Clark v. Rameker: Supreme Court Rules Inherited IRA's are not Protected in Bankruptcy. (But, There may be Exceptions!)

As I have said before, it's not often that the Supreme Court issues opinions related to the estate planning process. The last time the Supreme Court ruled on an estate planning case was back in April of 2012 finding that a post-death conceived child was not entitled to receive Social Security survivor Benefits. This month, the court issued a ruling on Clark v. Rameker.

In Clark, a woman sought to protect an IRA that she had inherited from her mother from creditors after filing for bankruptcy. To do so, the woman invoked section 522(b)(3)(C) of the Bankruptcy Code, which allows a "debtor" (the person who has filed for bankruptcy) to "exempt" from the bankruptcy process "retirement funds to the extent those funds are exempt from taxation" under certain provisions of the Tax Code. In a unanimous ruling, the Supreme Court found against the debtor, determining that funds held in an inherited IRA, as opposed to a person's own IRAi, are not "retirement funds" within the meaning of the applicable section. Thus, they were not "exempt," and were available for distribution to the debtor's creditors.

Factors influencing the court's decision were the following:

  1. the debtor could not add any of her own money to the account,
  2. the debtor was required by statute to withdraw money from the account, regardless of how close to retirement she herself was, and
  3. the debtor was allowed by law to withdraw the entire amount without penalty.
The court held that even though the debtor had the ability to withdraw money and use the funds to pay for her retirement, the flexibility with which she could do so was fatal to her case. To determine whether funds in an account qualify as "retirement funds," the court held, the appropriate inquiry is whether the account is one reserved for the day the individual stops working - and it was clearly not in Clark. The court's distinction between personal and inherited IRA's makes sense from a policy standpoint, as bankruptcy exemptions are designed to shield from creditors only those assets that are deemed necessary for the debtor's standard of living.

This case resolves a previously ongoing debate about whether or not inherited IRA's should be protected in bankruptcy. In 2012, the Court of Appeals for the Fifth Circuit noted the issue was one of first impression and held that a Texas debtor's inherited IRA was protected in bankruptcy under the federal exemption statute. This case was directly overturned by Clark. It also raises interesting issues about whether individuals with inherited IRA's can, for example, roll assets from those accounts into their own IRA's to be protected in the event that they file bankruptcy at some point in the future. If such a transfer were made when a bankruptcy filing was in sight, it would likely be viewed as fraudulent and "avoided," meaning that the funds would be ordered back into the debtor's estate to be distributed to creditors along with the rest of the debtor's non-exempt assets.

One further thing to note is the difference between the federal and state lists of exemptions. Under Wisconsin law (which governed the debtor in Clark), an individual filing bankruptcy may choose to use either the federal exemptions or the Wisconsin state exemptions. The debtor in Clark chose to use the federal exemptions, which is why the language interpreted by the Supreme Court in the case came from the Bankruptcy Code, the federal statute. However, a majority of states have chosen to "opt out" of the federal exemptions, providing their citizens with a list of exemptions chosen by that state's legislators. These state exemption lists are mandatory - meaning the federal exemptions are not an option in states that have opted out - and may contain exemptions for different items, different caps on the value of certain assets, and different statutory language than the federal list.

People with inherited IRA's should first check their state's bankruptcy statute to see which code section they are operating under before determining whether the issue in Clark could potentially be applicable to them. For an example, D.C. generally provides full exemption to retirement accounts under D.C. Code 15-501. Maryland also generally provides that most retirement benefits including the Individual Retirement Accounts under Maryland Code 11-504(h) are exempt from creditors. Virginia is not as accommodating to debtors but does provide IRAs, not protected by the ERISA anti-alienation statute, is partially exempt by a formula dependent upon the total sum and age of the beneficiary under Virginia Code 34-34 and 51.1-124.4A.

Given that a large percentage of American's inherit non-spousal IRA from parents and other loved ones this could impact a great many people in the future.

Basics of Estate Planning: What are Spendthrift Clauses?

I try to interweave related topics into my newsletter. And, after our discussion of IRA's in bankruptcy in the Clark case, a spendthrift clause is a logical follow-up topic. The first question becomes what is a spendthrift? A text book answer is a spendthrift is someone who spends money prodigiously and who is extravagant and recklessly wasteful, often to a point where the spending climbs well beyond his or her means. I am sure we all know at least one person that falls into that description.

A spendthrift clause is included in a trust document in order to restrict the trust beneficiary's ability to assign away his or her right to receive distributions from the trust. This is known as a restraint on voluntary transfer. In many states, in order for a spendthrift clause to be valid, the spendthrift provision must also provide that the trust assets are unavailable to the beneficiary's creditors as well - a restriction on involuntary transfer. This means that creditors may not levy on the assets until they are out of the trust and into the hands of the beneficiary.

As the name indicates, a spendthrift clause can be a tool for the grantor of the trust to protect against unwise disposition of future trust distributions. For example, denying a beneficiary wanting to pledge future payouts as security for a loan. It is also a way to ensure that the assets remain in the hands of the beneficiary and out of the reach of creditors in the event that the beneficiary is facing claims from third parties. This may prove especially relevant in the event of the beneficiary's bankruptcy in determining whether the trust (or the portions of it covered by the spendthrift clause) becomes part of the debtor's estate to be distributed to creditors or whether it is exempt from the bankruptcy process entirely.

Another prime example for the need spendthrift provisions is when parents wish to provide their children with trust distributions in the future, but also want to restrict the ability of third parties to have access to trust assets in the event that a child runs into financial trouble. One of biggest third parties concerned parents fret over is dubious son-in-law or daughter-in-law. The spendthrift provision is created to limit unsavory spouse of child from reaching into the trust during a divorce when the divorcing spouse of the child is seeking spousal support.

Some states provide for a trust completely dedicated to this purpose, known as a spendthrift trust or an asset protection trust. One example of this type of spendthrift trust was Virginia's enactment in 2012 of a self-settling of domestic asset protection trust statute. You can read more about these types of trusts here.

Estate of the Month: Donald Sterling - the Ongoing Saga

Well, it was bound to happen. Looks like Whitney Houston's estate, my only two-time Estate of the Month winner (March 2012 and April 2012) is getting some company. Last month, I wrote about the events leading to Donald Sterling's lifetime ban from the NBA, and explained why getting rid of the Clippers owner might not be as straightforward as the league had envisioned it. I also talked about the team ownership complications due to the existence of the Sterling family trust. While it appeared at one point that Sterling might actually go quietly, the events of the past few weeks have shown otherwise.

After negotiations between Rochelle ("Shelly") Sterling, Donald's estranged wife, and former Microsoft CEO Steve Ballmer culminated in an offer for the Clippers of $2 billion, Donald reiterated his earlier vow to fight the sale at all costs. Were the sale to be consummated, the Sterlings would receive not only a record-breaking sum of money but also "extras" such as floor seats, reserved parking spaces, and championship rings in the event that the team won a title. However, in spite of public statements) to the effect that he would allow the sale to go through, Sterling's most recent comments indicate a complete 180 from that position.

According to reports, Shelly Sterling's lawyers had a contingency plan in the event that Donald attempted to obstruct the sale. A provision in the trust agreement stated that if either of the Sterlings was found to be mentally incapacitated, the other would then take over as sole trustee - and thus would be in control of the trust assets' disposition. Such a finding would require the opinion of a medical professional. Donald's erratic behavior, including a largely incoherent interview that he gave with Anderson Cooper of CNN in which he made contradictory statements and denied accusations, led Shelly Sterling to seek such a medical opinion. Sure enough, two California neurologists found that the 80-year-old Sterling had a cognitive impairment, which effectively transferred complete control of the trust's management to Shelly. While Donald will still get his share of the sale proceeds, as he retains a financial interest in the trust assets, he may no longer participate in any decision-making process with regard to the team.

The sale is not out of the woods just yet - Mr. Sterling may contest the determination of incapacity, his $1 billion lawsuit against the NBA remains to be decided, and the league owners still have the right to vote on any change in ownership of a team. The NBA vote on Sterling is postponed.However, the transaction has the blessing of the NBA's general counsel (with the condition that Mrs. Sterling indemnify the league against any unfavorable outcome as a result of the Donald Sterling suit), and so it is likely - although not absolutely certain - that Ballmer will soon become the new Clippers owner. The Sterling saga demonstrates that estate battles can erupt even before a person passes away, as competency, mental capacity and perhaps undue influence are disputed. More broadly, it underscores the importance of careful legal drafting, planning for contingencies, and fully understanding each aspect of a governing document to thoroughly explore all potential options in order to arrive at a desired result.

There are several important hearings, rulings and meetings occurring or schedule over the next month that could impact his estate including a July 7th hearing on Sterling's competency and a July 15th NBA owners meeting set to approve Ballmer as owner of the Clippers. Do I dare ask if Sterling could be a three time winner of the Estate of the Month? I guess we will have to find out.

iClark only relates to non-spousal inherited IRAs and not impact spousal inherited IRAs where the spouse inherits an IRA and otherwise characterizes the inherited IRA as his/her own i.e. rolls over the spousal inherited IRA into the surviving spouse's name.

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