Self-Directed IRA Retains Qualified Status and Is Exempt from Bankruptcy Estate

(Parker Tax Publishing June 2022)

A bankruptcy court overruled a trustee's objection to an exemption claimed by a debtor for his self-directed individual retirement account (IRA) after concluding that the IRA had not lost its tax-qualified IRA status. The court found that the IRA had not engaged in prohibited transactions with disqualified persons in violation of the Employee Retirement Income Security Act of 1974 and IRS rules, as the trustee had argued. In re Moore, 2022 PTC 136 (Bankr. S.D. Ohio 2022).

Background

John Moore and his wife, Janet Martin (Martin), filed a joint petition under Chapter 7 of the Bankruptcy Code. Paul Spaeth (Trustee) was appointed as the Chapter 7 Trustee. Moore claimed an exemption in a self-directed individual retirement account (IRA) under Ohio law. The Trustee objected on the basis that the account lost its tax-qualified IRA status when Moore engaged in a number of prohibited transactions with disqualified persons in violation of the Employee Retirement Income Security Act of 1974 (ERISA) and IRS rules.

Moore opened his self-directed IRA in 2016. He planned to use the IRA as a vehicle for investments in non-traditional assets. Initially, Moore funded the IRA with funds rolled over from other existing IRAs he owned. He exercised discretionary authority over the IRA's investment and asset liquidation activity, making all investment decisions personally and providing instructions to the IRA custodian (Custodian). Later that year, Moore directed the Custodian to invest the IRA funds in vacant real estate properties located in Florida. The IRA funds were also invested in an options trading account held by R.J. O'Brien, a corporate entity. Option IQ, another entity, acted as the introducing broker. Moore did not have any relationship to either company. Moore and Martin were also co-owners in Louisiana Oil and Gas LLC (Louisiana Oil). Until 2018, Louisiana Oil held a 20 percent ownership interest, purchased for approximately $30,000, in the Harry O'Neal oil well located in Mississippi and received regular revenue dividends from oil sales. Louisiana Oil in turn made regular transfers to Moore. The terms and conditions of the IRA account included an explanation of statutorily prohibited transactions between the account and disqualified persons under ERISA and IRS rules. Moore and Martin agreed that they and Louisiana Oil were disqualified persons under the ERISA and Code Sec. 4975(e)(2).

In 2017, Moore transferred $40,000 from the IRA to his personal bank account. Shortly thereafter, he transferred $135,000, including the earlier transferred $40,000, from his personal account to an account held by Louisiana Oil. In August, Louisiana Oil loaned $40,000 to a Mr. Steven Ford. Later in 2017, Moore transferred an additional $54,000 from the IRA to his personal bank account. The Form 1099-R issued by the IRA Custodian to Moore for the 2017 tax year showed a total of $94,000 in gross distributions from the IRA to Moore. The custodian classified using distribution code "7" on the tax form, the code for regular distributions. In January 2018, Moore loaned approximately $28,059 to "PPU," the oil well operator for the Harry O'Neal well in which Louisiana Oil held an ownership stake, from his personal account. The loans were used to pay Louisiana Oil's share of the expenditure obligations and treated as investment credits. In May and June of 2021, the IRA liquidated the Florida properties at Moore's direction and deposited the proceeds into the IRA. As of August 1, 2021, the IRA's value equaled $96,256.

When a debtor files a bankruptcy petition under Chapter 7 of the Bankruptcy Code, all of his or her assets and property interests become part of the bankruptcy estate, and thus available to the Chapter 7 Trustee to administer for the benefit of creditors. However, debtors in bankruptcy may claim portions of their property as exempt from the bankruptcy estate. Because Ohio chose to withdraw from the federal exemptions in 11 U.S.C. Sec. 522(d), debtors domiciled in Ohio must look to the state statute to determine and claim applicable exemptions. Under the Ohio exemption statute, an exemption from the bankruptcy estate is provided for individual retirement accounts that meet the Internal Revenue Code (the "Code") requirements, as well as for earnings, dividends, interest, appreciation, or gains that are part of the account. Accordingly, an Ohio debtor may claim an IRA as exempt only if the account meets the Code qualifications for tax-exempt status. The Trustee argued that Moore's IRA lost its tax-exempt status in 2017 when Moore made prohibited indirect transfers in violation of Code Sec. 4975(c)(1) to Louisiana Oil, a disqualified person, and to a third party for Louisiana Oil's benefit. According to the Trustee, by funneling the money through his own personal account before transferring it to the intended recipient, Moore attempted to circumvent the restrictions set out in the IRS rules and cited the timing of the transactions as evidence

Under Code Sec. 408(e)(2)(A), an IRA loses its tax-exempt status if the individual for whose benefit the account is established engages in any transaction prohibited by Code Sec. 4975 with respect to such account. Thus, an IRA loses its tax-exempt status if the IRA owner engages in self-dealing transactions. Under Code Sec. 4975(c)(1), such prohibited transactions include any transfer (direct or indirect) to, or use by or for the benefit of, a disqualified person of the income or assets of a plan. In turn, Code Sec. 4975(e)(3)(A) provides that a disqualified persons include any fiduciary, a person who exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets.

Analysis

The bankruptcy court concluded that Moore's self-directed IRA had not lost its tax-qualified IRA status and thus overruled the Trustee's objection. The Trustee's argument, the court noted, pointed to the timing of the transactions as evidence of Moore's intent that the money should benefit Louisiana Oil rather than be used by him for retirement purposes as intended by the IRS rules and IRA plan. According to the court, this argument raised two questions: (1) whether Moore engaged in a prohibited transaction by transferring funds to himself, a disqualified person, and (2) if not, whether Moore tainted an otherwise lawful transaction by then transferring at least a portion of these funds for use by or for the benefit of Louisiana Oil, a disqualified person.

With respect to the first question, the court found that while Moore is certainly a fiduciary and thus a disqualified person under Code Sec. 4975, this status does not disqualify him from receiving the benefits to which he is entitled under the IRA plan. The court noted that Moore was approximately 64 years old when the withdrawals from the IRA were made and was, therefore, entitled to take regular distributions without tax penalties as a plan beneficiary. Moore reported the withdrawals as income on his tax return, the court observed, and nothing in the record suggested that the IRS disputed the characterization of the withdrawals as anything other than a regular IRA distribution to which Moore was entitled.

With respect to the second question about the way Moore used the distributed funds to benefit a disqualified person, the court concluded that the trustee's interpretation of the term "indirect" in Code Sec. 4975(c)(1) was misguided and that Moore did not run afoul of the law. While the term "indirect" is certainly broad, the court said, its meaning is limited by the context in which it is placed. According to the court, in taking an allowed distribution, Moore acted as a beneficiary, not as a plan fiduciary or disqualified person. Therefore, the court concluded, no transfer between the IRA and a disqualified person occurred. The court noted that IRS rules permit (and at times require) owners to take allowed distributions from an IRA, regardless of whether the funds will be used for a wise or ill-advised purpose. The IRS rules limit how plan assets can be used and when they can be withdrawn, the court said, but do not regulate the purpose for which the funds are used after they are withdrawn by the beneficiary and cease to be plan assets.

For a discussion of the treatment of retirement accounts in bankruptcy, see Parker Tax ¶134,580.

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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