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Another crack in bankruptcy protection for clients

Advisors may now have to rethink their guidance on how clients should treat retirement assets acquired during a divorce after a recent bankruptcy court ruling.

The 8th Circuit Bankruptcy Appellate Panel in October ruled that an IRA awarded in a divorce settlement is a property settlement, not a retirement account, and thus is not shielded from bankruptcy.

The ruling relied heavily on a 2014 Supreme Court decision (Clark v. Rameker) that found inherited IRAs are not protected under the bankruptcy code. The High Court concluded the bankruptcy code exemption was limited to retirement assets, which it defined as “sums of money set aside for the day an individual stops working.”

That Supreme Court ruling had noted that beneficiaries of inherited IRAs must take annual minimum distributions regardless of age, can withdraw funds without limit from the IRA penalty-free regardless of age and cannot contribute to their inherited IRAs to save for retirement.

A recent ruling could alter the landscape of how individuals with retirement plan assets approach bankruptcy filings.

In the recent 8th Circuit ruling (In re Lerbakken, 122 AFTR 2d, October 16, 2018), the court extends the Supreme Court finding to IRAs that are part of a divorce settlement. This expands creditors’ reach.

This case began in 2014, when Brian Lerbakken and his wife finalized their divorce. Lerbakken was awarded his ex-wife’s entire IRA and one-half of her 401(k) plan. For reasons not known, a qualified domestic relations order (QDRO) was never filed with the plan administrator, and it appears that the IRA assets were never transferred. In fact, at oral arguments before the court, Lerbakken’s attorney confirmed that both IRA and 401(k) plan monies remained in the ex-wife’s accounts.

In January 2018, Lerbakken filed a Chapter 7 bankruptcy petition and listed both the 401(k) and IRA assets awarded during the divorce as exempt property. Under the federal bankruptcy code, assets in a qualified retirement plan have unlimited protection while IRA assets are protected up $1,283,025. The 8th Circuit Bankruptcy Appellate Panel had to decide whether the protections afforded to retirement plan assets extends to those transferred in a divorce.

If adopted on a wider basis, the Lerbakken decision will alter the landscape of how individuals with retirement plan assets approach bankruptcy filings.

No, the court ruled; the 401(k) and IRA assets were property settlements, not retirement accounts.

The distinction between bankruptcy protection and general creditor protection is clear. General creditor protection involves claims other than bankruptcy, such as lawsuits or other judgments. That distinction is not a problem for company plans such as 401(k)s because they receive broad federal creditor protection under the Employee Retirement Income Security Act, or ERISA. IRAs receive no such federal protection; IRA creditor protection is based on state law, which varies.

In New York, for example, (In Re: Todd, Bktcy Ct NY, 121 AFTR 2d 2018-658, March 23, 2018), a federal bankruptcy court ruled that under New York State law inherited IRAs receive no protection in bankruptcy, citing the Clark ruling.

In this case, Laurie A. Todd received an inherited IRA from her deceased mother in 2008 that in January 2018 was worth $800,000. In May 2015 she had declared bankruptcy while facing a potential liability of up to $1.8 million after she joined other family members in indemnifying an insurance company that issued performance and payment bonds for a construction project.

The court concluded that an exemption from bankruptcy funds that have not been saved by individuals for their retirement would be "fundamentally inconsistent with the statute’s purpose" and the New York State Legislature's intent.

US Bankruptcy Court (Bloomberg)

Thus, it held that no exemption for the inherited IRA is allowed under New York law, and the IRA is subject to creditors' claims as property of the bankruptcy estate.

In Illinois, a bankruptcy court (In Re: Hamm – 122 AFTR 2d. 2018-5384 (Bktcy. Ct. IL), July 9, 2018), again citing the Clark ruling, determined that an inherited IRA does not qualify as “retirement funds” that are exempt from bankruptcy, under either federal or state law. As a result, most of the debtor’s IRA assets were not protected from bankruptcy creditors.

Advisers with clients negotiating a divorce settlement should help them look to other assets that might be better protected in bankruptcy.

If the inherited IRA is explicitly protected under state’s bankruptcy law, the client can go through bankruptcy proceedings knowing that her or his inherited IRA assets are safe. However both the Todd and Hamm cases are warnings that state law may treat inherited IRAs in the same manner as federal bankruptcy law and provide no or very limited protection for these assets.

While the Lerbakken decision only applies to the 8th Circuit (Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota), all advisers should pay attention, in the event other courts adopt a similar rule. If adopted on a wider basis, it will alter the landscape of how individuals with retirement plan assets approach bankruptcy filings. Most clients have retirement accounts; divorce is often cited as one of the most common reasons for ending up in bankruptcy court.

The Lerbakken court had relied heavily on the unanimous Supreme Court decision in Clark v. Rameker, which held that inherited IRAs are not protected retirement funds under the bankruptcy code. The Lerbakken court held that the 401(k) and IRA assets were property settlements, not retirement accounts.

It didn’t matter that while the two were married, Lerbakken’s wife had contributed to those funds for their joint retirement. As a result, bankruptcy protection was denied.

The bankruptcy panel said that the Supreme Court’s ruling in Clark v. Rameker “clearly suggests that the exemption is limited to individuals who create and contribute funds into a retirement account. Retirement funds obtained or received by any other means do not meet this definition.”

That far-reaching view is a huge stretch of the Clark ruling. Whether this interpretation will hold up before the Supreme Court remains to be seen. One implication of these rulings is that, if they were taken a step further, even ordinary spousal IRA rollovers after death could be exposed to creditors, since the inheriting spouse did not create or contribute to those funds. That seems like a bridge too far.

The Lerbakken decision raises and leaves unanswered two important questions:
1. Would the result have been the same if Lerbakken had filed the QDRO with the 401(k) plan and acted to possess the IRA assets?
2. And what if Lerbakken had rolled those assets into his own IRA or 401(k)?

United States Bankruptcy court - closer

Best practices indicate that a QDRO should be filed with the plan as soon as it is executed by the Court; there is no reason to delay this final step. Similarly, IRAs awarded in a divorce proceeding should be transferred in a trustee-to-trustee transfer once court action is resolved. In this case, Lerbakken could have simply retitled the IRA since he was awarded the full account.

Yet these steps might not have helped the debtor after filing for bankruptcy. The Lerbakken court mentioned this fact only in passing and repeatedly emphasized that the funds were obtained through a property settlement. So retitling the accounts might not have affected this characterization.

On the other hand, what if Lerbakken had rolled those assets into his own IRA or qualified plan prior to filing for bankruptcy? Clearly, his own IRAs and qualified plan contributions would be considered retirement funds entitled to bankruptcy protection.

Would this protection extend to the entire account or would the amount obtained in the divorce be carved out? If there was a carve-out, would it include earnings and losses on the transferred sums? And would the court have denied exemption to the entire account under the reasoning that the rolled-over divorce assets somehow tainted the account? These questions remain unanswered.

For now, and until these questions are addressed in any future rulings, in any divorce settlement where a spouse is awarded retirement funds, those funds should be directly transferred to a separate new IRA that doesn’t contain any of that spouse’s own IRA funds.

This would ensure that the spouse’s own IRA funds would not be tainted by being commingled with IRA funds received in a divorce in the event of bankruptcy. Financial advisors should carefully monitor these accounts and keep those IRA funds separate.

And with the knowledge that retirement funds split in divorce could be vulnerable in bankruptcy, should your clients be negotiating a divorce settlement, help them look to other assets that might be better protected or that could be held by the receiving spouse in a protected trust.

How the Lerbakken Decision Could Affect Alimony Planning
Beginning in 2019, the new tax law changes the rules on alimony, so it will no longer be deductible for the spouse who pays it and no longer taxable to the spouse receiving it. Pre-2019 agreements are grandfathered.

One strategy I have recommended to advisors to effectively salvage the alimony deduction is to use IRA funds in lieu of alimony. This way, the spouse giving up an IRA is effectively gaining a deduction since these funds are pre-tax funds that the IRA owner would have paid tax on when they were eventually withdrawn.

But this tactic, even if viable, may not work as well if the spouse receiving the IRA has financial problems that could lead to a bankruptcy situation. Under Lerbakken, the IRA could be exposed to creditors in bankruptcy, so advisors should be careful to take this into account.

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