The United States Could Not claim Sovereign Immunity in Debtors’ Adversary Proceeding to Retain their Tax Refund

The United States Could Not claim Sovereign Immunity in Debtors’ Adversary Proceeding to Retain their Tax Refund

The District Court has requested that this Court address the question of whether the “Debtors,” in seeking a tax refund from the United States, constituted trustees as contemplated under  11 U.S.C. § 505. Additionally, the District Court has requested that this Court determine whether the Debtors were seeking that tax refund for “the right of the estate.”

This matter was originally before the Court on cross-motions for summary judgment on the question of whether a Chapter 7 debtor may exempt and recover an overpayment of federal income taxes for the year prior to the filing of the bankruptcy, despite the authority of the federal government, under the Treasury Offset Program, 26 U.S.C. § 6402, to set off the refund against the debtor’s dischargeable prepetition income tax liability. This Court found that the Debtors’ tax overpayment was property of their bankruptcy estate and that their pre-setoff exemption in that refund, claimed pursuant to § 522 of the Bankruptcy Code and Va. Code Ann. § 34-4, superseded the setoff rights of the United States under § 553 of the Bankruptcy Code. As pointed out by the District Court, the United States did not raise the issue of sovereign immunity in this Court but raised it for the first time on appeal.

The Debtors filed a petition under Chapter 7 of the Bankruptcy Code on May 29, 2014. In Schedule C filed on that same date, the Debtors claimed an exemption in a refund from federal taxes in the amount of $3,208 for the tax year 2013. No party has objected to the Debtors’ exemption claim, although the United States has asserted that its setoff rights are superior to the Debtors’ allowed exemption. On July 7, 2014, the chapter 7 trustee in the Debtors’ case filed a “Report of No Distribution” with this Court. In that report, the chapter 7 trustee stated that he had abandoned total assets valued at $24,904 and that assets valued at $11,410 were exempt. The total, $36,314, constitutes the value of all of the assets, exempt and nonexempt, listed by the Debtors in their bankruptcy schedules. The Trustee also asked to be discharged from any further duties as trustee.

The Debtors commenced this adversary proceeding by filing a complaint on September 17, 2014, which was amended with leave of Court on February 1, 2015. In the amended complaint, the Debtors sought the turnover of the $3,208 tax refund, pursuant to § 542(a) of the Bankruptcy Code.

In its answer, the United States admitted “that between the filing of their income tax return on June 2014 and July 8, 2014, the Secretary of the Treasury exercised his discretion under 11 [sic] U.S.C. § 6402 to setoff Debtors’ tax overpayment for the 2013 tax year against non-priority, dischargeable tax debts.” The United States contended that the amended complaint failed to state a claim upon which relief could be granted, that the Debtors’ claim was barred by setoff, and that the overpayment of the Debtor’s federal income tax liability for 2013 did not constitute property of the estate and was not subject to exemption under § 522 of the Bankruptcy Code.

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