Bankruptcy Court Denies IRS and IDOR Setoff Against Chapter 12 Debtor's Refund

Note: This case was reversed on appeal on 11/25/2020.

A bankruptcy court recently ruled in a Chapter 12 case that federal and state taxing authorities do not have the right to offset a refund with tax debt stripped of its priority by 11 U.S.C. § 1232. This was a court’s first opportunity to rule on this question since the passage of the Family Farmer Bankruptcy Clarification Act of 2017. The case was In re DeVries, No.19-00181 (Bankr. N.D. Iowa April 28, 2020).

Background

In 2005, Congress added § 1222(a)(2)(A) to the Bankruptcy Code.  That provision carved out an exception for claims owed to a governmental unit that arose as a result of the sale, transfer, exchange, or other disposition of any farm asset used in the debtor's farming operation. These claims were to be treated as general unsecured claims subject to discharge. As explained by In re Ficken, 430 B.R. 663, 666 (B.A.P. 10th Cir. 2010) rev'd on other grounds, 433 Fed. Appx. 682 (10th Cir 2011):

The new provision attempts to mitigate the tax expense often incurred by farmers who have significant taxable capital gains or depreciation recapture when their low basis farm assets are foreclosed, sold, or otherwise disposed of by their creditors. Formerly, these dispositions created large priority tax claims that barred confirmation of Chapter 12 plans. By stripping these claims of their priority status and rendering them unsecured claims for distribution and discharge purposes, the drafters of BAPCPA sought to facilitate farmers' use of Chapter 12.

The provision, however, did not turn out to be as helpful as hoped. A split among the circuits arose as to whether the priority-stripping provision covered taxes from post-petition sales of farm assets during the pending Chapter 12 action. In 2012, the U.S. Supreme Court ruled that it did not in Hall v. United States, 566 U.S. 506 (2012). For the next five years, taxes arising from the disposition of farm assets during the pendency of a Chapter 12 case were not dischargeable. This meant that many farmers could not reorganize their operation by selling assets to “right-size” the business after the bankruptcy action began. And liquidating assets before the filing was often unworkable.

In October 2017, Congress enacted legislation to overrule Hall. New § 1232 was created to retain the “priority stripping” attributes of former § 1222(a)(2)(A) but extend them to taxes arising from post-petition sales.

In re DeVries

In re DeVries was a case of first impression on the question of whether the IRS or another taxing agency can offset a tax debt stripped of its priority by § 1232 against a tax refund otherwise owed to the debtor.

Facts of the Case

The debtors were a married couple. The husband had farmed for more than 20 years. The wife maintained employment off the farm. In 2017, the farmer separated his business from his brother and sold farmland and machinery as part of a workout plan with a secured creditor. This added $986,612 in capital gains to the debtors’ taxable income for the year. As a result of this sale, the debtors owed a significant amount of unpaid income taxes. This amount was reduced somewhat by income tax withholdings from the wife’s non-farm employment. These included $4,584 in withholdings for federal income taxes and $2,006 for taxes to the State of Iowa. To gain relief from their heavy tax debt, the debtors sought Chapter 12 bankruptcy protection. In their proposed plan, the debtors sought a return of the setoffs taken by the IRS and the Iowa Department of Revenue against the wife’s withholdings.

Objections to the Plan

IRS and the Iowa Department of Revenue objected to confirmation of debtors’ Chapter 12 on the grounds that it would require the agencies to deliver tax refunds to the estate for income withheld during the 2017 tax year. The agencies argued that the requested refunds had been rightfully offset against the tax debt owed under 11 U.S.C. § 553(a). The debtors argued that under 11 U.S.C. § 1232(a) income tax debt arising from the sale of farming property could not be offset against tax collected already, and that collected taxes had to be returned to the bankruptcy estate. The debtors also argued that allowing a taxing entity to keep withheld income would violate general bankruptcy policy by allowing similarly-situated creditors to be treated differently.

Court Opinion

The court overruled the agencies’ objections and confirmed the plan. With no case law on point to guide the decision in this case, the court looked to the code directly. Section 553 preserves a creditor's right to setoff that exists under non-bankruptcy law. It provides that mutual, pre-petition obligations can be set off against each other. The debtors argued that sections 553 and 1232 were are at odds with each other and that the more specific provision, § 1232, should control. The agencies argued that the provisions were clear and consistent.

The court sided with the debtors, explaining that general rules of statutory construction provide that where two statutes conflict, the specific governs over the general. Even so, the court found that § 1232 was ambiguous. Looking to legislative history, the court found that the purpose of what eventually became § 1232 was to de-prioritize treatment of capital gains taxes to free up funds for reorganization and boost reorganization possibilities for family farmers. Specifically, the goal was to relieve family farmers from having their reorganization plans fail because of certain tax liabilities owed to the government.

As such, the court concluded that Congress intended the priority-stripping provision to be interpreted to promote successful reorganizations of family farming operations—by limiting the impact of the substantial capital gains taxes that tend to follow the sale of farm land or equipment—and to put that capital into the farmers’ hands—not the taxing authorities. Allowing taxing entities to setoff withheld taxes against these capital gains taxes runs directly counter to these objectives.

Because § 553 was contrary to this result, the court found that the specific provision in § 1232(a) controlled. As such, family farmers who have capital gains tax debt under Chapter12 may require the taxing entities to issue a refund of withheld income taxes to the bankruptcy estate.

This case is an important win for future family farmers forced to seek the protection of Chapter 12 bankruptcy.