Beginning with In re Daley, 459 BR 270 (Bkcy. EDTenn., 2011), some recent bankruptcy decisions have created doubt as to whether Individual Retirement Accounts (“IRA’s) created by major brokerage firms such as Merrill Lynch and Charles Schwab are exempt from the liquidation efforts of a Chapter 7 Trustee. For years these brokerage firms have employed boiler plate Client Relationship Agreements (or similarly titled agreements) with their account holders that contain clauses similar to the “cross collateralization” clause made famous by your friendly local credit union, and such an Agreement existed in Daley. These clauses grant liens on all client accounts held at the brokerage firm (which would include an IRA) as security for the payment of any other indebtedness the account holder may have with the brokerage firm. These recent cases reason that it is the granting of a lien on the IRA that makes the account vulnerable to liquidation by a Chapter 7 Trustee.
The Courts that have reached this conclusion rely on IRC Section 408(e)(2), which provides that an IRA loses its tax exemption if the account holder engages in a “prohibited transaction”, which under IRC Section 4975(c)(1) includes “any direct or indirect—(B) lending of money or other extension of credit between a plan and a disqualified person” (emphasis supplied). Section 4975(e)(2)(A) provides that the term “disqualified person” includes a “fiduciary”, which is defined by Section 4975(e)(3)(A) as any person who “exercises any discretionary authority or control respecting management…or disposition of [the plan] assets”. The owners of self-directed IRA’s are held to be “fiduciaries” of an IRA, and as such are “disqualified persons”. Accordingly, the Daley court ruled that (1) once the account holder granted a lien on his or her IRA they had engaged in a “prohibited transaction” that caused the funds in said IRA to lose their “exempt from taxation” status under the Internal Revenue Code, and (2) loss of this tax exempt status meant that the IRA could not be claimed as exempt under Bankruptcy Code Section 522(d)(12), or any corresponding state exemption statute.
The IRA in Daley received a “favorable determination” by the IRS, which entitled it to a rebuttable presumption of exemption under Bankruptcy Code section 522(b)(4)(A). The Trustee in Daley was able to rebut the statutory presumption of exemption and proceed against the IRA. QUERY—Would the debtor have been better off if the IRA had not received a “favorable determination” by the IRS? The Daley court does not reach this question, but the Bankruptcy Code exemption statute suggests that the answer might be “yes”. Bankruptcy Code section 522 (b)(4)(B) provides that if the fund in question has not received an IRS “favorable determination” it nevertheless is exempt if (1) no “unfavorable determination” has ever been made by the IRS or any court, and (2) either the fund is in compliance with IRC regulations, or if the fund is not in compliance, the non-compliance is not the account holder’s fault. It is critical to note that this sub-section ( 522(b)(4)(B)) does not create are buttable presumption of exemption, but rather, states that the fund is exempt. It is curious that a fund receiving a “favorable determination” (such as in Daley) enjoys only a rebuttable presumption of exemption, whereas a non-compliant fund seems to enjoy an unqualified exemption providing the account holder did not cause the non-compliance. How does this make any sense?
The Daley ruling is currently on appeal to the Sixth Circuit, but the underlying holding is troubling on many levels. First, the big brokerage firms have created countless thousands of IRA’s for the general population so its effect could be far-reaching—good news for Chapter 7 Trustees but bad news for unsuspecting, struggling debtors. In addition, the debtor in Daley had no other accounts with Merrill Lynch and owed no money to Merrill, so the “cross collateralization” clause in question had no tangible application to the particular account holder. The Daley court held that it was just the existence of the complained of language in the Client Relationship Agreement that made the IRA fair game for the Chapter 7 Trustee. If the Court’s do not fix this unexpected (and presumably unintended) threat to retirement plans then Congress should adopt a statutory fix.