IRA, 60-Day Rollover and Loss of Bankruptcy Exemption

[401 Chaos]

Anyone have any experience or able to offer any insight with respect to the treatment of IRAs in bankruptcy and the potential loss of a bankruptcy exemption due to the IRA owner's prior distribution / rollover of an amount within the IRA during the 60-day rollover period?

Facts are as follows: IRA owner has an IRA with a fairly large balance. IRA owner had expenses to pay and was nearing possible bankruptcy filing. IRA Owner went to bank with intention of taking an early distribution from the IRA (and paying applicable taxes and penalties) in order to get sufficient funds to cover immediate expenses until his tax refund arrived Bank told him instead that he could take money out as a "rollover," use the funds to cover expenses, then use his tax refund to redeposit the amounts without adverse consequences provided the amount was replaced prior to the 60-day rollover period expiring. IRA Owner did that just that, took a distribution, used the funds, received tax refund and made the redeposit within 60 days. The bank and IRA owner have considered IRA to remain qualified / tax exempt IRA for all purposes.

IRA owner then filed for bankruptcy. Bankruptcy Trustee is now challenging exemption for the IRA account saying the entire IRA account was disqualified due to prohibited transaction created by virtue of IRA Owner's use of the rollover amounts before redepositing. Basically the Bankruptcy Trustee claims such use constitutes an impermissible loan of the IRA funds to himself and/or use of the IRA funds for his own benefit and/or general self-dealing. The Bankruptcy Trustee points to a couple of Florida Bankruptcy Cases--In Re Hughes, In Re Willis--where the bankruptcy court appears to have held in favor of the Trustee on somewhat similar facts finding that the withdrawal and repayment of the withdrawn amount within 60 days resulted in a prohibited transaction under the tax rules thereby disqualifying the entire IRA for tax purposes and thus causing the IRA to lose bankruptcy exemption.

Has anyone dealt with anything similar? Interestingly, the Bankruptcy Courts in these cases appear to arrive at this conclusion by applying the tax laws but it is unclear whether the IRS has ever considered much less arrived at a similar holding with respect to these particular IRAs. Indeed, the IRS has numerous PLRs which would seem to suggest this same thing is generally possible in a non-bankruptcy context without disqualifying the IRA. Specifically, there are rulings where the IRA amounts are withdrawn but repaid within the 60-day period and even cases where the funds were apparently used for the IRA Owner's benefit during the 60-day period. Am I missing something? How can the Bankruptcy Trustee claim the bankruptcy exemption is lost because there has been a prohibited transaction under the tax rules resulting in the IRA's loss of tax exempt status when the IRS has not made that determination and appears to have permitted similar transactions without disqualifying the IRA on similar facts. Given that having access to / holding the distributed amounts during the 60-day rollover period could arguably be viewed as providing a general benefit to the IRA Owner even if he or she does not actually use the IRA amounts to cover expenses during the rollover period, it seems that the prohibited transaction issues would likely always be such a concern in any IRA rollover scenario that the IRS would not / could not permit the 60-day rollover policy in the first place.

[Lou S.]

I'm not a lawyer and I haven't seen this set of facts before but just a guess - The bankruptcy trustee is probbaly trying to argue that the redeposit of the tax refund prior to filing bankrupcy was an attempt to hide those assets from the bankruptcy proceedings and not legitamate IRA savings since the owner already used the IRA assets to pay for expenses.

From an IRA standpoint I agree with you 100% that if this was all done in the 60 day period and there is no other such occurance in the last 12 months, the IRA should be fine. But I can see where the bankrupcy issues might cloud this somw. I don't think the term "prohibited transaction" is correct in this case since as you note this looks permisable under the law but rather a potential "improper diversion of the assets" from the bankrupcy (if that's the correct term) by funneling the tax return back into the IRA.

Again I'm not a lawyer and bankruptcy rules vary by state, I'd have the client talk to qualified tax counsel that specializes in bankruptcy and who has some pretty strong knoweledge of IRA exepmtions as they pertain to bankruptcy laws in that state.

[masteff]

My thought is that because of preemption, the trustee lacks standing to attack the rollover itself, but w/ a PT he can attack the entire IRA resulting in the whole account being available for payment of bankruptcy debts.

So let's suppose for the sake of argument that the trustee isn't smoking crack, then what? PTs are the domain of the DOL. So your first course of action is to contact the DOL and get as much info as you can on whether they've ever ruled on whether indirect 60-day rollovers create a PT and, more importantly, if they've issued any exemptions or opinions on such. They can also give you ideas on a further course of action. If nothing else, you stall the trustee by filing for a PTE or advisory opinion w/ the DOL.

Hmm, I just found this webpage: http://www.dianedrain.com/Bankruptcy/BankruptcyLaw/BankruptcyCaseLaw-RetirementAccountsAndBankruptcy.htm Looks to me like the thing to request from the DOL is an advisory opinion letter. (Frankly, if the facts in the OP are correct, the case discussed on that webpage makes me think the trustee in the OP is way overreaching.)

http://www.dol.gov/ebsa/publications/exemption_procedures.html

http://www.dol.gov/ebsa/regs/aos/ao_requests.html

[Gary Lesser]

The IRA-to-IRA rollover rules do not preclude the use of the withdrawn funds by the IRA account owner. That being said, a valid rollover should not be considered a prohibited transaction under the IRC so as to invalidate the account's exemption. What if a different IRA was used to receive the repayment amount?

In both the matters you mentioned the IRA owner engaged in a clear violation of Code Section 4975 and the disqualification of the account was warrented. Here a distribution was made, it is not a loan as there is no obligation to repay. I do not see a PT under the IRC based on the facts you mentioned.

OTOH, the transfer of funds to the IRA shortly before the filing of the bankruptcy petition, is arguably a transaction that is treated as fraudulent as to creditors in a bankruptcy proceeding and BUT does not cause the account to lose its exemption under the IRC. Thus, I can not see the bankruptcy court having any claim beyond the amount that was repaid to the IRA shortly before the bankruptcy petition was filed. The new IRA exemption amount (eff 4/1/2013)is $1,245,475 (78 Fed Reg 12089, 12090). Hopes this helps.

[401 Chaos]

Thanks to all for your thoughts (and for generally agreeing with my general take on this). The facts in the OP are not glossed--the individual here took out a single distribution and used it to cover a single expense then redeposited the same amount in the same IRA within 60 days (after receiving the tax refund). No pretense on his part that he was trying to take or make a true rollover to another account--he simply wanted to cover the expense and knew he would be able to repay within the 60 days. Basically he was just following the advice of the bank / trust department rep in making the redeposit--had he known this might have jeopardized the larger account balance then he would have simply taken an early withdrawal and paid taxes and penalty or tried to delay payment.

I am not a bankruptcy lawyer either but the Trustee here is squarely claiming the individual's actions resulted in a loan from the IRA to him and thus yielded a prohibited transaction thus blowing up the entire IRA. Essentially he appears to be citing / tracking the same claims / charges made in the Willis case cited above without any real discussion or analysis as to the 60-day rule, IRS (or DOL) guidance, etc. There appear to be a few other bankruptcy cases taking a similar approach (without getting into the details on the PT front) with a couple cases basically acknowledging the existence of the 60-day rule but finding that doesn't apply even though the money was clearly redeposited within the 60-day period because the indivdiual never intended to actually roll the deposit over to another qualified account or plan. There is no authority cited for that result really--the court just seems to rule out it being a qualified rollover based on the individual's intent. See In Re Bostic; In Re Cobb.

In contrast to that, the IRS in PLR 9010007 examining the 60-day rule concludes as follows: "An individual may withdraw funds from his IRA for personal use and this may be considered a rollover as long as he replaces it back into the same IRA or into another qualified IRA within 60 days."

Gary,

Thanks for your thoughts. I don't disagree that the overall facts around the debtor's actions in the Willis case are particularly bad given the check kiting scheme, etc. The Court there, however, seems to say the IRA engaged in a prohibited transaction and so was disqualified due to the debtor's initial withdrawal and use of funds to pay toward the mortgage on a piece of investment real estate held outside the IRA. Even though he repaid / redeposited the withdrawn funds to the IRA within 60 days, the bankruptcy court seems view that as disqualifying the IRA without having to get into his later, more troubling actions, etc. Although our guy's actions are perhaps more sympathetic in that he used the amounts to pay expenses rather than make a real estate investment, the general fact pattern is very similar so I think the Trustee in our case sees that case (rightly or wrongly) as being clearly on point. (Perhaps the court may have come down differently if that were the only IRA transaction and there hadn't been other clearly troubling activities but the court seems OK finding a problem with that initial distribution / redposit.)

Welcome any additional thoughts anyone has on this--the lack of analysis in the Bankruptcy case law around these issues is worrisome.

[masteff]

I don't disagree that the overall facts around the debtor's actions in the Willis case are particularly bad given the check kiting scheme, etc. The Court there, however, seems to say the IRA engaged in a prohibited transaction and so was disqualified due to the debtor's initial withdrawal and use of funds to pay toward the mortgage on a piece of investment real estate held outside the IRA. Even though he repaid / redeposited the withdrawn funds to the IRA within 60 days, the bankruptcy court seems view that as disqualifying the IRA without having to get into his later, more troubling actions, etc.

You might double check the actual case but this recount of Willis says the 1993/4 transaction was done in 64 days, making it a somewhat different situation. http://pwacpa.com/articles/20090824.html

Edit: This write up concurs: http://www.southsidetrust.com/library/Retirement%20PDFs/IRAs%20and%20bankruptcy.pdf

Edit: you might review this California case http://www.leagle.com/xmlResult.aspx?xmldoc=In%20BCO%2020081126763.xml&docbase=CSLWAR3-2007-CURR

[Guest BKIRA]

Look into your state's tracing laws. If the debtor can clearly trace the IRA funds to exempt assets, the prior IRA, they are probably fine.

Keep in mind bk trustees are paid on commission and are going to bring up any objection to exemption they can. They tend to throw a lot of "mud" against the wall. What most debtors don't realize is that when they paid their attorney, typically the fee only covered the preparation of the schedules and the meeting of the creditors. Motion work is going to cost more. Even more embarrassing fact is that a lot of bk attorneys are newbies and don't have a clue what they are doing. Especially when you start talking about retirement plan assets.

So, even if the rollover is characterized as a pt, so long as the debtor can trace the funds to an exempt asset, such as the prior IRA, then the funds should stay exempt.

[401 Chaos]

Thanks to all and particularly Masteff and Belgarath for the additional summary of the Willis case. This is very helpful--it appears the BR Trustee misquoted the Willis case suggesting the first withdrawal was redeposited within 60 days. As noted in the summaries, that was not the case and the later check swapping transactions that actually were redeposited within 60 days clearly violated the "onle one rollover every 12 months rule" (and likely other rules as well) so there was no valid rollover there. That is all extremely helpful as I think it clearly allows us to distinguish Willis, the primary authority cited by the BR Trustee here. AS BKIRA notes, there is a lot of mud slinging.

Unfortunately, I think the Trustee may be able to draw on more caselaw where the 60-day rule was met and where other BR courts appear to base their decision largely on the intent of the debtor when withdrawing the funds, etc. We are still helping the BR lawyers try and sort through these cases but the thrust of the BR Trustee's argument here (while not really stated this directly) seems to be that because the withdraw was not characterized as an early withdrawal when first taken out of the IRA and because those amounts come back into the IRA the court should basically treat them as plan / IRA assets (subject to the prohibited transaction rules) while they were outside the IRA. If the withdrawn amounts come back into the IRA and the IRA Owner hasn't benefited then that is presumably okay; however, if the IRA Owner benefits or clearly does indirectlywhat he could not do directly with the amounts if actually in the IRA (e.g., use the amounts to pay personal expenses), then the IRA Owner has engaged in a prohibited transaction blowing up the IRA and thus the IRA exemption.

To me, that analysis seems to clearly be the wrong way to think about withdrawls during the 60-day period and seems inconsistent with IRS rulings, guidance, etc. As Gary notes, this was a distribution, not a loan, and so was potentially subject to taxes / penalties if the withdrawn amounts were not redeposited within 60 days. As long as the amounts are redeposited within 60 days (and no more than 1 rollover occurs per year, etc.), however, it is immaterial what is done with the withdrawn amounts outside the IRA during the interim period.

[masteff]

I was thinking further on Willis and concluded (aside from the trustee grasping at any toehold possible) the reason to bring Willis into the mix is it establishes the context for the BR judge to rule on the qualified status of the IRA.

I now more firmly think a good starting point is contacting the DOL. It'd be a pretty straightforward question: if the taxpayer withdraws funds for personal use but replaces them within 60 days, as in PLR 9010007, is the personal use a PT?

Edit: By contacting the DOL, you've gone to a higher authority for determining a PT than the judge; a judge would be remiss to still declare a PT if the DOL (THE authority on PTs) said there wasn't one.

[401 Chaos]

Thanks very much. We've done a bit of looking at prior DOL guidance and haven't found anything directly considering an IRA owner's personal use of funds during the 60-day rollover period and potential PTs. I think requesting an Advisory Opinion and/or PLR may be helpful here but obviously a long and expensive process for the debtor to get a formal ruling. Maybe something to offer the court though? Will see if we might be able to get some informal guidance from DOL too as a possibility.

On this particular point, the PT rules are all generally grounded in transactions involving plan assets or transfers from the plan, etc. Wonder if there is any general guidance or authority out there we might point to that basically says distributions are no longer plan assets after a distribution even if that didn't directly get into the whole rollover / personal use / PT issues.