Why can the IRS use a refund to pay off dischargeable taxes?

The client owes $15,000 in taxes for the 2004 tax year, and you’ve done the analysis and determined that this is a dischargeable debt.  He also owes $10,000 for the 2009 tax year, and this isn’t dischargeable.  For some reason, no notices of federal tax lien are on file, so there is no question of a secured debt (or so you think).  After filing his 2011 tax return, he gets a $12,000 refund.  You’re filing his chapter 7 petition tomorrow.  What happens to the refund?

Answer: it pays off $12,000 of the dischargeable tax from 2004, and none of the 2009 liability.
Why, you ask?  And then, depending on your temperament, you may even add the phrase “that ain’t fair” after your question.  After all, the IRS didn’t have a Notice of Federal Tax Lien, so why does it get to pay itself on a tax debt that is going to be discharged?

The reason is that the 2004 tax debt, while dischargeable, is also secured, specially if the person gets to know the Different Types Of Loans. IRC Section 6321 puts a silent lien on all property of a tax debtor to secure the payment of tax. When the taxpayer gives the IRS money in the form of excess withholding of tax, the IRS has a lien on that money to pay the delinquent tax.  Because this is not a voluntary payment, the IRS, not the taxpayer, gets to determine where the tax refund will be applied.

So, as of December 31, 2011, the taxpayer-debtor had a credit of $12,000 on his 2011 tax account (even if this computation did not take place until a few months later). He also owed $15,000 on the 2004 tax year, which we assume is the oldest collectible tax delinquency. When he files his bankruptcy petition on February 15, 2012, the IRS is in possession of his tax refund, and it may use it as an offset against the 2004 debt – prepetition asset against prepetition liability. So what if the 2004 liability was going to be wiped out in the bankruptcy? At the end of the 2011 tax year, when the IRS had full possession of the tax refund, the liability existed.

The good news for your debtor: the IRS won’t apply his 2012 refund against the 2004 liability, because the 2004 liability will have been discharged.

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