IRAs are usually exempt from creditor claims; however, recent case rules "prohibited transactions" kill bankruptcy exemption for self-directed IRA

 The U.S. Court of Appeals has affirmed a district court decision (which affirmed the bankruptcy court), that funds in three of an individual's IRAs were not exempt from his bankruptcy estate under the Bankruptcy Code. The individual had engaged in prohibited transactions with one IRA, causing it to lose both its income tax and bankruptcy exemption, and the second and third IRAs weren't exempt because they contained funds rolled over from the first IRA after it lost its exempt status.

Background.

Under the Bankruptcy Code, an individual debtor may exempt IRA funds from the bankruptcy estate. That is, IRA assets are protected from creditors.

Under the Tax Code, if an IRA owner or his beneficiary engages in a "prohibited transaction" during a tax year, the IRA is disqualified as of the first day of that tax year, and the IRA owner is treated as having received a taxable distribution equal to the fair market value of all of the assets in the account as of the first day of the tax year.

A prohibited transaction includes the lending of money or other extension of credit between an IRA and the owner of the IRA.

New Case.

In this case, Ernest Willis opened a self-directed IRA (i.e., he was responsible for managing the investments) at Merrill Lynch with a transfer of funds from an IRA at Smith Barney. The IRA agreement stated that engaging in certain transactions, including borrowing from the account and selling property to it, may cause the IRA to lose its tax-deferred status. However, Willis authorized a $700,000 transfer to a personal account.

Willis repaid the $700,000 with borrowed funds shortly thereafter.

Willis then engaged in a series of "check-swapping" transactions between a personal account and the Merrill Lynch IRA. He repeatedly engaged in simultaneous transfers of funds from the IRA to the account and vice versa, and attempted to avoid tax on the IRA withdrawals by returning funds within 60 days.

Willis also had an AmTrust IRA and a Fidelity IRA, both of which were funded, in full and in part, respectively, with funds from the Merrill Lynch IRA.

Willis filed for relief under the Bankruptcy Code in 2007, years after the prohibited transactions. He claimed exemptions under the Bankruptcy Code for the full value of the three IRAs, a total of $1,499,000.  The Bankruptcy Trustee and Creditors objected to Willis' claimed exemptions in these IRAs.

Bankruptcy Court decision.

The court determined that since Willis was responsible for managing the investments in the Merrill Lynch IRA, he was a fiduciary and thus a disqualified person, and the various actions he took with respect to the IRA constituted "prohibited transactions," meaning the IRAs were not exempt and Willis will have a less enjoyable retirement.

Willis appealed, and the bankruptcy court's decision was affirmed by the U.S. district court. He then appealed to the U.S. Eleventh Circuit Court of Appeals.

The Circuit Court agreed with the lower courts.

Conclusion.

Anyone in financial distress who has substantial assets in one or more IRAs and who anticipates a possible bankruptcy filing should be very vigilant about not using IRA funds in ways that could constitute a prohibited transaction. Whether or not bankruptcy protection is ultimately sought, prohibited transactions can result in the disastrous income tax consequence of having the IRA lose its income tax exemption and the individual being taxed on the IRA funds. In addition, if there is a bankruptcy filing, this can prevent loss of the bankruptcy exemption for the IRA funds.