Four recent court decisions shed some new light on certain situations clients may encounter in dealing with creditors' claims on individual retirement accounts and employer sponsored tax-qualified retirement benefits. Three of those were bankruptcy court decisions dealing with inherited IRAs (Nessa, Chilton and Tabor).1 The courts in those cases reached differing conclusions concerning whether IRAs inherited by the original owners' daughters are entitled to the same exemption that would have pertained to IRAs of the living original owners. One case was from the Tax Court (Wadleigh).2 That decision illustrates that an individual's retirement benefits may be, with the wrong fact situation, vulnerable post-bankruptcy for his pre-bankruptcy federal tax liens.3
The three bankruptcy court decisions deal with whether inherited IRAs are eligible for the Bankruptcy Code exemption for “[r]etirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457 or 501(a) of the Internal Revenue Code of 1986.”4 In each case, the debtor-daughter in the bankruptcy proceedings was the beneficiary of an IRA of her parent who had passed away. Following her parent's death, each debtor directly transferred the deceased parent's IRA to another IRA titled in substantially the IRS' recommended form, that is, “debtor's name, beneficiary of (parent's name), deceased IRA.” It appears that all three IRAs were under ordinary custodial arrangements allowing the debtors to withdraw all, or any portion, of her IRA at any time. Also, none of the cases alleged or hinted at any acts that would have disqualified any of the IRAs.5 Finally, in each case, the debtor claimed the exemption in her bankruptcy filing and the bankruptcy trustee objected.
The three bankruptcy courts recognized two components to their exemption analyses: (1) whether the IRAs were “retirement funds,” and (2) whether they were exempt from taxation under IRC Section 408. In Nessa and Tabor, the courts held that both those criteria had been satisfied. Therefore, Nancy Nessa's and Merri Simpson Tabor's accounts were protected from their creditors. In Chilton, the court held that neither criterion had been met. Therefore, Janice Chilton's inherited IRA was included in her bankruptcy estate to satisfy her creditors' claims.
The question of whether inherited IRAs constitute “retirement funds” is interesting. Clearly IRAs are retirement funds during the original owner's lifetime. The Nessa and Tabor courts found that transfer to a beneficiary's control doesn't change the characterization of the IRAs as someone's retirement funds. The Chilton court's holding to the contrary focused on the IRA not being retirement funds contributed by the beneficiary who is the bankruptcy debtor.
From my tax lawyer perspective, the right answer on the second criterion is clear and the Chilton court got it wrong. All IRAs, inherited or otherwise, are tax-exempt under IRC Section 408 absent improper actions that weren't alleged and aren't indicated for any of these three inherited IRAs.
So, the Chilton court's finding that Section 408 doesn't exempt Chilton's inherited IRA was erroneous. It's not known if the Chilton court would have arrived at the same “not exempted” conclusion if it had found the inherited IRA was tax-exempt under Section 408, as that tax-exemption as an “individual retirement account” might have influenced the court's reasoning on the “retirement funds” criterion.
Federal Tax Liens
When Vance L. Wadleigh filed for bankruptcy in 2005, the benefit due him from his employer's ERISA-qualified pension plan was excluded from his bankruptcy estate.6 Among the debts Wadleigh listed in that filing were his unpaid 2001 federal income taxes. His subsequent bankruptcy discharge relieved Wadleigh of personal liability for those 2001 income taxes. However, in January 2007 the IRS sent Wadleigh a “Notice of Intent to Levy” (NOIL) on his pension benefits for the unpaid 2001 taxes, to take effect when he would begin receiving monthly benefits in November 2007. Wadleigh requested an administrative hearing before the IRS and contested the levy. Among other arguments, he claimed that the IRS lien on the pension had been discharged by his 2005 bankruptcy. The IRS ruled against Wadleigh and he filed a Tax Court action. The Tax Court reasoned that a lien on property excluded from a bankruptcy estate isn't affected by a bankruptcy discharge. It distinguished excluded property from property that the law exempts from the bankruptcy estate. Exempt property is initially part of the estate but is removed from it so that the debtor has enough property with which to make a fresh start. Therefore, the 2007 NOIL was valid. However, the Tax Court remanded the case to the IRS for it to consider whether Wadleigh needed the retirement benefits to live on.
An interesting aspect of the Wadleigh decision is that it appears the IRS levy would have been invalid if it attempted to reach property, such as an IRA, that had been included in, but then exempted from, Wadleigh's bankruptcy estate.
ERISA-qualified plan participants should consider the bankruptcy distinction between excluded and exempted property with regard to pre-filing federal tax liens when planning their estates. In certain circumstances, those plan participants eligible to roll over their benefits to IRAs might find that their benefits are more fully protected from creditor's claims if they do so.
- In re Nancy A. Nessa, 2010 WL 128313 (Bankr. D. Minn. 2010), aff'd 426 BR 312 (B.A.P. 8th Cir. 2010); In re Robert Gregg Chilton and Janice Elaine Chilton, 105 A.F.T.R.2d 2010-1271 (Bankr. E.D. Tex. 2010); In re Merri Simpson Tabor a/k/a Jamie Simpson Tabor, 105 A.F.T.R.2d 2010-XXXX (Bankr. M.D. Pa. 2010).
- Vance L. Wadleigh v. Commissioner, 13 T.C. No. 14 (June 15, 2010).
- In “Keeping Benefits Safe From Creditors,” Trusts & Estates, September 2005 at p. 64, I summarized the rules applicable to creditors' claims on individual retirement accounts and employer sponsored tax-qualified retirement benefits. I encourage readers to reference the 2005 article, as the applicable rules haven't changed substantially. Note: There's one wording error in my prior article. In the first paragraph under “Reform Act,” the word “liberal” should be substituted for “literal.”
- Nessa, supra note 1 and Chilton, supra note 1, deal with the federal exemption under 11 U.S.C. Section 522(d)(12). Tabor, supra note 1, deals with an identical exemption under Pennsylvania law, 42 Pa. C.S.A. Section 8124(b)(1)(ix).
- For example, there are no indications in any of the three cases of self-dealing, pledging the IRAs to secure debts or impermissible IRA investments.
- 11 U.S.C. Section 541; Patterson v. Schumate, 504 U.S. 753 (1992).
Thomas C. Foster is a director of McCandlish Holton, PC in Richmond, Va.
The two companion articles below cover different aspects of the issue of creditor claims on retirement benefits. Thomas C. Foster gives a legal update of four recent court decisions dealing with the effect of bankruptcy law on a creditor's right to reach retirement benefits (the courts came up with different conclusions). Bruce D. Steiner explains how, despite the uncertainty in both bankruptcy law and state law, it's possible to use trusts to protect retirement benefits from the beneficiaries' creditors.