Employee-Benefits Bankruptcy Issues That Law Firms Need to Know

Impact of Bankruptcy Legislation on IRAs

This article provides an update on the protection of an individual retirement account (IRA) from creditors after the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the Act). In general, the Act, which took effect on Oct. 17, 2005, expands the bankruptcy protections previously available for a debtor's 'ERISA-qualified' retirement funds.

In a bankruptcy proceeding, a bankruptcy estate is created to collect funds for the payment of the debtor's debts. The bankruptcy estate consists of all of the debtor's legal and equitable property interests. The debtor can seek to protect his retirement funds from creditors by claiming either an exclusion from the bankruptcy estate or an exemption. Historically, there were limitations on the effectiveness of both kinds of protection with respect to IRAs. (Note: Funds which qualify for an exclusion are never brought into the bankruptcy estate. If an exclusion does not apply, the funds technically do become part of the bankruptcy estate but can be effectively shielded from creditors' claims by an exemption.)

The Act adds a new exemption to Section 522 of the Bankruptcy Code for 'retirement 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 Code.' (Note: The quoted language actually appears twice and constitutes two separate exemptions. It appears for the first time in Bankruptcy Code '522(b)(3)(C), a provision that cannot be overridden by a state wishing to opt out of the federal exemption scheme. It has also been added to the list of federal exemptions as new Bankruptcy Code '522(d)(12). Thus, the exemption is available whether or not a debtor elects the federal scheme under '522(d) or the exemptions available under applicable state bankruptcy law.) The reference to Sections 408 and 408A indicates that the exemption applies to traditional IRAs as well as Roth IRAs. The exemption for funds held in an IRA, calculated without regard to rollover contributions or the earnings thereon, is limited to $1 million.

Comment: It is a rare IRA account that will have accumulated $1 million from the modest contributions permitted to IRAs; thus, this is an unlimited exemption for all practical purposes.

The limit apparently does not apply to simple retirement accounts or to simplified employee pensions (SEPs). In addition, it will be adjusted for inflation and can be increased by a court 'if the interests of justice so require.'

The Act also provides for a limited exclusion from the bankruptcy estate for amounts contributed to Section 529 plans and Section 530 (Coverdell) education savings accounts. The beneficiary must be a child, stepchild, grandchild, or step grandchild in the taxable year for which the funds were contributed. Deposits within 1 year of the bankruptcy filing are not protected on the theory that recent deposits are a form of preference better devoted to creditors. Deposits made within the period beginning 720 days before filing and ending 365 days before filing that exceed $5000 for any one beneficiary are also unprotected.

Outside of bankruptcy, IRAs are not protected by ERISA's prohibition on the assignment or alienation of benefits, and judgment creditors in some jurisdictions have had little trouble in attaching IRA assets. The self-settled nature of an IRA trust or custodial account and the fact that the IRA owner has the ability to revoke the agreement and recover the funds at any time make the enforcement of a 'spendthrift' restriction problematic. Nevertheless, many states have enacted statutory protections for IRAs, in effect treating them as spendthrift trusts by legislative fiat.

It should be noted that the IRS can levy on the assets of an IRA under Section 506(a) of the Bankruptcy Code, although it has indicated that it will do so only when the taxpayer flagrantly disregards requests for payment.

Sole Owner Entitled as 'Participant' to Protect
Plan Assets from Bankruptcy Creditors under ERISA

The working owner of a business may qualify as a 'participant' in an ERISA-covered pension plan and shield assets under the plan's anti-alienation provision from bankruptcy creditors, the U.S. Supreme Court unanimously ruled in Raymond B. Yates, M.D., P.C. Profit Sharing Plan v. Hendon K. Reversing the Sixth Circuit Court of Appeals, the Supreme Court ruled that some small business owners may be considered to be employees as well as employers for ERISA retirement plan purposes. Thus, these working owners are entitled to all the rights and protections of ERISA, including protecting benefits from the reach of creditors. The plan must cover the owner and one or more employees other than the owner's spouse. If it covers only the sole shareholder, or the sole shareholder and spouse, he or she is not a participant under ERISA, and not entitled to protections under ERISA.

Impact of Bankruptcy Legislation on IRAs

This article provides an update on the protection of an individual retirement account (IRA) from creditors after the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the Act). In general, the Act, which took effect on Oct. 17, 2005, expands the bankruptcy protections previously available for a debtor's 'ERISA-qualified' retirement funds.

In a bankruptcy proceeding, a bankruptcy estate is created to collect funds for the payment of the debtor's debts. The bankruptcy estate consists of all of the debtor's legal and equitable property interests. The debtor can seek to protect his retirement funds from creditors by claiming either an exclusion from the bankruptcy estate or an exemption. Historically, there were limitations on the effectiveness of both kinds of protection with respect to IRAs. (Note: Funds which qualify for an exclusion are never brought into the bankruptcy estate. If an exclusion does not apply, the funds technically do become part of the bankruptcy estate but can be effectively shielded from creditors' claims by an exemption.)

The Act adds a new exemption to Section 522 of the Bankruptcy Code for 'retirement 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 Code.' (Note: The quoted language actually appears twice and constitutes two separate exemptions. It appears for the first time in Bankruptcy Code '522(b)(3)(C), a provision that cannot be overridden by a state wishing to opt out of the federal exemption scheme. It has also been added to the list of federal exemptions as new Bankruptcy Code '522(d)(12). Thus, the exemption is available whether or not a debtor elects the federal scheme under '522(d) or the exemptions available under applicable state bankruptcy law.) The reference to Sections 408 and 408A indicates that the exemption applies to traditional IRAs as well as Roth IRAs. The exemption for funds held in an IRA, calculated without regard to rollover contributions or the earnings thereon, is limited to $1 million.

Comment: It is a rare IRA account that will have accumulated $1 million from the modest contributions permitted to IRAs; thus, this is an unlimited exemption for all practical purposes.

The limit apparently does not apply to simple retirement accounts or to simplified employee pensions (SEPs). In addition, it will be adjusted for inflation and can be increased by a court 'if the interests of justice so require.'

The Act also provides for a limited exclusion from the bankruptcy estate for amounts contributed to Section 529 plans and Section 530 (Coverdell) education savings accounts. The beneficiary must be a child, stepchild, grandchild, or step grandchild in the taxable year for which the funds were contributed. Deposits within 1 year of the bankruptcy filing are not protected on the theory that recent deposits are a form of preference better devoted to creditors. Deposits made within the period beginning 720 days before filing and ending 365 days before filing that exceed $5000 for any one beneficiary are also unprotected.

Outside of bankruptcy, IRAs are not protected by ERISA's prohibition on the assignment or alienation of benefits, and judgment creditors in some jurisdictions have had little trouble in attaching IRA assets. The self-settled nature of an IRA trust or custodial account and the fact that the IRA owner has the ability to revoke the agreement and recover the funds at any time make the enforcement of a 'spendthrift' restriction problematic. Nevertheless, many states have enacted statutory protections for IRAs, in effect treating them as spendthrift trusts by legislative fiat.

It should be noted that the IRS can levy on the assets of an IRA under Section 506(a) of the Bankruptcy Code, although it has indicated that it will do so only when the taxpayer flagrantly disregards requests for payment.

Sole Owner Entitled as 'Participant' to Protect
Plan Assets from Bankruptcy Creditors under ERISA

The working owner of a business may qualify as a 'participant' in an ERISA-covered pension plan and shield assets under the plan's anti-alienation provision from bankruptcy creditors, the U.S. Supreme Court unanimously ruled in Raymond B. Yates, M.D., P.C. Profit Sharing Plan v. Hendon K. Reversing the Sixth Circuit Court of Appeals, the Supreme Court ruled that some small business owners may be considered to be employees as well as employers for ERISA retirement plan purposes. Thus, these working owners are entitled to all the rights and protections of ERISA, including protecting benefits from the reach of creditors. The plan must cover the owner and one or more employees other than the owner's spouse. If it covers only the sole shareholder, or the sole shareholder and spouse, he or she is not a participant under ERISA, and not entitled to protections under ERISA.