Cunning v. Rucker, No. 08-55652  U.S. 9th Circuit Court of Appeals, June 26, 2009 
In an appeal from the Bankruptcy Court's order denying an exemption for Debtor's assets in pension and 401(k) plans, the order is affirmed, where the retirement plans were not designed and used primarily for retirement purposes.  Facing a civil judgment debt of more than $6.5 million, Lloyd Myles Rucker declared bankruptcy and tried to exempt his assets as belonging to private retirement plans under California Civil Procedure Code (“CPC”) § 704.115. Rucker had previously placed the assets in pension and 401(k) plans funded by his wholly owned corporations. The bankruptcy court denied the exemption on the explicit ground that Rucker’s retirement plans were not designed and used primarily for retirement purposes. The district court reversed, but 9^th Circuit upheld bankruptcy court.

HELD: IRA NOT EXEMPT BECAUSE OF NUMEROUS FAILURES TO COMPLY WITH IRS CODE

In re Daniels ___ B.R. ___ (Bankr.Mass 2011) CLICK FOR FULL TEXT OF OPINION

In this case the Chapter 7 trustee challenged the debtor's claim of exemption of funds in a profit-sharing plan and an IRA. The court held that the debtor's handling of the plans failed to compy with applicable IRS regs and accordingly were not valid under the IRS Code, and therefore not exempt per 11 U.S.C. § 522(b)(1) et seq. The requirements differ depending on whether the IRS has issued a "favorable determination letter." In this case, the funds failed to qualify under either option.

The debtor and his family were actively involved in managing the funds. Among other things, the court found:
• The debtor managed the funds for his own benefit;
• Transferred non-exempt funds from the profit-sharing plan to the IRA;
• The fund never received a Favorable Determination Letter;
• Conducted prohibited transfers of funds to a disqualified person;
• Rented real property to a family member, a prohibited act;
• Loaned funds to his daughter, a prohibited act;
• Invested Profit-sharing funds into a business venture in which the Debtor had also individually invested.

The IRS prohibits such conduct between the fund and a disqualified person. Among the disqualified persons are "fiduciaries."

"A "fiduciary" is defined as any person who:
(A) exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets,
(B) renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so, or
(C) has any discretionary authority or discretionary responsibility in the administration of such plan.109

Additionally, "Prohibited transactions" include the following:
(A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
(B) lending of money or other extension of credit between a plan and a disqualified person;
(C) furnishing of goods, services, or facilities between a plan and a disqualified person;
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

The Debtor has admitted that he routinely used the funds in his retirement account to enrich the interests of his family and other disqualified persons, and it is evident from these admissions that executing taxable "prohibited transactions" was the routine manner by which he managed the assets held in his Profit Sharing Plan. Furthermore, having actively managed the affairs of the plan as employer, manager, and trustee of the Profit Sharing Plan, the Debtor was materially responsible for the failure of the plan to be in substantial compliance with applicable tax law. The Debtor has abused the profit sharing plan form and the consequence is that the funds held therein may not be exempted from the bankruptcy estate.

HELD: IRA NOT EXEMPT BECAUSE OF EXTENSION OF CREDIT BETWEEN FUNDS

In re Willis __ B.R. __ Bankr. S.D.Fla. 2009)  CLICK FOR FULL TEXT OF OPINION

In this case the debtor's IRA did receive an IRS Favorable Determination letter. Nevertheless, the court found the IRA not exempt. "The issue before the Court is the propriety of Mr. Willis' claims of exemptions for the full value of the Merrill Lynch IRA, the Fidelity IRA, and the AmTrust IRA pursuant to § 522(b)(3)(C)." "Movants argue that Mr. Willis is a disqualified person who engaged in prohibited transactions, the effect of which was to disqualify the Merrill Lynch IRA for exemption from taxation, and consequently disqualify the IRA from bankruptcy estate exemption under § 522(b)(3)(C).

"Movants contend that Mr. Willis engaged in prohibited transactions under § 4975 when: 1) Mr. Willis borrowed and used funds from the Merrill Lynch IRA to acquire assignment of the Ocean One Property Mortgage from Southwest, 2) Mr. Willis borrowed funds from the Merrill Lynch IRA in order to engage in a check- swapping scheme to cover a shortfall in the Joint Brokerage Account, and 3) Ocean One borrowed funds from the Merrill Lynch IRA to acquire the Ocean One Property Mortgage from Southwest.

"Under § 4975(c)(1)(B), any direct or indirect lending of money or other extension of credit between a plan and a disqualified person constitutes a prohibited transaction. In this case, Movants presented evidence at trial that Mr. Willis borrowed funds from the Merrill Lynch IRA to purchase the assignment of the Ocean One Property Mortgage from Southwest.

"In December 1993, Mr. Willis withdrew $700,000 from the Merrill Lynch IRA to purchase the assignment of the Ocean One Property Mortgage. On or about February 22, 1994, Mr. Willis returned $700,000 into the Merrill Lynch IRA. "Consequently, the Court finds that Mr. Willis engaged in a prohibited transaction under § 4975(c)(1)(B) by borrowing $700,000 from the Merrill Lynch IRA to acquire the assignment of the Ocean One Property Mortgage from Southwest.

"Therefore, as a result of Mr. Willis' prohibited transaction under § 4975(c)(1)(B), the Merrill Lynch IRA ceased to be an exempt IRA under § 408 of the IRC as of January 1, 1993. "For the reasons stated above, the Court determines that the following funds are not exempt from the bankruptcy estate under § 522(b)(3)(C): 1) all funds in the Merrill Lynch IRA, 2) all funds in the AmTrust IRA, and 3) $60,000 in the Fidelity IRA.

The court also cited In re Hughes 293 B.R. 528 (Bankr.M.D. Fla. 2003) " ... concluding that debtor's IRA was not exempt from the bankruptcy estate because debtor engaged in a § 4975(c)(1)(B) prohibited transaction by withdrawing $27,000 from his IRA to lend to a corporation for which he was the principal and subsequently returning the funds to the IRA)"; and Zacky v. Comm'r, 2004 WL 1172874 (T.C. May 27, 2004)(determining that a § 4975(c)(1)(B) prohibited transaction occurred when disqualified person caused plan to loan funds to companies for which he was the president and sole shareholder."

HOWEVER, the issue doesn't stop there. The circumstances in the two cases cited above appear to relate to retirement programs more likely associated with self-employed individuals than the more typical wage-earner employer funded IRA.

However, there may be a problem even with employer-sponsored IRAs if typical or standard agreements with brokerage firms contain tainted language. This appears to be the subject of a recent Labor Department memorandum issued in response to a question put by California attorney Tim Berry:

In 2009 Berry asked the U.S. Department of Labor to give an advisory opinion on the validity of a clause in a brokerage firm's agreement granting the firm a security interest in the IRA funds.

" ... whether it would be a prohibited transaction ... for an IRA owner to grant to a brokerage firm a security interest in the assets of his non-IRA accounts held by the Broker as a requirement for establishing an IRA with the Broker. "It is the opinion of the Department that the grant by an IRA owner to the Broker of a security interest in his non-IRA accounts in order to cover indebtedness of, or arising from, his IRA, as you describe, would be a prohibited transaction under Code section 4975(c)(1)(B).

"Section 4975(c)(1)(B) prohibits the direct or indirect lending of money or other extension of credit between a plan and a disqualified person. The granting of a security interest in the IRA owner’’s personal accounts to cover indebtedness of, or arising from, the IRA constitutes such an extension of credit.
"Nevertheless, the Department notes that to the extent that the situation you describe also would result in the granting by the IRA owner to the Broker of a security interest in the IRA’’s assets to cover the indebtedness of the IRA owner, prohibited transactions would likewise occur in violation of Code sections 4975(c)(1)(B), (D), & (E) ..."  CLICK FOR FULL TEXT OF 2009 DOL LETTER

SIMILAR QUESTIONS were the subject of a more recent DOL opinion letter, also involving the IRA owner's control of, and benefit from, the IRA assets:
" ... Mr. Warfield, as the IRA owner who has sole discretion to direct the investments made by his IRA, would be a fiduciary and a disqualified person with respect to the IRA under Code section 4975(e)(2) and would be subject to the restrictions imposed by section 4975(c)(1). Ms. Warfield, as Mr. Warfield’’s wife, would be a disqualified person with respect to the IRA as a ““member of the family”” of the IRA fiduciary. The Family Trust would also be considered a disqualified person under section 4975(e)(2), since Mr. Warfield is its trustee and the Warfields are its sole beneficiaries."

CLICK FOR FULL TEXT OF 2011 DOL LETTER

OTHER IRA ISSUES  The issues identified above add to a growing list of questions that may arise in a case involving claims of exemptions for IRAs and similar retirement accounts, including issues arising under state laws. See; In re Segovia 404 B.R. 896 (N.D.Cal. 2009) (whether fund was "primarily" intended for retirement purposes); In re McDonald __ B.R. __ (Bankr.ID 2008) and In re Cutignola __ B.R. __ (Bankr.S.D.N.Y. 2011) (inherited IRA); In re Beverly 314 B.R. 221 (9th Cir. BAP 2007) (rolled over from non-exempt benefit plan).

NOTES: 

ERISA Plans: Proof that a 401(k) is ERISA qualified.  An ERISA qualified 401(k) is exempted or protected in bankruptcy. ERISA is an acronym for Employee Retirement Income Security Act.  ERISA is a federal law setting the minimum protection standards for individuals contributing to pension and some health plans established by private companies.  ERISA does not apply to federal and state employees, since they are usually government retirement plans.

Most retirements plans meet the ERISA requirement.  Sources for this information: the employer may have a letter on file from the IRS, or the 401(k) administrator (ask them to provide you a copy of the plan summary), or review the plan summary online.  In the table of contents, there may be a section that speaks about ERISA.  Again, most employer sponsored 401(k) plans meet the requirements under ERISA.  However, it is something should be verified prior to filing bankruptcy.  Often the bankruptcy Trustee will ask for a copy of the most recent 401(k) statement and a notice of ERISA qualification prior to the meeting of creditors.

CHAPTER 13: normally, it is rare for a trustee object in a 13 to voluntary contributions.  The guidelines cite to 11 USC  541(b)(7)(B).  See 11 USC 541 (b)(7)(B) and it states ERISA and  Section 414, Section 457 and Section 403(b) plans are all protected (nothing is mentioned about voluntary 401k contributions).

Most likely the argument could be made that because you don’t count 401k contributions towards the means test definition of disposable income, you should not be able to count them for actual disposable income.  You could cite In re Ronald Mills, 99-07826, Southern District of CA, (while a Chapter 7 decision, it analyzes 11 USC 1325), stating: Here, the debtor attests that he has no other retirement savings plan, that he is 56 years old, and that he desires to continue funding his qualified 401(k) plan with 10% of his salary, approximately $302 per month. As of the petition date, the balance in the plan is only $9,000, so this is clearly not an instance where the debtor has accumulated substantial amounts of equity in a retirement plan, which he desires to continue padding at the expense of his creditors. Cf. In re Watkins, 216 B.R. at 396 ($1,099 monthly retirement fund contribution is not reasonably necessary); cf. also In re Fountain, 142 B.R. at 137. Moreover, a review of the debtor’s schedules indicates very modest budgeting on all scores. Based upon this evidence, the court concludes that under § 1325(b)(2)(A), this debtor is permitted to deduct as a reasonably necessary expense, the 10% voluntary contribution to his qualified 401(k) plan. In these circumstances, there is no reason to conclude that providing a modest amount of contribution to a 401(k) plan is not reasonably necessary for the maintenance and support of this debtor.