Certain assets are beyond the reach of one’s creditors. For various policy reasons, the law prevents creditors from collecting against some types of property. In bankruptcy, such assets are treated as “exempt,” meaning that the debtor may retain those assets. Examples include a small amount of cash, the debtor’s interest in one motor vehicle up to limited dollar value, a limited amount of personal jewelry, some household goods, and equity in the debtor’s residence up $22,975. There is also an exemption under the Bankruptcy Code for “retirement funds” to the extent that those funds are in an account that is exempt from taxation under applicable provisions of the Internal Revenue Code. See 11U.S.C. §522(d)(12). However, many Courts have concluded that an inherited IRA may not be claimed as exempt under the Section, including the Supreme Court in Clark v. Rameker, ___U.S.___, 134 S.Ct. 2242, 189 L.Ed.2d 157 (2014)(concluding that an inherited IRA does not constitute “retirement funds”).
Other property may be “excluded” from the bankruptcy estate, meaning that it never becomes available to pay the claims of creditors. In Pennsylvania, property held jointly with a spouse as tenants by the entireties may be excluded, such that jointly owned marital property is not available to satisfy the obligations of one spouse, and cannot be used by a bankruptcy trustee of just one spouse. The differences between “exempt” assets and property excluded from the estate are based in policy, but the impact on creditors is the same: that asset cannot be used for payment of their claims.
In addition to the exemption for retirement funds, certain qualified retirement accounts may be excluded from the bankruptcy estate as well. Section 541 of the Bankruptcy Code defines “property of the estate” to consist of “[e]xcept as provided in subsections (b) and (c)(2) of this section, all legal or equitable interests of the debtor in property as of the commencement of the case.” 11 U.S.C. § 541(a)(1). The relevant exception is subsection (c)(2), which states that, “a restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable” in a bankruptcy case. 11 U.S.C. § 541(c)(2).
In In re Norris, 2016 WL 2989234 (Bankr.D.N.J. May 20, 2016), the Bankruptcy Court in New Jersey addressed the question of whether an inherited IRA fell within the exclusion provided by Section 541(c)(2). The Court started its analysis with reference to the “applicable nonbankruptcy law,” which it identified as N.J.S.A. 25:2–1(b) (the “NJ Statute”).
The Court noted that the Third Circuit Court of Appeals had previously held that the NJ Statute operates to exclude IRAs from the bankruptcy estate. In re Yuhas, 104 F.3d 612 (3d Cir.1997). This exclusion is distinguished from the exemption afforded to IRAs by the Code itself in Section 522(b)(3)(c), which provides that retirement funds exempt from taxation under the Internal Revenue Code (“IRC”) are capable of being exempted by the debtor. According to the Court, the Bankruptcy Code section assumes IRAs are property of the estate, subject to the exemption, while the holding in In re Yuhas effectively operates to prevent IRAs from ever becoming estate property. In this case, the Court noted that the exemption was not applicable to the Court’s decision as to whether an inherited IRA is excluded from property of the bankruptcy estate.
The Court began its analysis with the wording of the NJ Statute itself, which includes trusts qualified and maintained pursuant to 26 U.S.C. § 408 of the IRC. Section 408 of the IRC defines an “individual retirement account” as “a trust” that is “created or organized in the United States for the exclusive benefit of an individual or his beneficiaries” and that meets several additional requirements.
In Yuhas, The Third Circuit had articulated a 5-part test to determine whether an IRA is excluded from the bankruptcy estate under section 541(c)(2).
The Norris Court applied the 5-part Yuhas test to the inherited IRA at issue and concluded that the inherited IRA, although distinct from an IRA in many regards, nevertheless met the requirements for exclusion. Thus, the Court held that an inherited IRA subject to the NJ Statute and otherwise qualified under IRC §408(a) is excluded from the bankruptcy estate and thus beyond the reach of the trustee and creditors.
The Bankruptcy Court recognized a troubling aspect of its decision, noting the significant differences between an IRA established by the debtor as a personal retirement vehicle and an inherited IRA, which has some, but not all of the aspects of an IRA. The Court quoted from the decision of the Supreme Court in Clark v. Rameker, which held that an inherited IRA was not subject to exemption, stating:
[I]f an individual is allowed to exempt an inherited IRA from her bankruptcy estate, nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete. Allowing that kind of exemption would convert the Bankruptcy Code’s purposes of preserving debtors’ ability to meet their basic needs and ensuring that they have a “fresh start,” into a “free pass.”
134 S.Ct. at 2248. However, the issue in Clark concerned a debtor’s claim of exemption, and not the question of whether the inherited IRA should be excluded from property of the estate. The Norris court acknowledged that the “determination that an inherited IRA is not property of the estate has the potential to similarly provide a ‘free pass’ to debtors in this district. It is difficult to envision a reasonable policy explanation for such a result.” Nevertheless, based upon the combined effect of the NJ Statue, IRC §408(a), and the 5-part Yuhas test, the Court felt constrained to conclude that the inherited IRA was excluded from the bankruptcy estate and effectively beyond the reach of creditors.
Given the Supreme Court’s determination in Clark that an inherited IRA is not subject to exemption, the Norris court’s holding that the inherited IRA before it was excluded from property of the estate will undoubtedly generate some reaction. Whether an appellate court will provide a differing interpretation, or whether a legislative fix will be forthcoming, remains to be seen. Pending such a resolution, inherited IRAs that meet the requirements of the NJ Statute and satisfy the 5-part Yuhas test are beyond the reach of bankruptcy trustees in New Jersey.
