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Contract with Investment Firm Did Not Cause Taxpayer's IRA to Become Part of Bankruptcy Estate. (Parker's Federal Tax Bulletin: July 5, 2013)

Generally, the assets in an individual retirement account (IRA) are off limits from tax collectors and creditors in bankruptcy. Yet if the owner of the retirement account uses it in a prohibited way, the taxation and bankruptcy protection disappears. In a recent case, In re Daly, 2013 PTC 145 (6th Cir. 6/17/13), the Sixth Circuit reviewed a decision in which both the district court and the bankruptcy court held that a taxpayer had impermissibly used his IRA to extend himself credit by granting Merrill Lynch a lien on the retirement funds to cover any potential future debts to the firm. The decision revolved around a boilerplate lien agreement the taxpayer signed when he opened his retirement account with Merrill Lynch. If this decision were allowed to stand, individuals going through a bankruptcy could see their retirement accounts disappear if they had signed similar agreements. Luckily, however, the Sixth Circuit reversed the lower courts and held that the taxpayer did not use his retirement account to extend himself credit. As a result, the taxpayer's retirement account was protected in bankruptcy.


James Daley opened an IRA with Merrill Lynch by rolling over $64,646 from another financial institution. Before doing so, James signed a Client Relationship Agreement with Merrill Lynch, which contained the following liens provision; "all of your securities and other property in any account margin or cash in which you have an interest, or which at any time are in your possession or under your control, shall be subject to a lien for the discharge of any and all indebtedness or any other obligations you may have to Merrill Lynch." By signing the agreement, James thus pledged his IRA as security for any future debts to Merrill Lynch.

No debts ever arose, however. Merrill Lynch offers other types of accounts that do carry debt risks for example, a margin-trading account that allows customers to purchase securities with money borrowed from the broker. But James never opened such an account or any other, and he thus never became indebted to Merrill Lynch. Outside of his account with Merrill Lynch, James also did not withdraw money from his IRA, borrow from it or use it as collateral for a loan of any sort.

Two years after opening the account, James sought protection from his creditors by filing a Chapter 7 bankruptcy petition. Seeking to protect his retirement savings from creditors, James invoked the exception for IRAs under 11 U.S.C. Section 522(b)(3)(C). The bankruptcy trustee objected, contending that the IRA lost its exempt status when James signed the Client Relationship Agreement and granted the lien to Merrill Lynch. A bankruptcy court and the district court agreed with the trustee.

In reaching its conclusion, the bankruptcy court invoked an advisory opinion by the Department of Labor (DOL), which shares administrative authority over retirement accounts with the IRS. According to DOL Advisory Opinion 2009-03A, granting a security interest in an IRA to cover debt in a non-IRA account amounts to an extension of credit by the IRA to the IRA owner.

Exemption from Bankruptcy for Retirement Funds

The Bankruptcy Code explains how to treat a Chapter 7 debtor's assets (what goes to creditors and what remains exempt.) The bankruptcy trustee obtains control of the debtor's non-exempt property and distributes it to creditors. Under Bankruptcy Code Section 522(b), a debtor may exempt retirement funds if they are in an account that is exempt from tax under Code Sec. 408. Code Sec. 408 designates certain trusts as IRAs and provides that such accounts are exempt from tax. Under Code Sec. 408(e)(2)(A), an IRA loses its tax-exempt status if the owner engages in any transaction prohibited by Code Sec. 4975. One of the prohibited transactions, as described in Code Sec. 4975(c)(1)(B), is any direct or indirect lending of money or other extension of credit between the IRA and its owner.

In Announcement 2011-81, the IRS responded to DOL Opinion 2009-03A and another DOL Advisory Opinion, 2011-09A, which involved circumstances under which an individual IRA owner's agreement to indemnify a broker in order to cover indebtedness of, or arising from, the individual's IRA with the broker would be an impermissible extension of credit. In Announcement 2011-81, the IRS provided that, pending further action by the DOL and until issuance of further guidance from the IRS superseding Announcement 2011-81, the IRS would determine the tax consequences relating to an IRA without taking into account the consequences that might otherwise result from a prohibited transaction under Code Sec. 4975 resulting from entering into any indemnification agreement or any cross-collateralization agreement similar to the agreements described in DOL Advisory Opinions 2009-03A and 2011-09A, provided there has been no execution or other enforcement under the agreement against the assets of an IRA account of the individual granting the security interest or entering into the cross-collateralization agreement.

Sixth Circuit's Analysis

The question before the Sixth Circuit was whether James used his IRA to obtain credit from Merrill Lynch, resulting in an indirect extension of credit between James and the IRA. The court held that James did not use his IRA to obtain credit and cited several reasons for reversing the lower courts:

(1) The Sixth Circuit said, there is a statutory presumption that James' account is exempt. If a retirement fund has received a favorable determination from the IRS, the court noted, those funds are presumed under Bankruptcy Code Section 522(b)(4)(A) to be exempt from the bankruptcy estate. Because there was a favorable determination in effect when James filed his bankruptcy petition that stated that Merrill Lynch's IRAs satisfied the requirements of the retirement-account exemption under Code Sec. 408, the statutory presumption was met.

(2) The court noted that the phrase; "any direct or indirect ... lending of money or other extension of credit" is broad but still demands the lending of money or other extension of credit between the IRA and James, and nothing of that sort happened. The salient reality, the court observed, was that James never borrowed from the IRA, and Merrill Lynch never extended credit to James based on the existence of the IRA. That a lien in some settings might be granted in connection with an extension of credit does not establish that any loan or other extension of credit occurred, the court concluded.

Because James never opened any other accounts with Merrill Lynch, the Sixth Circuit concluded that James never authorized Merrill Lynch to advance funds or securities. This meant to the court that James removed the possibility that he could become indebted to Merrill Lynch. The lien provision was contingent on an event that never occurred, and above all could not occur until James opened a separate account. The court noted that it was one thing to say that Merrill Lynch extends credit any time a customer opens a margin-trading account (and thus that a lien on an IRA acts as an extension of credit between the IRA and its owner), even in the absence of actual margin trading; but its quite another to say that Merrill Lynch extended credit to a nonexistent margin-trading account. James' naked lien, the court said, stripped of any connection to a credit transaction, was not an extension of credit. Consistent with this analysis, the court noted that the IRS had issued Announcement 2011-81 in which it said that lien provisions like the one in the instant case would not destroy an IRA's tax exempt status. The mere existence of a cross-collateralization agreement, as the IRS called it, does not by itself disqualify an IRA from exempt status. At most, it is the actual use of such an agreement and the prohibited extension of credit through it in a later transaction that might disqualify a retirement account.

With respect to the bankruptcy court's reliance on the DOL advisory opinion, the Sixth Circuit noted that the advisory opinion concerns a fact pattern that involved the opening of a second account, something that didn't happen in James' case.

The court then addressed the trustee's argument that the IRA lien amounted to an extension of credit even if James never opened any other accounts because the IRA itself could have placed James in debt to Merrill Lynch. With respect to that contention, the court said the trustee never explained why or how James's retirement account, even after accounting for automatic withdrawal of ordinary account fees, could itself create debt. The court also rejected the trustee's assertion that Announcement 2011-81 did not apply to James, saying it clearly did apply.

(3) The court held that the trustee had no more rights than Merrill Lynch to the assets in the IRA, and Merrill Lynch currently had none. In the final analysis, the court concluded that the bankruptcy trustee had not rebutted the statutory presumption that James' retirement account was exempt from bankruptcy. James signed a boilerplate lien provision as a requirement of opening an account that the IRS had approved. He made no other transactions with the account, and because he opened no other accounts there was no possibility that the lien would amount to anything. The court noted that the agency with ultimate authority to administer Code Sec. 4975, the Department of Labor, has given no definitive interpretation of Code Sec. 4975 in this context and the agency that shares enforcement authority over Code Sec. 4975, the IRS, has determined it will consider accounts like James' exempt.

CAUTION: Had James opened a margin-trading or similar account that carries debt risks, his retirement account most likely would not have been exempt from bankruptcy.

Staff Editor Parker Tax Publishing


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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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