Recoupment and Set-off: Tax Refunds, Unemployment, Medicare

Recoupment and setoff are two separate and distinct concepts. The main distinction is “whether the debt owed the creditor . . . arose out of the ‘same transaction’ as the debt the creditor owes the debtor.” In re Holyoke Nursing Home, Inc., 372 F.3d 1, 3 (1st Cir. 2004). See also In re Georgetown Steel Co., LLC, 318 B.R. 313, 325 (Bankr. D.S.C. 2004) (citing Black’s Law Dictionary (5th ed. 1979)).

The doctrine of setoff allows a creditor to offset a debt it owes to a debtor against a debt owed to it by the debtor arising from a different transaction. In re Univ. Med. Ctr., 973 F.2d 1065, 1079 (3d Cir. 1992). 11 U.S.C. § 553 addresses setoff and provides that a creditor cannot set off a pre-petition claim against a post-petition debt it owes to the debtor. 11 U.S.C. § 553; Univ. Med. Ctr., 973 F.2d at 1079.

Recoupment “‘is the setting up of a demand arising from the same transaction as the plaintiff’s claim or cause of action, strictly for the purpose of abatement or reduction of such claim.’”  Univ. Med. Ctr., 973 F.2d at 1079 (quoting 4 Collier on Bankruptcy ¶ 553.03) (emphasis original). Recoupment is not subject to the same limitations as setoff; therefore, if the creditor’s claim arises out of the same transaction as the debt owed to the debtor, recoupment is permissible. Id. at 1080. The automatic stay does not apply to recoupment, and it is not prohibited by the discharge injunction. In re Powell, 284 B.R. 573, 576 (Bankr. D. Md. 2002).

Can I lose this year’s tax refund after I file?

Not likely.  If you have a liability with arguable fraudulent circumstances, the creditor may argue to the bankruptcy court that they debt is non-dischargeable.  If that creditor is a government agency, they may ask to set-off a refund.

Can I lose my prior year’s tax refund after I file bankruptcy? 

11 USC § 553 – Setoff (click here to read statute) The right to set-off does exist under the circumstances described below.Mutuality. Setoff is only available when the obligations between debtor and creditor are mutual, i.e., both obligations are held by the same parties, in the same right or capacity, and both arise either prepetition or postpetition.

US Attorneys Civil Resource Manual

Parties – Mutuality as to parties is strictly construed.

The United States is one party for mutuality purposes and can setoff claims held by different agencies.

Capacity. The parties must be standing in the same capacity. Where the parties are identical, but they stand in different relationships in various transactions, mutuality does not exist. For example, the prepetition debtor is treated differently from the debtor-in-possession or the debtor’s estate for some setoff purposes.

Timing – For setoff to be permitted, both debts must arise prepetition or postpetition. In other words, a claim which arises prepetition may be setoff only against a credit which also arises prepetition.

When do claims arise? Claims “arise” for bankruptcy purposes when (1) all “transactions” or acts necessary for liability occur, and for government claims, (2) there is some prepetition relationship, “such as contact, exposure, impact, or privity” between the United States and the debtor such that the Government is able to “fairly contemplate” that it might have a claim against the debtor.

Character Of The Claim. The debt and the claim need not arise from the same transaction nor must they be of the same character.

Setoff And Equity – Bankruptcy courts lack a statutory predicate to disallow setoff for “equitable” reasons. Unlike other Code provisions, § 553 does not expressly confer a power to disallow setoff for equitable reasons.

At the least, we can argue that compelling circumstances are required to disallow setoff.

Generally, courts have only disallowed otherwise valid setoff in two categories of cases:

(a) where the creditor committed an inequitable, illegal, or fraudulent act, or the setoff is against public policyand 

(b) where the setoff would significantly harm or destroy the debtor’s ability to reorganize.

In reorganization cases where the debtor argues that setoff affects the opportunity to reorganize, we should argue as a backup that setoff be deferred rather than denied.

Bankruptcy courts may grant setoff on equitable grounds even if no mutuality

Click Here to read a South Carolina case where the Court permitted medicare recoupment after discharge under the theory that the payment and recoupment were part of an ongoing balance and thus one transaction.