Non-exempt Exempt IRAs and Undercompensated Chapter 7 Trustees

Some 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 exempt.

Pension jar image from Shutterstock.