Early Withdrawal Did Not Render Debtor's Annuity Nonexempt in Chapter 7 Bankruptcy

(Parker Tax Publishing July 2019)

A bankruptcy court held that a married couple's annuity account, which they formed 15 days before filing a Chapter 7 bankruptcy petition, was exempt from the bankruptcy estate under Wisconsin law because it was a tax-deferred account under Code Sec. 72 and was payable on death. The court found that the annuity contained the required death benefit language in Code Sec. 72(s), the annuity's early withdrawal provision did not render the principal non-tax-deferred, and that there was no evidence that the debtors transferred assets with the intention of defrauding creditors. In re Kluck, 2019 PTC 229 (Bankr. W.D. Wis. 2019).

Lydell and Margaret Kluck filed a voluntary joint Chapter 7 petition. Before filing their petition, Mr. Kluck owned, among other assets, a 1974 Plymouth and several parcels of real estate in Wisconsin. In the months before filing bankruptcy, the Klucks sold those assets and deposited the proceeds of $181,780 into a bank account. The Klucks transferred $177,000 of the proceeds into an annuity account formed 15 days before they filed bankruptcy. They later withdrew funds from the annuity to pay attorney's fees. The Klucks stipulated that before the sales, the assets were not their homestead or exempt (1) from execution by judgment creditors under Wisconsin law, (2) under bankruptcy law, or (3) from federal or Wisconsin income tax.

When a bankruptcy case begins, most of the debtor's assets become property of the bankruptcy estate. However, to help give the debtor a fresh start, the Bankruptcy Code permits a debtor to exempt from the estate certain interests in property. Under Wisconsin law, a debtor may choose between the exemption scheme in the Bankruptcy Code or the Wisconsin exemption provisions. The Wisconsin retirement benefits exemption allows a debtor to claim property as exempt if it meets the following requirements: (1) it is tax deferred under Code Sec. 72, and (2) it provides benefits by reason of age, illness, disability, death or length of service. However, a bankruptcy court can deny an exemption if, in the court's discretion, the debtor procured, concealed or transferred assets with the intention of defrauding creditors.

The Klucks elected to claim their annuity as exempt under Wisconsin law. The trustee argued that the claimed exemption should be disallowed. According to the trustee, the account did not satisfy Wisconsin law because it was not tax deferred and because distributions under the account were not conditioned upon any particular event and thus also failed to satisfy Wisconsin law.

The bankruptcy court held in favor of the Klucks and overruled the trustee's objection. The court found that the annuity was exempt under Code Sec. 72 in part because it complied with the distribution requirement in Code Sec. 72(s) in the event the holder dies before the entire interest is distributed. The court noted that under the annuity contract, payment was to be made within five years if the death occurred before the annuity starting date or as soon after the death as proof of death or payment instructions are received. The annuity therefore contained the death benefit language required under Code Sec. 72(s), in the court's view. The court rejected the trustee's argument that the annuity was not tax-deferred because of the Klucks' early withdrawal. According to the court, early withdrawals do not render the principal non-tax-deferred, and funds in the account are tax-deferred until distribution. The court also concluded that the second requirement for exemption under Wisconsin law was met because the annuity provided for distribution by reason of age or death.

The bankruptcy court also concluded that there was insufficient evidence on which to find that the Klucks transferred assets with the intention of defrauding creditors. The court noted that exemption planning, where debtors seek to convert non-exempt assets into exempt assets shortly before filing bankruptcy, is commonplace and does not necessarily justify disallowance of a claimed exemption. The court said that exemption planning rises to the level of fraudulent conduct only if there is evidence the debtor committed an act extrinsic to the conversion which hinders, delays, or defrauds creditors. Such additional factors include any misleading contacts with creditors while converting non-exempt assets into exempt assets, the purpose of the conversion of assets, and conveyance for less than fair market value. The court found that none of these factors applied in the instant case.

For a discussion of individuals in Chapter 7 bankruptcy, see Parker Tax ¶16,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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