers to pursue a hardship discharge, and at no time indicated the IRS intended to collect on its Penalty Claim after the hardship discharge.

First, the Brown court understood that the hardship discharge of 11 U.S.C. §1328(b) is more limited in scope than the general discharge of 11 U.S.C. §1328(a).  Of particular importance was the discharge exception relating to tax penalties pursuant to 11 U.S.C. §523(a)(7). Unlike the general discharge of §1328(a) which eliminates tax penalties, the hardship discharge of §1328(b) does not discharge tax penalties relating to government claims for income taxes due within the three years prior to the bankruptcy filing.

Second, the Brown court found that the IRS’ inaccurate advice rendered prior to the entry of the hardship discharge did not affect the dischargeability of the IRS’ Penalty Claim.  The Penalty Claims remained non-discharged.  Therefore, the IRS was not violating the discharge injunction when it levied on the taxpayers’ bank accounts because the IRS’ debts were not discharged when the taxpayers received the §1328(b) hardship discharge.

Practice Pointer: Do not take the IRS’ advice on bankruptcy issues of law. Contact a qualified bankruptcy attorney with extensive experience in income tax dischargeability.  Taxpayers should follow the advice of experienced counsel and not the advice/strategy of the IRS.  Honest taxpayers who follow the IRS’ inaccurate advice could find themselves in deep trouble.  The old adage is true:  You get what you pay for; so don’t take free advice!

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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The IRS Seized the Corporation’s Assets. Can a Corporation File Bankruptcy and Discharge Tax Debts? 

I’m often asked how a corporation can eliminate its tax debts.  Typically, the corporation has withheld taxes from its employees’ paychecks but has not tendered these “trust fund taxes” to the IRS or state taxing authority.  These withheld funds are referred to as “trust fund taxes” because the employer withheld the money “in trust” for the benefit of the IRS or other taxing authority.

An employer who is struggling financially uses the trust fund taxes as a source of hard currency, much like it would if granted a bank loan.  An employer hopes the use of the trust fund taxes would defuse a business crisis or at least keep the business afloat until brighter days (entrepreneurs always see a brighter tomorrow).  The problem is the IRS is not a lender and did not voluntarily give the employer the money —and certainly has not granted the employer authorization to use the trust fund taxes.

The IRS is typically aggressive in collecting the trust fund taxes.  The IRS can intercept tax refunds, lien, levy, seize, and exercise other collection tactics.  Seizure of the corporation’s asset could terminate the business.  For example, what would a restaurant owner do if the president arrived at the restaurant one morning to find the IRS had seized all the tables, chairs, refrigerators, freezers, etc.? Panic of course!

So what is the corporation to do?  Call its lawyer of course!  But there is only so much a lawyer can do in such an emergency.

The corporation is generally not in a position to repay the IRS the full amount of the trust fund taxes in a quick lump-sum payment so that the assets are returned.  Lawyers can contact the IRS and try to negotiate an installment agreement or an offer-in-compromise— but that takes time and the IRS would be in no hurry to relieve the taxpayer’s pressure by returning the assets.  An emergency bank loan would be nice, but that is not realistic because of the pending tax obligation and the fact that the restaurant is not operating since the IRS seized the tables, chairs, refrigerators, freezers, etc.

So bankruptcy becomes the obvious solution.  Chapter 13 is not available because the tax debt is owed by the corporation and Chapter 13 is available only to individuals.  Chapter 11 is a great option. Filing the Chapter 11 bankruptcy case would grant the corporation with the “automatic stay” protections of the US Bankruptcy Code.  The attorney would contact the IRS to negotiate a return of the assets for the company’s promise to pay adequate protections payments to the IRS going forward.  If negotiations are unsuccessful, then the court should rush to the courthouse to file an adversary proceeding to force the IRS to return the assets… again, the company would have to provide the IRS adequate protection.  But at least the company could return to regular business operations.

Some clients ask if the taxes could be discharged by filing Chapter 7 bankruptcy without the need to pay any adequate protection payment to the IRS. The answer is NO.  That strategy was tried by a convenience store operating in Senatobia, Mississippi in the case of In re Sarfani, Inc., 527 B.R. 241 (Bankr. N.D.MS 2015).  In Sarfani, the company attempted to discharge unpaid sales taxes collected from customers as “trust fund” taxes.  The court rejected the company’s attempt to discharge the taxes because Sarfani, Inc. was a corporation and Chapter 7 bankruptcy discharges are only available to individuals (human) and not corporation, partnerships, LLCs, LLPs, trusts, etc.  11 U.S.C. §727(a)(1).  So, Chapter 11 would be the best bet.

PRACTICE POINTERS: The best tax planning is advanced tax planning. Bankruptcy lawyers are frequently contacted in emergencies after the IRS collectors have struck and struck hard—shuttering a business.  The IRS can be agreeable if the company negotiates before the issue comes to a boil.  But once the IRS collectors have taken action a company would typically need court intervention and the bankruptcy protections to survive.  How long can a company survive that is shuttered?  NOT LONG!  Customers find competitors, suppliers and vendors get frightened, and employees quit and find other jobs.  Immediate Chapter 11 bankruptcy protection would be warranted.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Will I Lose my Tax Refund if I File Bankruptcy?

Here’s a common fact pattern.  A taxpayer files bankruptcy in June of a tax year and receives an IRS tax refund in April of the following calendar year.  What happens to the non-exempt portion of the IRS tax refund?  The taxpayer would want to keep the refund, but the Chapter 7 trustee would want a turnover of the refund for the benefit of the unsecured creditors.

That issues was addressed in In re Mooney, 526 B.R. 421 (Bankr. M.D.GA 2015).  In Mooney, the parties agreed that the taxpayer should be allowed to keep the portion of the tax refund representing income earned after the bankruptcy case was filed to December 31.  The IRS argued that the taxpayer should be allowed to keep the same percentage of the tax paid after filing bankruptcy to the total tax refund; so if 25% of the tax payments were tendered after filing bankruptcy, then the taxpayer would be allowed to keep the same 25% of the total refund.

The Mooney court, rejected the IRS’ approach and adopted a “pro rata by days approach.”  Id. at 428.  The court held that the refunds should be prorated to the date of filing based on the number of calendar days before and after the bankruptcy filing date.  So, since the taxpayer filed bankruptcy on the 177th day of the year with 188 days remaining, then the trustee would be allowed to seize the percentage of the total refund that reflects 177/366, or 48.49%.  Similarly, the taxpayer would be allowed to retain the percentage of the total refund that reflects 188/365, or 51.51%.

Practice Pointer:  File as early in the calendar year as possible if a taxpayer is expecting a large refund. An early filing preserves the argument that the income was earned after the bankruptcy filing and the maximum share of the tax refund would be protected by the taxpayer.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Are Estimated Tax Payments Paid to the IRS Protected from Seizure in Bankruptcy?

Yes, estimated tax payments made to the IRS immediately before filing bankruptcy could be protected from seizure by the Chapter 7 trustee, according to In re Mooney, 526 B.R. 421 (Bankr. M.D.GA 2015).  In Mooney, an individual taxpayer tendered to the IRS $36,700 in estimated tax payments two days before filing Chapter 7 bankruptcy.  The Chapter 7 trustee wanted to seize those payments and filed a motion for turnover pursuant to 11 U.S.C. §542(a), arguing that the estimated tax payments were credits against the future tax liability and constituted “credits” that are property of the bankruptcy estate which are subject to turnover.  The taxpayer opposed the turnover motion and argued that the tax payments/credits are not within the taxpayer’s “control” because those payments can only be refunded by the IRS after the payments are applied to taxes due for the year in which the payments were made, citing Rev. Rul. 54-149, 1954-1 CB 159-60.

The Georgia bankruptcy court noted that the Eleventh Circuit in which it sits has never published a decision on the issue. But, the court noted that the Ninth and Tenth circuits have published conflicting opinions.  So the bankruptcy court analyzed both approaches.

Adopting the reasoning of the Tenth Circuit in the case of Weinman v. Graves (In re Graves), 609 F.3d 1153 (10th Cir. 2010), the Mooney court started its analysis by finding the tax credits were property of the bankruptcy estate.  But, the court noted that the Chapter 7 trustee succeeded only to the title and rights in the tax credits that the taxpayer had at the time the bankruptcy case was filed, nothing more.  The Mooney court believed the trustee’s interest in the tax creditors were limited to the same extent as a taxpayer’s interest in the application of a prior year tax refund, by the strictures of 26 U.S.C. §6513(d), which makes a taxpayer’s refund application election irrevocable.  A taxpayer would have no right to any cash refund of the estimated tax payments until their current tax liability is determined and then only if they are entitled to a further refund.

Finally, the court held that the bankruptcy estate’s interest in the pre-payment is limited to the taxpayer’s contingent reversionary interest in the pre-payment attributed to pre-petition earnings.  Stated differently, if the taxpayer is entitled to a refund after their current year tax liability was satisfied, then the Chapter 7 trustee is entitled to demand turnover of any amount of such refund attributable to the prepetition earnings.

Practice Pointer:  Tendering estimated tax payments to the IRS for the current year (or applying a tax refund from a prior year) prior to filing bankruptcy is a clever strategy to deplete non-exempt assets that would otherwise be seized by the trustee and distributed to the unsecured creditors.  Step two of the strategy would be to minimize the tax refund in the current year since the Chapter 7 bankruptcy trustee would be entitled to demand turnover of any amount of the refund attributable to the prepetition earnings. Taxpayers receiving a paycheck could reduce their tax withholdings in an effort to minimize the tax refund.  Self-employed taxpayers could seek to minimize refunds by minimizing net income from delayed income recognition and expedited expense recognition.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Taxpayer Keep an IRS Tax Refund Received Shortly Before Filing Bankruptcy?

An Illinois taxpayer received a $10,000 refund about a month before filing bankruptcy.  The taxpayer identified the tax refund in amended Schedule B as “2013 Tax Refund (Earned Income Credit) -$4,989.00; 2013 Tax Income Refund (Child Care Credit)-$3,000.”

The taxpayer sought to keep that money and protect it from seizure by the Chapter 7 trustee.  The trustee wanted to include the tax refund as a non-exempt asset that should be added to the “bankruptcy estate.” The taxpayer attempted to exempt the tax refund from the bankruptcy estate by claiming it was “public assistance benefits” protected under the Illinois exemption statute 735 ILCS 5/12-1001(g)(1).  The trustee did not object to the taxpayer’s characterization of the tax refund as “public assistance benefits.”  But, the trustee objected because the taxpayer received the refund before the bankruptcy filing date, and argued that the Illinois exemption statute cited by the taxpayer did not apply.

The court resolved the issue by sustaining the trustee’s objection to the taxpayer’s claimed exemption, thus causing the tax refund to become property of the bankruptcy estate for redistribution to the unsecured creditors.  In re Frueh, 518 B.R. 881 (Bankr. N.D.IL 2014)(Lynch, J).  The court made a distinction between a taxpayer’s Section 5/12-1001(g)(1) “right to receive…public assistance benefits” in the future and a taxpayer’s Section 5/12-101(h) “right to receive, or property that is traceable to…” an asset.  The Frueh court’s distinction clarified the Illinois legislature’s desire to exempt public assistance benefits to be received in the future and not public assistance benefits already received. The court noted that the legislature knew how to protect already received assets when it wanted to do so (citing Section 5/12-101(h)), and chose not to protect public assistance benefits already received.

Practice Pointer:  A taxpayer anticipating a tax refund relating to the Earned Income Credit and/or the Child Care Credit should file a Chapter 7 bankruptcy case PRIOR to filing the IRS tax return— to ensure the tax refund would be received AFTER the case filing.  If needed, a taxpayer could request from the IRS an automatic extension to the tax return filing deadline to ensure the refund would be received after the bankruptcy case was filed.  To do otherwise results in the loss of the tax refund to the Chapter 7 trustee for re-distribution to the bankruptcy creditors.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.