The Internal Revenue Service can take a tax refund for the year that you filed if you have not received the refund before you filed your case. The Good News Is That They Cannot Keep It. Many people file a Chapter 13 bankruptcy case to deal with outstanding tax issues. Therefore, the Debtor is often prepared for the IRS to take the refund as a set off for their past due taxes owed.
However, the IRS might have a right to set off but they do not have a right to keep the set off if several circumstances are met or several steps are not taken by the IRS. In these situations, it is best to go right to the source on what they can or cannot do. The IRS regulaitons provide the following:
Setoff: Under BAPCPA, the automatic stay does not prohibit the IRS from setting off prepetition income tax refunds against prepetition income tax liabilities. 11 USC § 362(b)(26). Where the automatic stay prohibits other types of setoffs, the IRS can temporarily retain a refund to preserve its setoff rights. In those cases, the IRS should seek relief from the stay before permanently offsetting refunds. See Citizens Bank v. Strumpf, 516 U.S. 16 (1995). After confirmation of the Chapter 13 plan, and where the plan fully provides for the IRS claims, retaining the refund indefinitely may be considered a violation of the automatic stay.
So what does all this mean to a person who has had their tax refund set off by the IRS in a Chapter 13 case? It means that the IRS can take the refund for a setoff but it can only be temporarily retained. The IRS cannot bully you into accepting that the tax refund is to be setoff and end of story. Rather this special provision of the automatic stay only allows them to hold the refund until either the Chapter 13 plan is confirm that provides for the IRS claim. The IRS must give it back if the confirmed plan provides for the tax claim.
Additionally, if the IRS tries to keep the refund even after the confirmed plan, the IRS is required to file a Motion for Lift Stay in order to actually be entitled to a setoff. You see the IRS cannot just freely take the funds and do what it pleases. The IRS must follow the rules also pursuant to Title 11. The setoff must be justified due to the fact that the Debtor is not providing for the IRS through their plan. There has to be cause for the IRS to be allow to setoff the refund.
Keep in mind that a setoff might not be such a bad thing for a Debtor. The setoff might actually be agreed to and noted in a Chapter 13 plan for it benefits the Debtor. The only way to understand whether a setoff is better returned or better to agree to a setoff is to review this matter with your attorney.