How the Amici Came Together for the Fifth Circuit's Disappearing Exemptions Cases

When a case is heard at the Supreme Court, the docket is filled with briefs of amicus curiae trying to say something that will catch the court's attention.   With so many briefs filed, they sometimes cancel each other out in a flutter of pdf files sounding variations on the same themes.   However, amicus briefs are much less common at the Court of Appeals level.  Recently I was part of an effort where a panel of the Fifth Circuit reversed itself in one instance and reversed a district court in another.   The cases are Hawk v. Engelhart (In re Hawk), 871 F.3d 287 (5th Cir. 2017) and Lowe v. DeBerry (In re DeBerry), 2018 U.S. Appl LEXIS 5772 (5th Cir. 3/7/18).    In this post, I would like to share how our amicus briefs came together as well as some tips on amicus practice before the Fifth Circuit.

Fifth Circuit Goes Further Down the Disappearing Exemption Rabbit Hole

In yet another blow to the finality of exemptions, the Fifth Circuit has ruled that a chapter 7 debtor who claimed an IRA as exempt but later withdrew the proceeds must pay the funds to the trustee.   Engelhart v. Hawk (Matter of Hawk), No. 16-20641 (5th Cir. 7/19/17).    The decision follows on the Court's ill-conceived Frost opinion and raises the specter that no exemption can ever be final.   (I am abandoning my usual stance of editorial neutrality to come out and say I think this is a terribly bad decision).   

What Happened

Gregory Hawk filed chapter 7 bankruptcy and Eva Engelhart was appointed trustee.   Hawk claimed an IRA account with over $133,000 in it as exempt.   No party objected to the exemption within the period allowed by the bankruptcy rules.   The Trustee filed a no-asset report.   However, a creditor objected to the Debtor's discharge.   In the course of discovery, the creditor learned that the Debtor had withdrawn most of the funds shortly after filing bankruptcy and had used them to pay living expenses.    The Trustee filed a motion for turnover.   The Bankruptcy Court ordered that all of the funds be turned over to the Trustee on the basis that they lost their exempt status when they were not reinvested into a new IRA.  The District Court affirmed.

Fifth Circuit Report: Oct.-Dec. 2015

The Fifth Circuit decided cases dealing with appellate procedure, exemptions, judicial estoppel, jurisdiction, sanctions, standing and surcharging collateral during the fourth quarter of 2015.  A common theme among the cases is parties being disappointed in a variety of contexts, including having an appeal dismissed on procedural grounds, having a lawsuit dismissed based on incomplete filings in a bankruptcy case, losing exemptions based on unfortunate timing and failure to establish damages after dismissal of an involuntary petition.  

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?

Exemptions Continue to Feel Frost's Bite

The rift in the bankruptcy universe created by Viegelahn v. Frost (Matter of Frost), 744 F.3d 384 (5th Cir. 2014) continues to widen, drawing more exemptions into its vortex in seeming disregard of Supreme Court precedent.   The latest opinion to come down is  In re Hawk, 2015 Bankr. LEXIS 309 (Bankr. S.D. Tex. 1/30/15) which holds that the Debtor in a chapter 7 proceeding forfeited his IRA exemption when he liquidated the account after the deadline to object had expired.   

The Debtors filed their chapter 7 proceeding on December 15, 2013.   On this date, they held an IRA in the amount of $164,902.   Over the period from December 11, 2013 to July 14, 2014, the Debtors withdrew the funds from the IRA. The Trustee filed a no asset report on April 3, 2014.  The deadline to object to exemptions expired on April 28, 2014.  No party filed an objection.

A creditor objected to the Debtors' discharge.   At a deposition on November 18, 2014, the creditor learned of the liquidated IRA in a deposition.   The Trustee then made demand for the Debtors to turn over the IRA proceeds because they had not been reinvested within sixty days.   The Trustee then filed a motion for turnover of the funds.

The Bankruptcy Court granted the Trustee's motion for turnover, finding that the failure to file a timely objection was not material.   The Court stated:

(T)he Court finds that the pertinent threshold question is whether property deemed exempt under state law loses its statutory protection at any point during the pendency of a Chapter 7 case. Here, the Liquidated IRA Funds lost their exempt status under state law while the Debtors' bankruptcy case was open. Once the Liquidated IRA Funds became non-exempt, the Funds automatically became property of the estate and the Chapter 7 Trustee was immediately entitled to them.

Opinion, at *9.    The Court emphasized the Fifth Circuit's language in Frost that

a change in the character of the property that eliminates an element required for the exemption voids the exemption, even if the bankruptcy proceedings have already begun.

Frost at 388.   The Court found that it was significant that the IRA exemption under the Texas Property Code included a provision allowing proceeds to retain their exempt character if reinvested within sixty days.   As explained by the Court:

(A)pplication of the 60-day rule here is merely applying the entire IRA exemption statute and should not turn on whether a party in interest lodged an objection to the claimed IRA exemption In fact, the imposition of an objection condition when applying either the Texas homestead or IRA exemption statute would violate state law. There is no objection requirement in either sections 41.001 or 42.0021. Construing an extratextual objection requirement would preclude application of the reinvestment provisions--thereby contravening the intent of the Texas legislature.  (emphasis added).

Opinion, at *20-21.   Thus, according to the Court, in order to give effect to the intent of the Texas legislature, proceeds from an IRA must be timely reinvested to retain their exempt status.

While the Court may be correct as to the intent of the Texas legislature, why is this relevant?   Exemptions in bankruptcy are a matter of federal law.  When a Debtor claims exemptions under Texas law, he does so as a matter of federal law.    In re Dyke, 943 F.2d 1435 (5th Cir. 1991).  Federal bankruptcy law very definitely does contain an objection requirement.  Under bankruptcy law, any property claimed by the Debtor as exempt leaves the estate absent a timely objection.   According to this term's opinion in Law v. Siegel, 134 S.Ct. 1188 (2014), "a trustee's failure to make a timely objection prevents him from challenging an exemption."   Under the previous Supreme Court opinion in Taylor v. Freeland & Kronz, 503 U.S. 638 (1992), a clearly invalid claim of exemption could not be challenged once the objection period had passed.    According to the Court:

We reject Taylor's argument. Davis claimed the lawsuit proceeds as exempt on a list filed with the Bankruptcy Court. Section 522(l), to repeat, says that "unless a party in interest objects, the property claimed as exempt on such list is exempt." Rule 4003(b) gives the trustee and creditors 30 days from the initial creditors' meeting to object. By negative implication, the Rule indicates that creditors may not object after 30 days "unless, within such period, further time is granted by the court." The Bankruptcy Court did not extend the 30-day period. Section 522(l) therefore has made the property exempt. Taylor cannot contest the exemption at this time whether or not Davis had a colorable statutory basis for claiming it.

 Taylor, at 643-44. 

There seems to be a clear conflict here.   The Supreme Court has stated that once property becomes exempt, it remains exempt.   It has now said this for over twenty years.   However, under Frost, as interpreted by Judge Bohm, property must retain its exempt character at all times during the pendency of the case or be subject to turnover.    It does not seem possible to reconcile the Supreme Court opinions in Taylor and Law with Frost and Hawk.  If property could be claimed by the trustee at any time that it lost its exempt character, then property which was never exempt could be challenged at any time.    However, the Supreme Court expressly rejected that proposition.   To reiterate, if we protect property claimed as exempt with no colorable basis, as the Supreme Court did in Taylor, how can we fail to protect property which was legitimately exempt on the date of filing?

With any luck, this issue will eventually make its way back to the Fifth Circuit, or if necessary, the Supreme Court.   Until then, the watchword is debtors beware:  your exemptions are less secure than you might think.

Hat tip to Steve Roberts.