Opinion
Case No. 01-51154-S, APN 01-5043-S
June 20, 2002
MEMORANDUM OPINION AND ORDER
On April 25, 2001, Dennis A. Donna M. Grannan ("Debtors") filed for bankruptcy protection under Chapter 7 of Title 11 of the United States Code, and David R. Ruby was appointed Trustee. This Court has jurisdiction over this core proceeding pursuant to 28 U.S.C. § 157(b) and 1334(b). Venue is proper pursuant to 28 U.S.C. § 1408 and 1409.
FINDINGS OF FACT
The instant dispute arises from the United States of America's, through the Internal Revenue Service ("IRS"), complaint to recover funds held by the Trustee. Allegedly, the IRS erroneously issued two tax refunds to the Debtors and it now seeks to recover them.
Prior to filing for bankruptcy, on April 9, 2001, Dennis Grannan asked for a "quick assessment" of unemployment tax liabilities for his business, Sunray Cleaning Services, for the tax period ending on June 30, 2000. Ex. 101. On April 18, 2001, the United States through the Internal Revenue Service ("IRS") assessed a trust fund liability of $50,902.66 against Dennis Grannan individually. Ex. 102. The IRS completed the quick assessment by completing the 2751 form and assigning Dennis Grannan's tax liability a DLN number, document location number. Tr. 10-11, 27. Subsequent to this assessment, the Debtors, through joint tax returns, became entitled to two refunds for the 1998 and 2000 tax years, which total $43,925.00 and $8411.00, respectively. Compl. 6; Answer 6; Tr. 19; Ex. 103. The IRS manually processed the refunds and issued them to the debtors, the IRS issued the 2000 refund in the middle of May 2001. Tr. 19. The Debtors then lent these tax refund checks to the Trustee on June 18, 2001, which the Trustee deposited into an escrow account. Compl. 10, 12; Answer 10, 12. On July 27, 2001 Gregory Stefan, Assistant United States Attorney and Jason Zarin, Trial Attorney, Tax Division, United States Department of Justice, for the IRS, filed this adversary proceeding to Recover Money held by the Trustee.
There is some ambiguous testimony that such refunds arose from the Debtor's business; but even with such testimony, it is not clear how much of the refund is attributable to Dennis or Donna Grannan. Tr. 32.
At the pretrial conference held on October 12, 2001, both parties expressed an intention to file motions for Summary Judgment, which both Clara Swanson, counsel for David Ruby, Chapter 7 Trustee ("Trustee") and the IRS, filed on January 10, 2001. Pursuant to these motions, this Court held a Summary Judgment hearing on March 19, 2002, where it addressed whether or not the Internal Revenue Service can waive its right to offset a certain tax refund with certain outstanding tax liabilities. This Court denied the cross motions for Summary Judgment on March 21, 2002, and held a trial on May 15, 2002, to further address the factual issues in this matter. This opinion constitutes the Court's findings of fact and conclusions of law pursuant to Federal Rule of Bankruptcy Procedure 7052.
CONCLUSIONS OF LAW
The IRS asserts it is entitled to setoff the refunds distributed to the debtors against the tax liability of Dennis Grannan. The Trustee asserts the IRS has waived its right to setoff or in the alternative setoff is not appropriate since there is no mutuality. The Court will first address the latter argument.
26 U.S.C. § 6402(a) (2002) grants the IRS the right to setoff, "[i]n the case of any overpayment, the Secretary, within the applicable period of limitations, may credit the amount of such overpayment, . . . against any liability in respect of an internal revenue tax on the part of the person who made the overpayment." "The right of setoff (also called `offset') allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding `the absurdity of making A pay B when B owes A.'" Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18 (1995) (quoting Studley v. Bolyston Nat. Bank, 229 U.S. 523, 528 (1913)). No federal right of setoff is created by the Bankruptcy Code, 11 U.S.C. § 553(a) (2001), merely preserves the right of setoff as it is allowed under nonbankruptcy law with certain limitations. Id; Durham v. SMI Indus. Corp., 882 F.2d 881, 883 (4th Cir. 1989); Hal, Inc. v. United States (In re Hal, Inc.), 122 F.3d 351, 853 (9th Cir. 1997);. 11 U.S.C. § 553(a) (2001) states
At the trial, the IRS apparently asserted it need not follow the requirements of § 553 in order to effectuate a setoff of Dennis Grannan's tax liability. Tr. 41 (stating "Mr. Whitaker [IRS agent] testified as to the IRS standard practice which is that setoffs are handled automatically.") This Court finds the case law is contrary to such assertion. In United States v. Whiting Pools, Inc., 462 U.S. 198, 209 (1983), the Supreme Court required the IRS to return property the IRS seized prepetition to satisfy a tax lien, and it further asserted "[n]othing in the Bankruptcy Code or its legislative history indicates that Congress intended a special exception for the tax collector." In Belloff v. Commissioner, 996 F.2d 607, 613 (2d Cir. 1993), the Second Circuit Court of Appeals rejected the IRS's claims § 6402(a) procedures allow it to avoid the tax court's jurisdiction over setoff. With such prior opinions, it becomes clear the IRS's assertion is contrary to the law and this Court must continue to analyze this case under § 553 of the Bankruptcy Code.
[e]xcept 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.
Inherent within such language are several limitations; thus, a creditor must establish by a preponderance of the evidence: (1) a debt owed by the creditor to the debtor, which arose prior to the commencement of the bankruptcy case; (2) a claim of the creditor against the debtor, which arose prior to the commencement of the bankruptcy case; (3) the debt and claim are mutual obligations; and (4) the debts are subject to setoff under nonbankruptcy law; in order to assert the right of setoff under § 553. Internal Revenue Serv. v. Luongo (In re Luongo), 259 F.3d 323, 334 (5th Cir. 2001) (citing Braniff Airway, Inc. v. Exxon Co., 814 F.2d 1030, 1035 (5th Cir. 1987)); Public Serv. Co. of New Hampshire v. New Hampshire Elec. Coop. Inc. (In re Public Serv. Co. of New Hampshire), 884 F.2d 11, 14 (1st Cir. 1989); King v. Fulbright Jaworski, LLP. (In re Koch), 224 B.R. 572, 576 (Bankr. E.D. Va. 1998); In re Holder, 182 B.R. 770, 774-75 (Bankr. M.D. Tenn. 1995); Bavely v. Cinoco Terminal, Inc. (In re Triple A Coal Co.), 41 B.R. 641, 646 (Bankr. S.D. Ohio 1984) (holding the defendant established by a preponderance the right of setoff); See Eckles v. Petco, Inc., Interstate (In re Balducci Oil Co., Inc.), 33 B.R. 847, 850-51 (Bankr. D. Colo. 1983) (explaining § 553 limits the assertion of setoff but nonbankruptcy law determines the right of setoff). After establishing the prerequisites for asserting setoff, the Court generally must examine the equities to determine whether or not to allow its assertion. Cumberland Glass Mfg. Co. v. DeWitt, 237 U.S. 447, 455 (1915) (holding setoff is permissive and not mandatory, and thus its assertion is guided by principles of equity); Gordon Sel-Way, Inc. v. United States (In re Sel-Way, Inc.), 270 F.3d 280, 292 (6th Cir. 2001); Blanton v. Prudential-Bache Securities (In re Blanton), 105 B.R. 321, 336-37 (Bankr. E.D. Va. 1989).
In the present case, the debtors' refunds arose from overpayments for federal income taxes in 1998 and 2000 pursuant to joint income tax return filings on or before April 15, 2001. Compl. 6, Answer 6. The Debtors asserted a claim for a 1998 refund at that time due to a loss carryback. Tr. 19. Thus, both the tax years where the refunds arose and the tax filings, occurred prepetition. Segal v. Rochelle, 382 U.S. 375 (1966) (holding under the Bankruptcy Act, refunds based on prepetition overpayments arise at that time, rather than at the postpetition assertion of the loss carryback refunds); Still v. United States (In re W.L. Jackson Mfg. Co.), 50 B.R. 506, 508 (Bankr. E.D. Tenn. 1985) (holding Segal also applies under the Bankruptcy Code); In re Conti, 50 B.R. 147, 149 (Bankr. E.D. Va. 1985) (holding the tax refund arises at the end of the tax year where overpayment occurred and not at the claiming of the tax refund).
The tax liability also arose prepetition since such taxes arose from Dennis Grannan's failure to pay employment taxes for his business, Sunray Cleaning Service, Inc., for the period ending June 30, 2000. Ex. 101; Rozel Indus., Inc. v. Internal Revenue Serv. Un re Rozel Indus., Inc.), 120 BR. 944, 949 (Bankr. N.D. Ill. 1990) (holding tax liability arises in the year it is due whether or not the debtor filed a tax return). Such taxes were assessed against Dennis Grannan prior to the bankruptcy filing on April 18, 2001. Ex. 102. However, whether such liability arose upon completion of the tax assessment or upon the end of the tax period, is not at issue in this case since it is uncontested both actions occurred prepetition.
The IRS must next prove there was mutuality, which simply means "the debts are between the same parties, standing in the same capacities." In re Blanton, 105 B.R. at 334; Lubman v. Sovran Bank, N.A. Un re A B Homes, Ltd.), 98 B.R. 243, 248 (Bankr. E.D. Va. 1989). As Chief Judge Fox explained, same parties refers to the identity of the parties while capacity refers to the parties' relationship such as a fiduciary, trustee, or agent. In re Nuclear Imaging Systems, Inc., 260 B.R. 724 (Bankr. E.D. Pa. 2000) (quoting L. King, 5 Collier on Bankruptcy, ¶ 553.03[3][c] (15th ed. rev. 1999)); In re Carlyle, 242 B.R. 881, 888 n. 4 (Bankr. E.D. Va. 1999) (quoting First Nat'l. Bank v. Johnson, 183 Va. 227, 31 S.E.2d 581, 585 (1944)) (stating a fiduciary may not setoff a trust res against a debt owed to the trustee personally since the res is held in a separate capacity).
Generally, courts strictly construe the mutuality requirement. Gray v. Rollo, 85 U.S. (18 Wall.) 629, 633 (1873) (holding mutuality is construed strictly unless justice requires a particular result); In re Koch, 224 B.R. at 576 (holding courts strictly construe mutuality); Virginia Block Co. v. Bushong (In re Virginia Block Co.), 16 BR. 560, 562 (Bankr. E.D. Va. 1981) (holding courts strictly construe mutuality). In the present case, it is undisputed the tax liability is a personal liability of Dennis Grannan while the tax refunds arose through the debtors' joint tax returns. To properly setoff the tax liability and refund, this Court must determine what amount of the refunds are due Dennis Grannan.
The language of 26 U.S.C. § 6402 (2002), as previously quoted, appears clear, the IRS may setoff one person's tax liability against that same person's overpayment. Gens v. United State, 673 F.2d 366, 367-68 (Ct.Cl. 1982) (holding the language of the § 6402 limits setoff to the person who actually made the overpayment). It is undisputed the tax refunds in the present case arose from joint tax returns.
Spouses filing a joint return have separate interests in any overpayment, the interest of each depending on his or her income, i.e., an overpayment is apportionable to a spouse to the extent he or she contributed to the overpaid tax.
Rosen v. United States, 397 F. Supp. 342, 343-44 (E.D. Pa. 1975) (citing Maragon v. United States, 153 F. Supp. 365 (Ct.Cl. 1975)); Jahn v. Regan, 584 F. Supp. 399 (E.D. Mich. 1984); Rev. Rul. 74-611, 1974-2 C.B. 399 (holding an overpayment on a joint return filed by a husband and wife, each individual has a separate interest in the overpayment). The IRS specifically conceded at trial that with regard to the 1998 and 2000 tax refunds, the amount of overpayment attributable to each spouse is not a matter of the record . . . But the IRS is willing to concede that for the 2000 returns that $452.62 would not be, in fact, a fee, [sic] a joint liability, and $452.62 would incur to Donna Grannan, but the remainder could be applied under Glaubke to Mr. Grannan' s individual liability." Tr. 41. The IRS further asserted the entire 1998 overpayment is attributable to Dennis Grannan's income. However, the Court in Glaubke v. United States, Civ. No. 77-94-N, 1978 WL 1150, at *5 (E.D. Va. Jan. 3, 1978) (unpublished opinion), held the IRS with regard to a joint tax return, may only setoff an individual's personal tax liability against the amount of overpayment attributable to that individual's income. See McClelland v. Massinga, 786 F.2d 1205 (4th Cir. 1986) (stating with regard to interception of tax refunds, "if the [nonobligated] spouse has made some contribution, he or she does have an interest in the refund and must be given notice.")
The IRS may argue the Trustee has the burden to establish both Mr. and Mrs. Grannan contributed to the overpayment. St. John v. Bookwalter, 58-1 U.S. Tax Cas. (CCH) P 9216 (W.D. Mo. 1957). While such an assertion is perhaps correct in the context of a suit for a tax refund, as discussed previously, the IRS bears the burden to prove mutuality, and as such it must demonstrate the tax liability and tax refunds are attributable to the same party. Such conclusion is further supported in that when the United States seeks to recover an allegedly erroneous refund, it bears the burden of proof. United States v. Commercial Nat. Bank, 874 F.2d 1165, 1169 (7th Cir. 1989); United States v. Russell Mfg. Co., 349 F.2d 13, 16 (2d Cir. 1965); United States v. CSX Corp., Civ. No. 3-94CV773, 1995 WL 381537, at *3 (E.D. Va. 1995)
Since the IRS declined to present the Debtors income tax returns or any other information about their respective incomes, the only other information on the amount of income contributed by each of the debtors respectively is the following statement offered by the IRS's counsel during argument, "[f]or 2000, based on the information attached to the Grannans' income taxes [not in evidence], Dennis Grannan earned wages of $66,825.20, of which $6457.10 was withheld." Tr. 41. While this Court may agree part of the refund is likely attributable only to Dennis Grannan, the plaintiff has failed to introduce any evidence proving how much or if any. Thus, the evidence fails to provide the Court a proper basis to calculate the amount of refund attributable to Dennis Grannan. Therefore, the plaintiff has failed to establish mutuality, and thereby failed to establish setoff is proper in this matter.
Even if the stipulations from the Summary Judgment hearing continue in effect for the trial, this Court still does not have enough evidence to determine how much of the overpayments are attributable to each spouse. The only additional information offered is the IRS's demonstration of how to proportionately calculate the amount of refund attributable to Dennis and Donna Grannan respectively, offered in its Opposition to the Trustee's motion for Summary Judgment. Opp. to Summary Judgment, P. 2-4. However, the IRS declined to attach an affidavit demonstrating the basis for its figures and furthermore, the Trustee never stipulated to these figures at the Summary Judgment hearing nor at the trial. Thus, this Court is without sufficient evidence to determine the amount of refund attributable to Dennis Grannan, if any.
This Court is unable to determine the equities of whether or not to grant setoff since the IRS failed to prove the prerequisites for asserting it. In re Gordon Sel-Way, Inc., 270 F.3d at 292 (citing DuVoisin v. Foster (In re Southern Indus. Banking Corp.), 809 F.2d 329, 332 (6th Cir. 1987) (holding "once the prerequisites for establishing a setoff claim are established, the court generally looks to the equities in order to determine if the setoff should be allowed.")
CONCLUSION
26 U.S.C. § 553 (2002) preserves right of setoff as it exists under nonbankruptcy law; therefore, those asserting such must right prove the debts and credits arose prepetition, the right of setoff exists pursuant to nonbankruptcy law, and there is mutuality between the debtor and creditor. There is no dispute the debts and credits arose prepetition, thus the plaintiff need only prove mutuality and that such right of setoff exists under nonbankruptcy law. The plaintiff in this matter has failed to prove the debts and credits exist between the same parties and in the same capacities, and thereby failed to prove mutuality.
As a practical matter, this Court's opinion may have little effect on the administration of the Debtors' bankruptcy since the IRS possesses a first priority creditor status and will thereby receive the funds retained by the Trustee upon distribution of the estate.
ACCORDINGLY, the relief sought in the United States' Complaint to Recover Money from the Trustee is DENIED.
IT IS SO ORDERED.