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SCOTUS adds IRA dispute in effort to avoid future chaos

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In agreeing to hear an appeal on the question of whether retirement funds remain retirement funds after they are inherited, the Supreme Court of the United States seems to be acknowledging that what is today a rare question could arise more often as the population ages and more parents leave money to their children.

The case, Clark v. Rameker, 13-299, came from the 7th Circuit Court of Appeals and concerns an Individual Retirement Account passed down to a daughter who subsequently filed for bankruptcy. Judge Frank Easterbrook, writing for the court, held that when the IRA was inherited by someone other than the owner’s spouse, it was no longer exempt from creditors’ claims.

This decision, handed down in April 2013, is contrary to a March 2012 ruling by the 5th Circuit Court of Appeals and opened a split within the Circuit courts.

dible-jeffrey-mug Dible

While a split alone is not always enough to entice the Supreme Court to wade into a dispute, some attorneys speculate that the justices added this case to the current docket because they want to clarify the law now, rather than let chaos prevail if the issue of exemption increasingly comes up as the baby boomers leave behind assets.

John Carr, of counsel at Ayres Carr & Sullivan P.C., described the question surrounding inherited IRAs as an emerging issue. He’s not surprised it caught the attention of the U.S. Supreme Court.

“This is a significant issue concerning the debtor’s right to an exemption or right to a fresh start versus receiving a windfall at the expense of the creditors,” Carr said. “Are they getting a fresh start or a head start?”

Public policy has been designed to reward individuals who save for retirement by keeping those accounts beyond creditors’ reach. Any time IRA owners get into financial difficulties, their assets intended for financial support in retirement will be protected.

Courts have had to decide a handful of times whether that protection continues when a non-spouse inherits the IRA. The cases that have popped up in U.S. Bankruptcy and District courts have focused on Section 522 of the U.S. Bankruptcy Code. This federal provision provides an exemption for IRA owners and trumps all state bankruptcy codes.

The decision for In re Chilton, 674 F.3d 486 (5th Cir. 2012), was the first time the question reached a federal court of appeals. Using the plain-meaning doctrine that Congress said exactly what it meant, the court held that an IRA passed along after the death of the owner still met the main characteristic in that the money was “set apart” for retirement. Consequently, the funds remained exempt from any bankruptcy proceeding.

Easterbrook was clear that the 7th Circuit disagreed with that analysis. The Chicago-based court used the rational-basis test and found that there is some ambiguity in what constitutes a retirement fund. In considering the Clark case, the 7th Circuit held that even though the inherited IRA continued to be sheltered from taxes until the money was withdrawn, the account had lost other key attributes.

Namely, the beneficiary could not contribute to the IRA nor roll it over into any other account. Also, the beneficiary was not allowed to hold the funds until her own retirement but had to begin making withdrawals within a year of the owner’s death.

The dispute before the 7th Circuit centered on Heidi Heffron-Clark and the IRA worth about $300,000 she inherited after her mother, Ruth Heffron, died in 2001. When the pizza parlor owned by Clark and her husband, Brandon, failed in 2010, the couple filed for Chapter 7 bankruptcy but claimed the inherited IRA was still a retirement fund and, therefore, was exempt from creditors under Section 522.

Robert Martin, chief judge of the U.S. Bankruptcy Court for the Western District of Wisconsin, ruled the exemption did not apply to inherited IRAs, but the U.S. District Court for the Western District of Wisconsin reversed.

Easterbrook stated the bankruptcy judge got the decision right. The 7th Circuit held the problem with taking the 5th Circuit’s view that an inherited IRA is exempt in bankruptcy is that it keeps from creditors a pool of money that the debtor could freely use at any time.

To underscore his ruling, Easterbrook offered the scenario of Ruth Heffron withdrawing funds from the IRA prior to her death and giving them as a gift to her daughter. Once in Heidi Heffron-Clark’s bank account, the money would be no different from any other assets she had and would be within creditors’ reach.

“Why should it make a difference whether the money passed to Heidi on Ruth’s death or a little earlier,” Easterbrook asked. “Either way, the money used to be ‘retirement funds’ but isn’t now.”

motsinger-dan-mug Motsinger

Dan Motsinger, partner and chair of the creditors’ rights and bankruptcy practice group at Krieg DeVault LLP, was struck by Easterbrook’s reasoning, comparing it to that of a mathematician. The decision is logical in a mathematical sense, Motsinger said, with the way Easterbrook views the bankruptcy code within the context of the tax statute.

“This opinion is very strongly worded,” Motsinger said. “There is no waffling at all in this opinion.”

At the Supreme Court, the Clarks could have a tougher time trying to convince the justices that the 7th Circuit was wrong. Motsinger said the presumption that the Supreme Court will affirm the 7th Circuit is not “wild speculation” given the reputation the 7th Circuit has as being a court that “doesn’t shoot from the hip,” coupled with the high regard in which both Easterbrook and Martin are held.

The U.S. Supreme Court’s ruling in Hamilton v. Lanning, 560 U.S. (2010), also gives Carr, with nearly 40 years of practice in bankruptcy law, reason to believe the 7th Circuit’s decision will be upheld.

Prior to the 2005 bankruptcy reform, the Supreme Court seemed to lean toward the plain-meaning doctrine. But after the reform, the court shifted, as Hamilton v. Lanning demonstrates, to doing what the 7th Circuit did by looking at what Congress intended.

The impact of having the 7th Circuit affirmed would fuel renewed emphasis on estate planning to try to prevent children with financial troubles from losing their inheritance.

Jeff Dible, an attorney at Frost Brown Todd LLC who concentrates his practice on estate planning, taxation and general business law, sees the potential for an increase in qualified disclaimers and spendthrift trusts should the Supreme Court agree with the 7th Circuit. Both would provide ways for the inherited IRA to be used for the benefactor’s wellbeing rather than going to creditors.

With a qualified disclaimer, a benefactor who owes money could turn down the inheritance, sending the funds either back to the estate or to a secondary benefactor. Through a spendthrift trust, the inherited retirement funds would be administered by the trustee who could guard against the benefactor’s worst impulses by making payments directly to the third party.

Not seeing how the Circuit courts could have healed the split on their own, Dible asserted the U.S. Supreme Court was right to tackle the question about inherited IRAs. As it stands, the division between the Circuits could spur some debtors to forum shop and file their petitions in the court most likely to rule in their favor.•

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