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Non-exempt Exempt IRAs and Undercompensated Chapter 7 Trustees

posted by Bob Lawless

Pension Piggy BankSome chapter 7 trustees have found a problem that could affect thousands of IRAs, leading to the first post in a  two-post series on unintended consequences. A better reading of the law is that these IRAs should remain exempt from the bankruptcy process. Cases are wending their way through the court system, and until the courts resolve the issues, many IRAs may remain under threat. And, there is no guarantee the courts will agree with me on how the cases should be resolved.

The situation begins with the 2005 changes to the bankruptcy law. One of the few ways these changes were favorable to consumer debtors was to clarify and expand the exemptions available to retirement assets, including IRAs. Most retirement assets are exempt from the bankruptcy process, meaning debtors can retain these assets even after the bankruptcy case.

The Bankruptcy Code clearly exempts IRAs but only does so if the IRAs qualify for tax-favored treatment. The law has more details about how to determine whether an IRA is tax-favored, but those details are best skipped in a blog post. You might wonder where I am going with this because you should be thinking to yourself, "Isn't most every IRA tax-favored by definition?" And, yes, that is the expectation everyone has about their IRAs, but the tax law can be a funny thing.

To qualify for tax-favored treatment, the IRA owner cannot engage in a prohibited transaction with the IRA. Among the transactions that are prohibited is taking a loan from the IRA, a prohibition that makes eminent sense given that IRAs are tax-favored to encourage retirement savings and it would be self defeating to allow the IRA owner to use the IRA funds for consumption today.

Most people have their IRAs with large brokerage firms that require their clients to sign lengthy form contracts before opening the IRA. Buried in many of these form contracts that many of the brokerage firms use is a clause stating that if the IRA owner borrows money from another account at the brokerage -- say to buy stock on margin -- the brokerage has a lien against the IRA assets to assure repayment of the loan. Of course, in most instances, this language is quite hypothetical. The average person often does not even have other, non-IRA accounts at the brokerage let alone have borrowed against those accounts to buy stock on margin.

Nonetheless, some chapter 7 trustees have challenged IRAs on the theory that the possibility a lien could arise means the IRA is not tax-favored. A few lower bankruptcy courts have agreed -- although one notably has not -- with the upshot that the IRA becomes part of the bankruptcy estate. In these cases, the debtor can lose substantial retirement savings. Because the contracts at issue were used by many of the nation's major brokerages, the practical consequences of these rulings could be large. The U.S. Court of Appeals for the Sixth Circuit currently has the issue before it in a case called In re Daley

It is the technicality of all technicalities to say an IRA is not exempt because of the hypothetical possibility a lien could arise. One way the Sixth Circuit could dispose of the case is to fall back on the old idea that a lien does not exist in the absence of a debt. If there is no lien, there is no transfer of a property interest in the IRA, and it should remain tax favored. Also, there is some authority from the IRS as well as the Department of Labor that an IRA remains tax-favored even if the brokerage account agreement has language that could hypothetically create a lien but does not actually give rise to a lien because no debt exists. But, there are no sure bets on how the case will go.

In the first paragraph, I promised the first of a two-part series on unintended consequences. Although the story of the "non-exempt exempt IRA" is important in its own right, it is also part of a larger story about what chapter 7 trustee compensation is doing to the bankruptcy system.

In over 90% of the cases, chapter 7 trustees earn the statutory minimum of $60/case. This amount has not changed in 19 years. Even worse, chapter 7 trustees earn no compensation for the increasing number of cases where no filing fee has been paid because the debtor has in forma pauperis status. To top things off, bankruptcy filings continue to decline each year meaning fewer cases for each chapter 7 trustee. To make a reasonable living and to pay staff and overhead, chapter 7 trustees are increasingly reliant on the statutory percentage they earn in the few cases with assets to administer.

Trustees have ever stronger incentives to find assets in chapter 7 cases. The result is aggressive and novel legal positions, as I would characterize the arguments over the IRAs' exempt status. Not that there is anything wrong with that -- the trustees are only responding to the incentives the system has handed them and are making reasonable and good-faith arguments of law, even if I ultimately disagree with the conclusions. The incentives, however, ultimately lead to distortions in the balance the bankruptcy law has struck between creditor repayment and a debtor's fresh start. The distortions are incremental, but they accumulate over time. Legal positions taken in individual cases get accepted by a few courts, and one day we suddenly realize the law's effects have ended up in a very different place than where Congress had started out. For those who are interested in the health of the bankruptcy system, one of the most important things that needs to be done is to fix chapter 7 trustee compensation.

And, I still think the IRAs should be exempt.

Pension jar image from Shutterstock.


While I agree 100% with increasing Trustee compensation(How about a Proof of Claim filing fee?), I'm not sure that such would eliminate Trustees seeking additional compensation through creative assaults on normally exempt assets.

Increasing trustee compensation would indeed be favorable, and you made good points as to why. It's an interesting issue in the bankruptcy system, especially as bankruptcy filings decrease. Striking the balance between the creditor and the debtor's interests (and the trustee's) is not an easy thing to do.

That is a fair point, but I think you have demanded too high of a standard. Incentives matter and work only at the margins. No matter what the context, there are few changes that will fix everything or eliminate a problem. Improving trustee compensation will move things in the right direction. That is only my claim.

What about the following from the IRS & DOL:
Internal Revenue Bulletin: 2011-81
December 27, 2011........ it would seem to trump bankruptcy court's holding the IRA lost It's status

Announcement 2011-81
Relief With Respect to IRAs Whose Owners Have Entered Into Certain Agreements With Brokers or Other Financial Institutions


Table of Contents

*This announcement provides temporary relief with respect to Individual Retirement Accounts (IRAs) in circumstances in which the IRAs' owners have signed certain indemnification agreements or granted certain security interests in accounts that may have an effect on their IRAs.

On October 20, 2011, the Department of Labor (DOL) issued Advisory Opinion 2011-09A regarding circumstances under which an individual IRA owner's agreement to indemnify a broker in order to cover indebtedness of, or arising from, the individual's IRA with the broker would be an impermissible "extension of credit," as described in § 4975(c)(1)(B) of the Code and whether, in such cases, any prohibited transaction would be covered by DOL class exemption PTE 80-26. Subsequent to the issuance of Advisory Opinion 2011-09A, similar issues have been raised regarding the IRA owner's grant of a security interest among the non-IRA accounts and the IRA (referred to collectively as cross-collateralization agreements) with a broker or other financial institution. Previously, on October 27, 2009, the DOL issued Advisory Opinion 2009-03A, holding that the grant by an individual to a broker of a security interest in the individual's non-IRA accounts with the broker would be an impermissible extension of credit to the individual's IRA, as described in § 4975(c)(1)(B) of the Code. Advisory Opinion 2011-09A concludes that PTE 80-26 does not provide relief for such extensions of credit.[12]

The DOL has advised the Internal Revenue Service (IRS) that DOL is considering further action with respect to the issues described above, including consideration of a class exemption request expected to be submitted to the DOL. Pending further action by the DOL and until issuance of further guidance from the IRS superseding this announcement, the IRS will determine the tax consequences relating to an IRA without taking into account the consequences that might otherwise result from a prohibited transaction under § 4975 resulting from entering into any indemnification agreement or any cross-collateralization agreement similar to the agreements described in DOL Advisory Opinions 2009-03A and 2011-09A, provided there has been no execution or other enforcement pursuant to the agreement against the assets of an IRA account of the individual granting the security interest or entering into the cross-collateralization agreement. No inference with respect to the application of any Code section other than § 4975 should be drawn from this announcement.


[12] Under Reorganization Plan No. 4 of 1978, effective December 31, 1978, the authority of the Secretary of the Treasury to issue interpretations with respect to § 4975 of the Code was transferred, with certain exceptions not here relevant, to the Secretary of Labor.


The DOL should determine that these boilerplate provisions in the brokerages' IRA agreements are invalid as against public policy and do not disqualify the plans. The brokerages are overreaching to start with, and the customers do not understand the implications.

Is there any sign of people resigning as trustee or, perhaps more tellingly, vacancies going unfilled? That would be an indicator of under compensation. There are many reasons for being a trustee that make the actual compensation something akin to a Walmart door buster- resume polishing, access to judges and the UST, marketing.

This thesis would also be supported if there was an increase in trustees pursuing creditors, for example for pre-petition FDCPA violations (which aren't specifically exempt in many states). Some do, but for many its anathema to pursue anyone but debtors.

What about the possibility of the next step? If it is found to have lost its tax favored status, wouldn't this allow the debtor to bring an action against the brokerage for fraud in the inducement? These accounts are marketed as being tax favored, but it was the actions of the brokerage in setting up the account that caused it to lose the tax favored status. The Trustee could then claim the cause of action as an asset of the bankruptcy estate, effectively getting a "double dip" in assets available for the unsecured creditors.

There is a new DOL announcement as of 5/24/13 that handles this issue and will force brokerage accounts to re-write these agreements to not include IRAs in the cross-collateralization agreements but which retroactively protects IRA account holders from invalidation of their tax protected status as a result of owning an account where this language is used (that is, all of them). Sounds like a temporary problem that will be resolved shortly.

See federal register for 5/24/13. Thanks to Mary Komoronicka of my office here at Larkin Hoffman for finding this and pointing it out to me.

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