What Is a Set-Off in Law? Requirements, Limits, and Bankruptcy

A set-off in law is the right to cancel out a debt you owe someone by the amount that same person owes you, so only the net difference actually gets paid. If a contractor bills you $10,000 but owes you $3,000 for separate work gone wrong, a set-off lets you hand over $7,000 and call both debts settled. The right is old and widely recognized, but it only works when strict conditions line up, and federal law blocks it entirely for certain kinds of money.

What Has to Be True Before a Set-Off Works

A set-off does not happen automatically, and it does not apply just because two debts feel connected. Courts require “mutuality,” which breaks into three pieces that all have to hold at once.¹

The debts have to run between the exact same two parties. A debt your business owes cannot be offset against a debt owed to you personally, even if you own the business. The law treats you and your company as separate.

Each party has to be acting in the same legal capacity on both sides. Money you owe someone as an individual cannot cancel out money that person owes you as a trustee, because those are two different legal identities.

Both debts have to be for fixed amounts, legally enforceable, and currently due. A future or conditional obligation that has not matured yet cannot offset something already payable.

That last requirement catches people. Two debts can feel like a wash, but if one is a definite invoice and the other is a possible future claim, a set-off is not available.

Where Set-Offs Show Up

In commercial dealings, set-offs most often appear when a contract breaks down. A buyer who orders $20,000 in materials and suffers $5,000 in provable losses from a late delivery can withhold the $5,000 and pay only $15,000. That is not a refusal to pay; it is netting damages against the invoice.

Set-offs also drive counterclaims in lawsuits. If a plaintiff sues for $10,000 on an unpaid invoice and the defendant counterclaims for $4,000 in damages from the plaintiff’s defective work on a different job, a court that credits both claims enters a single judgment for $6,000 instead of ordering two separate payments.

Bank Accounts: The Set-Off That Surprises People

The banker’s right of set-off is the one most people run into without seeing it coming. If you have a deposit account and a loan at the same bank and you fall behind on the loan, the bank can pull money straight from your account to cover the missed payments. Default on a $5,000 loan at a bank where you keep $6,000 in checking, and the bank can take the $5,000 without filing suit.

Banks usually do not have to warn you first or get a court order. The authority is buried in the account agreements and loan documents you signed. Most people never read those clauses, which is why the withdrawal often feels like a seizure. In most circumstances it is lawful, and it happens quickly.

Joint accounts add a trap. If an account has two owners and only one owes the bank, the bank may still set off against the whole balance. The usual presumption is that joint holders share equal rights to all the funds. A co-owner’s debt can therefore drain money the other person deposited. Recovering your share is possible if you can document that specific deposits came from you alone, but it may require a fight.

When a Set-Off Is Blocked or Limited

Several categories of money are shielded by federal law, and those protections override whatever your bank agreement or loan contract says.

Social Security benefits carry some of the strongest shields. Federal law bars these payments from execution, levy, attachment, garnishment, or other legal process, including bankruptcy.² Veterans’ benefits, disability payments, and other federal benefits carry similar protections. Congress designed those funds for basic living expenses and kept creditors away from them.

There is also an automatic cushion for deposited benefits. When a bank receives a garnishment order or tries a set-off against an account, Treasury rules require it to look back two months for direct-deposited federal benefits. Amounts traceable to those deposits during the lookback are protected automatically, and the bank must leave them accessible without making the account holder file an exemption claim.³

Credit Cards

A credit card issuer cannot reach into your deposit account at the same institution to cover unpaid card charges unless you authorized the arrangement in writing beforehand. Even with that authorization, the issuer cannot offset any amount you are actively disputing.⁴ Most card agreements include language that satisfies the written-authorization part, so the practical teeth of the rule are in the disputed-amount piece. Challenge a charge, and the issuer has to leave that amount in your account alone.

Wage Deductions

Employers sometimes try a kind of set-off by deducting the cost of damaged equipment, cash shortages, or uniforms from a paycheck. Federal law puts a hard floor underneath that: no deduction for the employer’s benefit can drop effective hourly pay below the federal minimum wage of $7.25, and the same floor protects overtime pay. The rule holds even when the employee clearly caused the loss.⁵

The Department of Labor treats tools, property damage, and theft losses as costs that primarily benefit the employer, so the same floor applies. A minimum-wage cashier who comes up short on the drawer cannot be forced to reimburse the employer if doing so would push pay below $7.25. The employer also cannot sidestep the rule by demanding cash reimbursement outside of payroll.⁵ Many states tighten the rule further; the FLSA is only the baseline.

Contractual Waivers

The right to a set-off can be waived up front. Commercial contracts sometimes require each side to pay invoices in full regardless of any cross-claims, with disputes handled separately through arbitration or litigation. Supply agreements use these clauses when both sides care more about predictable cash flow than about the leverage of withholding payment.

When the Government Sets Off Against You

The federal government runs its own large set-off system called the Treasury Offset Program. TOP matches people who owe delinquent debts to federal or state agencies against payments the federal government is about to send them, including tax refunds. When there is a match, the government withholds some or all of the payment and redirects it to the agency owed.⁶

The debts collected this way most often involve past-due child support, defaulted federal student loans, and unpaid state taxes. If your tax refund is intercepted, you will usually get a notice identifying the debt and the amount taken.

Before referral to TOP, the creditor agency has to send written notice at least 60 days in advance for centralized offsets, including tax refund offsets. The notice has to explain how to ask for an administrative review of whether the debt is valid and enforceable, and the agency may suspend collection while a dispute is reviewed. For federal salary offsets and wage garnishments, the notice period is 30 days, and asking for a hearing within 15 days can pause the garnishment until a decision issues.⁷

What Changes in Bankruptcy

Filing for bankruptcy does not destroy a creditor’s set-off right, but it adds real friction around using it.¹

The moment a petition is filed, the automatic stay freezes almost all collection activity, set-offs included. The Bankruptcy Code specifically stays “the setoff of any debt owing to the debtor that arose before the commencement of the case … against any claim against the debtor.”⁸ A creditor who wants to proceed has to file a motion and get court permission. Acting without approval violates the stay and can draw sanctions.

Even with permission, both sides of the set-off have to be pre-petition. A creditor cannot offset a pre-petition claim against a debt the creditor took on to the debtor after the filing. The rule stops creditors from engineering set-offs once a case is underway.¹

There is also a 90-day “improvement in position” test. If a creditor exercised a set-off within the 90 days before the bankruptcy filing, the trustee can claw back the amount by which the creditor’s position improved during that window. The test compares the gap between the creditor’s claim and the mutual debt at two moments: the date of the set-off and 90 days before the petition. If the gap shrank, the creditor gained at the expense of other unsecured creditors, and the court can reverse the gain.⁹

Set-Off and Recoupment Are Not the Same

Recoupment looks like set-off but runs on stricter track. A set-off can involve debts from entirely separate transactions. Recoupment only applies to obligations arising from the same transaction. If a contractor you hired to remodel your kitchen both overcharged and did defective work, your damages claim is a recoupment because it grows out of the same contract the contractor is suing on.10

The distinction matters most in bankruptcy. A set-off is frozen by the automatic stay and needs court permission. Recoupment, because it just adjusts the amount owed under a single transaction rather than asserting a separate claim, is generally not subject to the automatic stay. A creditor asserting recoupment can often move forward without filing for relief, which is a meaningful procedural advantage.¹⁰

1
Office of the Law Revision Counsel. 11 USC 553 – Setoff
2
Office of the Law Revision Counsel. 42 USC 407 – Assignment of Benefits
3
eCFR. 31 CFR Part 212 – Garnishment of Accounts Containing Federal Benefit Payments
4
Office of the Law Revision Counsel. 15 USC 1666h – Offset of Cardholders Indebtedness by Issuer of Credit Card
5
U.S. Department of Labor. Fact Sheet 16 – Deductions From Wages for Uniforms and Other Facilities Under the FLSA
6
Fiscal.Treasury.gov. Treasury Offset Program
7
eCFR. 31 CFR Part 5 Subpart B – Procedures to Collect Treasury Debts
8
Office of the Law Revision Counsel. 11 USC 362 – Automatic Stay
9
Office of the Law Revision Counsel. 11 USC 553 – Setoff
10
United States Department of Justice. Justice Manual – 67. Setoff and Recoupment in Bankruptcy – Recoupment