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Bankruptcy Exemption

A district court has reversed a bankruptcy court decision awarding a debtor's inherited IRA under bankruptcy exemption 11 USC 522(b)(3)(C).  Under the bankruptcy exemption 11 USC 522(b)(3)(C), two requirements apply. First, the debtor's amount they want exempted must be "retirement funds". Secondly, once that amount is classified as "retirement funds", those funds must be exempt under the Internal Revenue Code provisions. There are several code provisions that must be considered, including Code Sec. 408, which is an exemption tax for IRA's.

In this particular case, Heidi Heffron-Clark and her husband (the debtors) claimed her mother, Ruth Heffron's, IRA in November 2001 after she died in September of 2001. Heidi established an inherited IRA after being named the sole beneficiary in August of 2000. In December 2001, Heidi took the remainder of her mother's IRA and transferred it to the inherited IRA. Over the years, Heidi and her husband withdrew monthly amounts from the inherited IRA account and neither of them was retired during this time.

October 28, 2010, Heidi and her husband filed a Chapter 7 bankruptcy petition. In this petition they claimed the inherited IRA to be exempt under 11 USC 522 (b)(3)(C). The creditors, the bankruptcy trustee and a judgment creditor objected, giving the bankruptcy court grounds to agree with them and deny the exemption petition. After this ruling, the debtors, Heidi and her husband appealed to the federal district court.

During the proceedings of the appeal, the bankruptcy court found that Heidi's inherited IRA was not applicable to "retirement funds". As the sole beneficiary to the inherited IRA, Heidi should have been taking distributions under the Code Sec. 401 (a)(9)(B) containing minimum distribution rules. Ultimately, the bankruptcy court ruled that the inherited IRA funds were not "retirement funds" because they were not benefitting nor meeting the need of any person's retirement. Included in this ruling, the bankruptcy court found the inability to determine any authority regarding the IRA being tax-exempt. This inability is heightened under Code Sec. 408(a) because inherited IRA's are not compatible with any criteria listed in this code. Such criterion includes requirements of contributions being made in cash that do not exceed certain limits, as stated by the bankruptcy court.

The district court did reverse this decision by explaining how every other bankruptcy court and federal district court has ruled in favor of the debtor regarding the validity of the bankruptcy exemption to inherited IRA's, minus a few specific cases. Amongst their ruling, the federal district court projected the majority view that the funds of the debtors inherited IRA do not have to be the debtors "retirement funds" to apply to the bankruptcy tax exemption provisions. However, contradicting the majority, the court did make an argument that under the Bankruptcy Code provisions, the property of the debtor "retirement funds" can imply that the retirement funds are that of the debtors.  In conclusion, this decision was helped through 11 USC 522(B)(34)(c), which supports the notion that the direct transfer of retirement funds from a tax-exempt fund or account does not negate the funds eligibility for bankruptcy exemption.

The district court did reverse the ruling of the bankruptcy court whose perception of traditional IRA's and inherited IRA's was unclear, which led to the first verdict. In the end, the district court did adhere to the question of should inherited IRA's be exempt from bankruptcy, but that is a matter for congress. The final decision was in favor of the debtors.

Source: Federal Tax Updates on Checkpoint News tab 2/2/2012

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