THE ROLE OF OFFSET IN THE COLLECTION OF FEDERAL TAXES.

• Author: Fogg, Keith

I.Introduction 3 II.General Provisions Regarding Offset 5 A.Common Law Offset Principles 5 B.Tax Code Offset Provisions 7 C.Priority Scheme for Offsetting Tax Overpayments 11 D.Creditor Offset After Receipt of Levy 14 E.Federal Tax Overpayment to Federal Tax Offset--Contesting Underlying Liability 16 F.Federal Tax to Federal Tax or TOP Offset--Injured Spouse Defense 17 G.Federal Tax Offset Effected Through TOP 20 III.Offset During Collection Stays 22 A.Collection Stays Imposed by Title 26 22 B.Collection Stay Imposed by Title 11 26 C.Judicial Review of Offset 31 D.Federal Payment Levy Program 35 IV.Policy Decisions Regarding Offset 38 A.Offset Bypass 38 B.Offset During COVID-19 Pandemic 41 C.Offset of Refunds Generated by EITC 45 V.Conclusion 52 I. INTRODUCTION

An interesting phenomenon has occurred at the tax blog Procedurally Taxing. (1) The blog receives an unusually high number of visitors seeking information about offset. The visitors primarily appear to be ordinary taxpayers--not tax professionals--searching for an answer concerning what happened to the refund they expected to receive. (2) The high interest of the general public in the complicated topic of offset has increased as a result of the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") (3) and the economic crisis caused by the COVID-19 virus generally (4) Watching this interest in offset and realizing that the area of offset receives little attention in the academic press, I decided to write this Article with the hope that it will provide a greater understanding of the most frequently used collection tool in the Service's arsenal. Offset (sometimes interchangeably called "setoff") involves mutual debts and actions of the parties taken with respect to those debts outside the judicial setting. Just because offset occurs outside the judicial setting does not mean that the judiciary never becomes involved in offset, though at least in the federal tax area, impediments exist to judicial review.

In federal tax practice three common situations raise offset issues: (1) the assertion of offset by a third party, typically a bank, to prevent the Service from collecting by lien or levy; (2) the Service seeking to offset a refund against an outstanding tax liability in situations where the taxpayer and the Service are mutual debtors; (3) the assertion of offset by the federal government where the taxpayer and the federal government are mutual debtors and the Treasury Department acting on behalf of other federal agencies (and some state agencies) seeks to offset a tax refund against an outstanding liability to an agency.

This Article discusses the three typical situations and explains the rights of the parties in each setting. Before discussing the typical situations in which offset issues arise, the Article traces the development of offset from common law into the Tax Code ("Code"). (5) Then it discusses the development of tax offsets in case law including the common applications of the concept in federal tax situations. After setting the scene regarding what is happening with offsets, the Article discusses certain policy decisions regarding offset and the situations in which the current policy fails the system.

Offset serves not only as a powerful and cheap collection tool but one that the government must implement with care in order to avoid misuse. When the Service makes a systemic mistake in its application of offset, as has occurred with the Economic Impact Payments (EIP) created in the CARES Act, there is significant anger and frustration in the affected population. (6) The problem with the CARES Act occurred when the Service implemented a new procedure in extreme haste. Mistakes in that setting present no surprises, and the Service acted relatively quickly to resolve the problem. Broader offset issues involving policy decisions made with greater deliberation and care deserve analysis to determine if these decisions--whether legislative, administrative or judicial--best serve overall offset policy.

2. GENERAL PROVISIONS REGARDING OFFSET

   A.C ommorL aw Offset Principles

   Offset is an equitable right allowing parties who are mutual debtors and creditors to each other to net out their debts, even if those debts arise from separate transactions. "The right of setoff... 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.'" (7) The common law right of offset arises for (a) equally matured obligations that are (b) between the same parties, who are (c) acting in the same capacity. (8) With regard to (a), matured debt requires that a debt be due and not merely a potential debt. Just because one party has potential claims under a contract that has not yet been breached does not give that party the right to offset a debt presently owing the debtor. (9) With regard to (b), the debts must be held by the same parties, or in other words, be considered mutual. For example, if one debt is joint and the other is not, they cannot be offset. (10) Expanding on (c), the debts must be held in the same capacity. Thus, if one debt arises in a fiduciary capacity (such as a bailment or constructive trust), and the other debt arises simply as a straight debtor-creditor relationship, courts have held that the parties do not hold the mutual debts in the same capacity, thus denying offset rights. (11)

   Related concepts of recoupment and counterclaim exist that deserve brief mention. Recoupment occurs in the special case where the mutual debts arise from the same transaction. (12) Equitable recoupment arises in tax law as a defense raised by either the taxpayer or the Service in situations time barred from payment. (13) A counterclaim is simply an offset or recoupment asserted in litigation.

   The Service obtains its right to offset from two sources, namely, common law and statute.

   The common law right of offset arises from the principle that one "should not be compelled to pay one moment what he will be entitled to recover back the next." (14) Courts of equity have long used offset to eliminate the need for two separate lawsuits by netting out the amounts owing and entering a single judgment. (15) The federal government has the same common law right of setoff as any private party. (16) The government may use its common law setoff rights to set off tax overpayments against both tax debts and non-tax debts, which allows for the Treasury Offset Program offsets, discussed further below. (17)

   2. Tax Code Offset Provisions

      The statutory basis for offset of federal tax refunds against unpaid federal taxes as well as other unpaid debts to state and federal governments exists in section 6402 of the Code. This section creates a regime for offsetting federal tax overpayments, first against outstanding tax liabilities and then against a list of other types of outstanding liabilities to other federal and state authorities permitted to benefit from a federal tax refund offset. (18) In 2011, 2012 and 2013 approximately $7 billion of federal tax refunds were offset against outstanding federal tax liabilities each year. (19) The offset program thus serves as a substantial part of the Service's effort to collect outstanding liabilities. Offset represents the cheapest and easiest method for the Service to collect outstanding tax debts, and it occurs without the need for a notice of federal tax lien or a levy. Because offset takes a refund for the year in which the overpayment occurs, taxpayers frequently confuse the offset of their refund with a problem in the year of the overpayment, rather than the application of the payment to a year with an outstanding balance. Obtaining account transcripts to follow the trail of the payment is a necessary step in providing assistance to a taxpayer whose refund has been offset. (20)

      One key question for the offset analysis is: When does a tax liability become an "outstanding liability"? An assessment is not a necessary predicate to creation of a tax liability, and therefore assessment is not necessary before the Service may perform an offset. (21) The Service takes the position that it may offset an agreed overpayment against an unagreed proposed deficiency. (22) This issue was raised in the early cases where the courts were interpreting the precursor statutes to section 6402. (23)

      The Service can be expected to take the position that it can offset a liability as soon as the taxable year has closed. Older IRS guidance provided that an agreed overpayment may be offset against "an unagreed proposed deficiency." (24) While that guidance does not define an "unagreed proposed deficiency," one can reasonably read it to mean at least the 30-day letter. (25) In 2007, the Service issued clarifying guidance, which holds that it can offset an overpayment "against unassessed internal revenue tax liabilities that have been determined in a notice of deficiency sent to the taxpayer." (26) While it is unclear how often the Service acts upon this interpretation, such an offset could potentially deprive a taxpayer of prepayment judicial review in Tax Court if the offset fully satisfied the proposed deficiency.

      The offset system established in section 6402 reflects Congressional priorities in much the same way that the bankruptcy provisions create a list for paying creditors in a specific order. The language of section 6402(a) contains the word "may" in referring to the offset against other federal tax obligations but the word "shall" in referring to other federal and state obligations mentioned in the statute. This gives the Service discretion in deciding whether to exercise its offset power when the taxpayer owes federal taxes but removes the discretion when another qualifying state or federal party exists. (27) The exercise of discretion by the Service to forgo the offset is discussed below under the heading of offset bypass refund and permeates other...