CLARK V. RAMEKER: WHAT DID THE SUPREME COURT REALLY SAY? WHAT IS HOLDING AND WHAT IS DICTA? DOES 522(b)(3) PRE-EMPT TEX. PROP. CODE SEC. 42.0021(a)?

By Guest Blogger Michael V. Baumer

On June 12, 2014, the U.S Supreme Court issued an opinion in Clark v. Rameker, 134 S.Ct. 2242 (2014) in which the court, in a 9-0 decision, affirmed a decision by the 7^th Circuit holding that an IRA inherited by a daughter from her mother is not exempt under 522(b)(3)(C).

It is important to note that although Clark determined whether inherited IRAs are exempt under 522(b)(3), the decision should also apply to whether inherited IRAs are exempt under 522(b)(2) and (d)(12). Both statutes exempt “Retirement funds to the extent that those funds are in a fund or account that is  exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986.” The Clark court concluded that funds in an inherited IRA are not “retirement funds,” although “retirement funds” is not defined in either the Bankruptcy Code or the Internal Revenue Code.

522(b)(1) says that a debtor can claim exemptions under 522(b)(2) which we commonly refer to as “federal exemptions,” or 522(b)(3)  which we commonly refer to as “state exemptions.” [522(b)(2) includes the “opt out” provision which allows the individual states to deny the federal exemptions to their residents.] It is not really that simple. The federal exemptions under 522(b)(2) are limited to the exemptions listed in 522(d). There is abundant case law that says that other federal exemptions not contained in 522(d) are not allowed in a bankruptcy case. And 522(b)(3) is not limited to exemptions allowable under state law. 522(b)(3)(A) specifically allows a debtor to exempt “any property that is exempt under federal law” [except 522(d)] as well as “State or local law.” 

In the first paragraph of its opinion, the Clark court stated “The question presented is whether funds contained in an inherited individual retirement account (IRA) qualify as ‘retirement funds’ within the meaning of this [522(b)(3)(C)] bankruptcy exemption. We hold that they do not.” Clark, at 2244.

The court almost casually notes “If the heir is the owner’s spouse, as is often the case, the spouse has a choice: He or she may ‘roll over’ the IRA funds into his or her own IRA, or he or she may keep the IRA as an inherited IRA (subject to the rules discussed below).” Clark, at 2245, (citing IRC Publication 590).

I think that this seemingly innocuous statement may actually give significant guidance to what the court might do in the case of an IRA inherited by a spouse. The court does acknowledge that a spouse may roll over the inherited IRA into his/her own IRA [in which case, it would qualify as a rollover IRA under 522(b)(4)(C)] or treat it as an inherited IRA. If the spouse elects to treat the IRA as an inherited IRA under the Internal Revenue Code, it seems only reasonable that it would/should also be treated as an inherited IRA under the Bankruptcy Code and would be subject to the court’s interpretation that funds in an inherited IRA are not retirement funds. If the spouse elects to roll over the IRA, it would no longer be an “inherited” IRA, but the spouse’s “own” IRA.

In Clark, the IRA was inherited by a daughter from her mother. This is very significant because the IRC provides substantially different treatment for inherited IRAs if the beneficiary is the spouse of the decedent or if the beneficiary is someone other than a spouse. The actual holding in Clark is that funds inherited by a child (someone other than a spouse) are not retirement funds and are not exempt under 522 (b)(3)(C).

To the extent that the court’s holding extends to spouses, it is dicta, not holding. In interpreting the phrase “retirement funds,” the court concluded that “retirement funds” are only retirement funds for the person who sets them aside for their own retirement. It would seem that this is typically not the case with married couples - they are saving for their joint retirement (singular), not their individual retirements (plural).

I would also note that the court engages in at least a little bit of public policy argument, in addition to judicial interpretation The court states that the purposes of bankruptcy exemptions are to “protect the debtor’s essential needs,” “to provide a debtor with the basic necessities of life so that she will not be left destitute and a public charge,” and “to ensure that debtors will be able to meet their basic needs.” Clark, at 2247. The court might want to consider 522(n) which allows a debtor to exempt an IRA with a value up to $1,245,475. In a joint case, that amount is doubled for a total of $2,490,950. And that does not include amounts in any other retirement plans. (Apparently, my notion of what is “basics” and “necessities” could be more expansive.)

Texas Property Code Sec. 42.0021(a) specifically provides that inherited IRAs are exempt to the same extent as they would be in the hands of the original owner of the IRA. Several commentators have expressed the opinion that inherited IRAs are exempt in a bankruptcy case using Texas exemptions, notwithstanding Clark. Many of those commentators note that the bankruptcy court opinion in Clark held that inherited IRAs are not exempt under the Wisconsin exemption statute. They distinguish this from the Texas exemptions which specifically provide that inherited IRAs are exempt. I think this interpretation is erroneous. The Supreme Court opinion in Clark never mentions whether inherited IRAs are exempt under Wisconsin law. The court held that inherited IRAs are not “retirement funds” as a matter of federal law under 522(b)(3)(C), so it never reached the issue of whether they can be exempt under applicable state law.

I am not sure how to reconcile this with 522(b)(3)(A) which permits a debtor to exempt “any property that is exempt under … State or local law.” The subsections of 522(b)(3) are stated in the conjunctive, not the disjunctive – debtors get to claim the exemptions in subsections (A), (B), and (C), so it would seem that even if a debtor is not entitled to exempt retirement accounts under 522(b)(3)(C), they should still be able to exempt them under 522(b)(3)(A) to the extent it is applicable. If Congress had intended that 522(b)(3)(C) would preempt 522(b)(3)(A), they coulda/shoulda/woulda done so explicitly. [They did, in fact, do this with the homestead caps under 522(o) and (p), which are expressly referenced in 522(b)(3)(A).]

My interpretation of the current status of the law based on what I understand Clark’s actually holding to be:

1.                  IRAs inherited from anyone other than a spouse are not exempt under 522(b)(3)(C). [Or 522(d)(12) – this is not part of the actual holding, but the statutory language is identical.]

2.                  IRAs inherited from a spouse which are not rolled over into the debtor’s own IRA should not be exempt under 522(b)(3)(C) or 522(d)(12), but should be treated as inherited IRAs.

3.                  IRAs inherited from a spouse which are rolled over into the debtor’s own IRA should be exempt under 522(b)(3)(C) or 522(d)(12).  Clark does not say that, but to the extent the statement in the opinion that inherited IRAs are not exempt is applied to a spouse is dicta, and the factual and legal basis for the opinion does not apply to spouses who elect to rollover an IRA inherited from a spouse. (Because they are treated differently under the IRC, they should also be treated differently under the Bankruptcy Code.)

4.                  Claiming an inherited IRA as exempt under Texas law is more problematic, at least as far as trying to read the judicial tea leaves.

a.                   Texas Property Code §42.0021(a) provides, in part:

"For purposes of this subsection, the interest of a person in a plan, annuity, account or contract acquired by reason of the death of another person, whether as an owner, participant, beneficiary, survivor, coannuitant, heir or legatee, is exempt to the same extent that the interest of the person from whom the plan, annuity, account or contract was exempt on the date of the person’s death."

It seems clear from the breadth of the language that the intent of the Texas legislature was to protect inherited retirement interests to the greatest extent possible. But how does Texas Property Code interact with the Bankruptcy Code in this context?

b.            In Clark the Bankruptcy Court held, in part, that the inherited IRA was not exempt because the Wisconsin exemption statute did not provide an exemption for inherited IRAs. The Supreme Court, however, never mentions whether the account was exempt under state law, but held that funds in an inherited IRA are not “retirement funds” under 522(b)(3)(C).

c.                Clark, however, never mentions 522(b)(3)(A) which allows a debtor to exempt “any property that is exempt under Federal Law, other than subsection (d) of this section or State or local law that is applicable on the date of filing of the petition.…” 522(b)(3)(A) does not contain the “retirement funds” language found in 522(b)(3)(C) or 522(d)(12).

d.             522(b)(3)(A), (B) and (C) are stated in the conjunctive – the debtor gets to claim (A), (B), and (C), so even if an inherited IRA is not exempt under 522(b)(3)(C), the debtor should still be able to exempt it under 522(b)(3)(A). Assuming that the state exemption statute allows a debtor to exempt an inherited IRA (as does the Texas Property Code), it should be allowed under this subsection.

With all that said, until we get further clarification, I would suggest that it is very risky to claim an IRA inherited from a spouse as exempt under federal exemptions, or to claim an IRA inherited from anyone under the Texas Property Code.

Any volunteers?

Supreme Court Denies Exemption for Inherited IRAs But Texas Debtors May Still Be Able to Keep Them

Most Americans don’t save enough money for retirement.   However, the Supreme Court recently dealt with the opposite situation—what happens when someone saves more than they need and their heirs receive the money (and then file bankruptcy).   

This is the third time that the high court has considered what happens to retirement funds in bankruptcy.  In Patterson v. Shumate, 504 U.S. 753 (1992), the Court held that funds in an employer's pension plan were not property of the estate. In Rousey v. Jacobsen, 544 U.S. 320 (2005), the Court ruled that non-inherited IRAs were included under the exemption for “a stock bonus, pension, profitsharing, annuity, or similar plan or contract” under 11 U.S.C. §522(d)(10)(E).  This time, the Court held that an inherited IRA does not constitute “retirement funds” under 11 U.S.C. §522(b)(3)(C) and 522(d)(12).    Clark v. Rameker, Trustee, No. 13-299 (6/12/14).    The opinion can be found here.   

While the opinion denies the exemption under two subsections of the Bankruptcy Code, it does not address exemptions under state law.   As will be discussed below, this makes a big difference for Texas debtors.   

What Happened

The facts are pretty straightforward.   Ruth Heffron established a traditional IRA in 2000 and passed away the next year.   Her daughter and beneficiary, Heidi Heffron-Clark, received the IRA and elected to take monthly distributions from it.    In October 2010, she and her husband filed bankruptcy.    She claimed the $300,000 in the inherited IRA under both Wisconsin law and 11 U.S.C. §522(b)(3)(C).    The Bankruptcy Court ruled against her on both grounds.   In re Clark, 450 B.R. 858 (Bankr. W. D. Wisc. 2011).   The District Court reversed, but the Seventh Circuit reinstated the Bankruptcy Court’s ruling.  In re Clark, 714 F.3d 559 (7^th Cir. 2013).    The Supreme Court granted cert to resolve the conflict between the Seventh Circuit and the Fifth Circuit’s decision in In re Chilton, 674 F.3d 486 (5^th Cir. 2012). 

  

Exemption Statutes and Types of IRAs

Retirement accounts can be broken into two main categories:   employer plans and individual retirement accounts (IRAs).   Employer plans are required to contain anti-alienation language which the Supreme Court previously held was sufficient to keep them from ever becoming property of the estate.

IRAs do not have the same anti-alienation protection.  As a result, they come into the bankruptcy estate and only come out if there is an applicable exemption statute.    Prior to 2005, IRAs could be exempted under state law under 11 U.S.C. §522(b)(3)(A) or under 11 U.S.C. §522(d)(10) in the handful of states that permitted use of the federal exemptions.   Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Congress allowed Debtors electing state or federal exemptions to claim:

retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986.

11 U.S.C. §522(b)(3)(C) and (d)(12).   The effect of this amendment was that all debtors could keep those funds so long as they were “retirement funds” and were in a fund or account exempt from taxation under the listed sections of the Internal Revenue Code. 

  

IRAs are governed by 26 U.S.C. §§408 and 408A.   As a result, they fall within the enumerated sections.    According to the Supreme Court, there are three types of IRAs.   Under a conventional IRA, contributions are tax deductible, while under a Roth IRA, qualified distributions are tax free.    Both types of accounts are subject to a 10% penalty if funds are withdrawn prior to age 59 ½.     (Remember when you were a kid and you were quick to point out that you were 7 ½ as opposed to just 7?   With IRAs, your half-birthday becomes important once again).   

The third type of IRA is an inherited IRA.    If the beneficiary is the deceased’s spouse, they can roll the funds over into their own IRA account in which case, they become part of the conventional or Roth IRA.   However, if the beneficiary is not a spouse or if the spouse elects not to take the roll over, they can be treated as an inherited IRA.    Funds can be withdrawn from an inherited IRA at any time without penalty.   The beneficiary must either withdraw all of the funds within five years or elect to take minimum distributions on an annual basis.   The beneficiary cannot make additional contributions into the account.   

The Supreme Court’s Ruling

Engaging in its role as dictionary of last resort, Justice Sonia Sotomayor’s opinion explored what it meant for funds to be “retirement funds.”   Because the relevant statutes do not define “retirement funds,” the court attempted to divine the term’s “ordinary meaning.”  Opinion, p. 4.

Justice Sotomayor found three reasons why inherited IRAs were not “retirement funds”:

Three legal characteristics of inherited IRAs lead us to conclude that funds held in such accounts are not objectively Three legal characteristics of inherited IRAs lead us to conclude that funds held in such accounts are not objectively set aside for the purpose of retirement. First, the holder of an inherited IRA may never invest additional money in the account. 26 U. S. C. §219(d)(4). Inherited IRAs are thus unlike traditional and Roth IRAs, both of which are quintessential “retirement funds.” For where inherited IRAs categorically prohibit contributions, the entire purpose of traditional and Roth IRAs is to provide tax incentives for accountholders to contribute regularly and over time to their retirement savings.

Second, holders of inherited IRAs are required to withdraw money from such accounts, no matter how many years they may be from retirement. Under the Tax Code, the beneficiary of an inherited IRA must either withdraw all of the funds in the IRA within five years after the year of the owner’s death or take minimum annual distributions every year. See §408(a)(6); §401(a)(9)(B); 26 CFR§1.408–8 (Q–1 and A–1(a) incorporating §1.401(a)(9)–3 (Q–1 and A–1(a))). Here, for example, petitioners elected to take yearly distributions from the inherited IRA; as a result, the account decreased in value from roughly$450,000 to less than $300,000 within 10 years. That the tax rules governing inherited IRAs routinely lead to their diminution over time, regardless of their holders’ proximity to retirement, is hardly a feature one would expect of an account set aside for retirement.

Finally, the holder of an inherited IRA may with draw the entire balance of the account at any time—and for any purpose—without penalty. Whereas a withdrawal from a traditional or Roth IRA prior to the age of 59½ triggers a 10 percent tax penalty subject to narrow exceptions, see n. 4, infra—a rule that encourages individuals to leave such funds untouched until retirement age—there is no similar limit on the holder of an inherited IRA. Funds held in inherited IRAs accordingly constitute “a pot of money that can be freely used for current consumption,” 714 F. 3d., at 561, not funds objectively set aside for one’s retirement.

Opinion, pp. 5-6.

Because “plain meaning” analysis is never quite so plain as its proponents contend (especially if the case has made its way to the Supreme Court), the Court buttressed its ruling with policy considerations.    Among them, the purpose of an exemption is to allow the debtor to meet “essential needs.”   Encouraging (although not requiring) debtors to keep their funds in an IRA until after age 59 ½ sort of aligns with the goal of ensuring that debtors have sufficient funds to support themselves in their golden years and do not become a burden on society.   On the other hand, inherited IRAs can be freely withdrawn and could be used on “a vacation home or sports car immediately after her bankruptcy proceedings are complete.”   Opinion, p. 7.   This conclusion seems a bit strained.   Funds in a conventional or Roth IRA could also be used for wild living once the bankruptcy was over; it’s just that there would be tax consequences if the person was under age 59 ½.   Further, in an age when the full retirement age is 67 and rising, being allowed to utilize fund at age 59 ½ means that they will likely be used as a stopgap to carry the person to retirement rather than funding actual retirement costs.

Another factor which was not mentioned in the opinion was that the Debtors had $300,000 in the inherited IRA and had unsecured debts scheduled of $311,000.    As a result, the Debtors could have used the funds to settle with their creditors and likely had money left over.   Instead, they tried to file bankruptcy and keep it all.  While there is nothing wrong with using the tools made available by the law, avoiding a windfall to the Debtors at the expense of the creditors could have been rolling around in the back of the justices’ minds.

Thus, inherited IRAs cannot be retained in a bankruptcy proceeding—except for the cases in which they can.

What It Means

The Court’s opinion only addressed 11 U.S.C. §522(b)(3)(C) and (d)(12).    It did not address either exemptions under applicable state law.    In the Clark case, the Bankruptcy Court had ruled that Wisconsin law did not include an exemption for inherited IRAs.   However, the relevant Texas statute provides:

(a) In addition to the exemption prescribed by Section 42.001, a person's right to the assets held in or to receive payments, whether vested or not, under any stock bonus, pension, annuity, deferred compensation, profit-sharing, or similar plan, including a retirement plan for self-employed individuals, or a simplified employee pension plan, an individual retirement account or individual retirement annuity, including an inherited individual retirement account, individual retirement annuity, Roth IRA, or inherited Roth IRA, or a health savings account, and under any annuity or similar contract purchased with assets distributed from that type of plan or account, is exempt from attachment, execution, and seizure for the satisfaction of debts to the extent the plan, contract, annuity, or account is exempt from federal income tax, or to the extent federal income tax on the person's interest is deferred until actual payment of benefits to the person under Section 223, 401(a), 403(a), 403(b), 408(a), 408A, 457(b), or 501(a), Internal Revenue Code of 1986, including a government plan or church plan described by Section 414(d) or (e), Internal Revenue Code of 1986. For purposes of this subsection, the interest of a person in a plan, annuity, account, or contract acquired by reason of the death of another person, whether as an owner, participant, beneficiary, survivor, coannuitant, heir, or legatee, is exempt to the same extent that the interest of the person from whom the plan, annuity, account, or contract was acquired was exempt on the date of the person's death. If this subsection is held invalid or preempted by federal law in whole or in part or in certain circumstances, the subsection remains in effect in all other respects to the maximum extent permitted by law. (emphasis added).

Tex.Prop.Code §42.0021(a).    The language specifically including inherited IRAs was added to the statute in 2013 after a Texas Bankruptcy Court concluded that inherited IRAs were not exempt under state law.   In re Jarboe, 365 B.R. 717 (Bankr. S. D. Tex. 2007).  (Given the dysfunctional nature of the Texas legislature, Judge Bohm should be proud of the fact that his opinion prompted them to do something, even if it was to legislatively overrule his decision).  The fact that the Texas legislature amended the statute to add specific language about inherited IRAs is pretty good evidence that they really intended these accounts to be exempt.    

 The practice tips for Texas debtors are:

1. If you are in financial difficulty, leave the money in the inherited IRA.   If you pull it out, it may lose its protection.
2. If you have an inherited IRA, always choose Texas state exemptions.
3. If you don’t live in Texas, move here and wait two years (but please don't move to Austin as there are too many people here already).
4. If you can settle with your creditors and then withdraw the funds, you might want to do so.   The best bankruptcy you can ever have is sometimes the one you don’t file.

Hat-tip to Quincy Long with Quest IRA, Inc. who pointed out the new language in the Texas Property Code to me.