CLARK ET UX v. RAMEKER, TRUSTEE, ET AL., U.S. no. 13-299

In January 2014, we reported that the U.S. Supreme Court had granted certiorari to the United States Court of Appeals for the Seventh Circuit (the Circuit in which Illinois is located). In, Clark v. Rameker, U.S. no. 13- 99, the U.S. Supreme Court decided to resolve a conflict among the District Courts regarding whether an inherited IRA is subject to receiving protection from creditors – specifically to be addressed in Clark was whether an inherited IRA was to be considered “retirement funds” pursuant to 11 USC §522(b)(3)(C) and thus exempt from consideration as individual assets during bankruptcy proceedings.

The Supreme Court, with Justice Sotomayor delivering the opinion of a unanimous Court, settled the matter on June 12, 2014, when it held that funds contained in an Inherited IRA are not “retirement funds” within the meaning of 11 USC §522(b)(3)(C) and therefore, not exempt from consideration in bankruptcy proceedings. The rationale for the Court’s decision was based on the fact that the purpose of the exemptions, specifically the “retirement funds” exemption in the bankruptcy code, is to balance the creditor’s interest in receiving payment with the debtors need to provide for himself during retirement years. The Court looked to the plain meaning of the term “retirement funds” and determined the definition could be properly understood as “…sums of money set aside for the day when the individual stops working.” The Court applied an objective analysis to determine whether the legal characteristic of the account in which the funds are held is one in which the account is of the type that the funds are set aside for the day when an individual stops working.

In its analysis the Court pointed out the differences between an Inherited IRA, and a traditional and Roth IRA, classified as “retirement funds” within the meaning of §522(b)(3)(C). The first distinction the Court identified was that the holder of an inherited IRA is unable to contribute additional money to that account, whereas there are incentives to regularly contribute to a traditional IRA or a Roth IRA account. In addition, holders of inherited IRAs are required to withdraw all money from the account within five years of the original owner’s death, or take mandatory minimum distributions annually, no matter how close or far they are from retirement. In fact, a beneficiary of an inherited IRA could withdraw the entire amount of the account at anytime without penalty. In comparison, a holder of a traditional or Roth IRA cannot withdraw funds from the account prior to age 59 1/2 without incurring a tax penalty; a rule that was designed to encourage holders of such accounts to leave the funds untouched until retirement. These fundamental differences led the Court to conclude that the legal characteristic of an inherited IRA did not match the characteristics of a retirement fund within the meaning of 11 USC §522(b)(3)(C). The Court noted that to hold otherwise would be to transform the “Fresh Start” bankruptcy provides into “Free Pass” as nothing could prevent the beneficiary of an inherited IRA from withdrawing all the funds and going on vacation after declaring bankruptcy.

U.S. Supreme Court To Consider Whether Inherited IRA is Creditor Protected

In April 2010 we reported on the cases, In re Chilton, No. 08-43414 (Bankr. E. D. Tax. Mar. 5, 2010) and In re Nessa, No. BKY 09-60081 (Bankr. D. Minn. Jan 11, 2010). The Chilton court found that while an IRA is given creditor protection, that protection does not extend to an inherited IRA.  The Nessa court found the opposite.

In a recent case arising from the Seventh Circuit of the Court of Appeals, (the Circuit in which Illinois is located), Clark v. Rameker, U.S. No. 13-299, cert. granted 11/26/2013, the U.S. Supreme Court as agreed to hear the Clark case, and perhaps to resolve the conflict among the Districts.  The underlying facts of Clark turn on a woman who inherits a $300,000 IRA.  Shortly afterward she and her husband declared bankruptcy.  The Seventh Circuit Court of Appeals found that the inherited IRA does not warrant the same protection as an IRA or 401(k) since no new contributions may be made to it and the inherited IRA cannot be merged with any other account.  Further, the assets in an inherited IRA must begin to be distributed to the beneficiary over the beneficiary’s life expectancy and in some cases, as soon as within 5 years.  Accordingly, an inherited IRA should not be considered “retirement assets” and given the same protection in bankruptcy court as IRAs and 401(k) plans.

Life Insurance and Revocable Living Trusts

Illinois exempts from creditors all proceeds payable because of the death of the insured and the aggregate cash value of any and all life insurance and endowment policies and annuity contracts payable to a spouse of the Insured or to a child, parent, or other person dependent upon the Insured, whether the Insured reserves the right to change beneficiary or whether Insured’s estate is a contingent beneficiary.

Until recently, this protection was not available if proceeds were payable to a revocable living trust.  This was at cross purposes with conventional estate planning using trusts where the revocable living trust is often named as the primary beneficiary on life insurance.   Effective August 17, 2012, proceeds payable to a revocable living trust under which the spouse, child, parent or other dependent of the Insured is the trust beneficiary are now exempt.

Nevertheless, the payment of a premium by insolvent insured would create presumption of fraudulent intent once a claim for liability is clear so purchasing a huge single premium annuity would not likely be protected from creditors.

Court finds that Assets transferred to an Alaska Asset Protection Trust are reachable in Bankruptcy Creditor Protection

In Battley v. Mortensen, Adv. D. Alaska, No. A09-90036-DMD, the Court focused whether the grantor of the trust, Mortensen, intended to hinder, delay or defraud his creditors by establishing the Alaska Domestic Asset Protection Trust and transferring land to it.  The court applied Section 548(e) of the Bankruptcy Abuse Protection and Consumer Protection Act of 2005, which voids transfers if made within 10 years of the bankruptcy filing. 

Mortensen created the Alaska asset protection trust in 2005, naming himself and his children as the trust beneficiaries.  Mortensen expressly stated that the purpose of the trust was to “maximize the protection of the trust estate or estates from creditors’ claims of the Grantor or any beneficiary and to minimize all wealth transfer taxes.”  Mortensen transferred land to the trust and four years later filed for bankruptcy.  The court easily found that the Mortensen trust was a self-settled asset protection trust created to defraud creditors.