Supreme Court to decide whether bankruptcy protection applies to inherited IRAs

N.J.S.A. 25:2-1 provides for conveyances in trust for use of persons making them void as to creditors.  The statute deals with frauds and fraudulent conveyances.  This statute makes “self settled trusts” to avoid creditors void against public policy.

Notwithstanding, the same statute exempts from creditors and bankruptcy transfer to “qualifying trusts.”  “Qualifying trusts” are limited to IRC Section 401–Pension, Profit Sharing and Stock Bonus Plans; 403–Qualifying Annuity Plans; 408-Individual Retirement Accounts (IRAs); 408-Roth IRAs; 409-Employee Stock Ownership Plans (ESOPs); 529-Qualified Tuition Programs and 530-Coverdell Education Savings Accounts.

Because of a conflict in the circuit courts the United States Supreme Court has agreed to review whether an Inherited IRA may qualify for a bankruptcy exemption under Bankruptcy Code §522(b)(3)(C)

In Clark, Brandon C., In re (2013, CA7), 2013 WL 1729600 cert granted 11/26/2013 the court held that a debtor's inherited IRA may not qualify for a bankruptcy exemption under Bankruptcy Code §522(b)(3)(C). As explained below, the Seventh Circuit decision conflicted with decisions of the Fifth and Eighth Circuits. Thus, in taking the case, the Supreme Court will resolve the conflict.

Bankruptcy exemption requirements. 

A bankruptcy exemption under 11 USC 522(b)(3)(C) must meet two requirements:

(1) the amount the debtor seeks to exempt must be “retirement funds,” and

(2) those retirement funds must be exempt from income taxation under one of several specified Internal Revenue Code provisions, including Code Sec. 408 which provides a tax exemption for IRAs.

Facts of Seventh Circuit decision.  In August of 2000, Ruth Heffron established an individual retirement account (IRA) and named her daughter, Heidi Heffron-Clark, as the sole beneficiary. Ruth Heffron died in September of 2001, and the account passed to Heidi. In December of 2001, Heidi had the balance in her mother's IRA transferred to an inherited IRA. Heidi and her husband (the debtors) took monthly distributions from the inherited IRA. Neither of the debtors was retired at the time.

In October of 2010, the debtors filed a Chapter 7 bankruptcy petition, and claimed the inherited IRA (which contained $293,300) as exempt under Bankruptcy Code §522(b)(3)(C) (11 USC 522(b)(3)(C)) and under Wisconsin law. The bankruptcy trustee and a judgment creditor objected to the exemption, and the bankruptcy court ruled in their favor, denying the exemption. The federal district court, to which the decision was appealed, reversed and held that the inherited IRA qualified for a bankruptcy exemption. This decision was appealed to the Seventh Circuit, which held against the debtors.

Conflicting decisions.  Under the leading cases of Chilton v. Moser (5^th Cir. 2012) 674 F3d 486 and Doeling v. Nessa (2010, 8^th Cir. Bktcy) 426 BR 312, the funds in a debtor's inherited IRA do not have to be the debtor's  “retirement funds” (a term that the Bankruptcy Code does not define) to satisfy the bankruptcy exemption requirements under Bankruptcy Code §522(b)(3)(C) or §522(d)(12). It is enough if the funds were ever “retirement funds.”

Seventh Circuit disagreed.  Unlike the courts in Chilton  and Nessa  , the Seventh Circuit said that the word “retirement” in “inherited individual retirement account” designated the funds' source, not their current status (i.e., as non-retirement funds). Unlike a regular IRA, an inherited IRA is a time-limited, tax-deferral vehicle, but not for holding wealth for use after the new owner's retirement, the court said. Heidi, as owner of the inherited IRA, was required to begin taking distributions under the Code Sec. 401(a)(9) required minimum distribution rules, even though she was still working. The Seventh Circuit noted that, instead of being dedicated to Heidi's retirement years, the inherited IRA had to begin distributing assets within a year of Ruth's death, and the payout had to be completed in as little as five years. Money counts as “retirement funds” only when held for the owner's  retirement—here, Heidi's, the bankruptcy court had concluded. Thus, the funds in the inherited IRA did not meet this standard. The Seventh Circuit agreed, finding that the bankruptcy judge “got this right.”

By the time Heidi and her husband filed for bankruptcy, the money in the inherited IRA did not represent anyone's  retirement funds, the Seventh Circuit said. To treat this account as exempt under Bankruptcy Code §522(b)(3)(C) would be to shelter from creditors a “pot of money” that could be freely used for current consumption. Thus, the Seventh Circuit reversed the district court's decision, and thereby created a conflict among the circuits.

Supreme court grants cert.  The Supreme Court has now agreed to resolve this conflict.