Retirement Funds Received in Divorce Settlement Were Not Exempt in Bankruptcy

(Parker Tax Publishing March 2020)

The Eighth Circuit affirmed a decision of the Bankruptcy Appellate Panel for the Eighth Circuit holding that an individual retirement account (IRA) and a half of a 401(k) fund that a taxpayer received in a divorce settlement were not exempt assets in the taxpayer's Chapter 7 bankruptcy. The Eighth Circuit held that the funds were not exempt "retirement funds" under 11 U.S.C. Sec. 522(b)(3)(C) because, as of the date the taxpayer filed for bankruptcy, the taxpayer's interests in the funds did not satisfy all three requirements under Clark v. Rameker, 573 U.S. 122 (2014), that the taxpayer (1) was able to make additional contributions to the funds, (2) was not obligated to withdraw the funds, and (3) would be required to pay a penalty to withdraw the funds before age 59 1/2. In re Lerbakken, 2020 PTC 48 (8th Cir. 2020).

Background

In 2014, Brian Lerbakken hired Sieloff and Associates, P.A. (Sieloff) to represent him in his divorce proceeding. The court order dissolving the marriage adopted the parties' stipulated property settlement, which awarded Lerbakken half of the value in his ex-wife's Code Sec. 401(k) account and an entire individual retirement account (IRA) (collectively, the accounts). The order also directed the attorneys to submit a Qualified Domestic Relations Order (QDRO) related to the accounts. A QDRO was never submitted, and Lerbakken undertook no other action to obtain title or possession of the accounts.

In 2018, Lerbakken filed a voluntary Chapter 7 bankruptcy petition. He claimed the accounts as exempt retirement funds for the values agreed to under the property settlement. Sieloff, who was listed as a creditor for its unpaid fees, objected to Lerbakken's claim of exemption on the accounts. The bankruptcy court disallowed the exemption on the basis that the accounts were not retirement funds. Lerbakken appealed to the Bankruptcy Appellate Panel for the Eighth Circuit (BAP). In Lerbakken v. Sieloff and Associates, P.A., 2018 PTC 362 (B.A.P. 8th Cir. 2018), the BAP affirmed the bankruptcy court and held that Lerbakken's interests in the accounts were not retirement funds. Lerbakken appealed the BAP's decision to the Eighth Circuit.

When a debtor files for bankruptcy, all of his or her property becomes property of a bankruptcy estate. Under 11 U.S.C. Sec. 522(b)(3)(A), the date of filing determines the property of the bankruptcy estate. An exemption is provided in 11 U.S.C. Sec. 522(b)(3)(C) for retirement funds, to the extent the funds are in a fund or account that is exempt from taxation under certain provisions of the Internal Revenue Code, including Code Sec. 401. Thus, to be exempt from the bankruptcy estate, the funds must be both (1) "retirement funds" and (2) held in a covered account.

In Clark v. Rameker, 573 U.S. 122 (2014), the Supreme Court defined "retirement funds" as "sums of money set aside for the day an individual stops working." The Court focused on three legal characteristics of ordinary retirement funds. The Court found that account holders of ordinary retirement funds (1) are able to make additional contributions to the funds, (2) are not obligated to withdraw the funds, and (3) must pay a penalty to withdraw the funds at any time, for any purpose, prior to the age of 59 1/2. According to the Court, "retirement funds" are "funds objectively set aside for one's retirement," not "a pot of money that can be freely used for current consumption."

Lerbakken advanced four arguments for why the accounts were exempt. First, he said the BAP and the bankruptcy court misapplied Clark by limiting the exemption for retirement funds to individuals who create and contribute funds into the retirement account. Second, Lerbakken argued that the similar tax treatment of transferred and surviving-spouse IRAs necessitated treating accounts transferred incident to divorce the same as accounts inherited by surviving spouses. Third, Lerbakken asserted that the funds in his ex-wife's IRA and 401(k) were intended to support both spouses in retirement. Finally, Lerbakken argued the accounts should be exempt on policy grounds.

Eighth Circuit's Analysis

The Eighth Circuit affirmed the BAP's decision and held that that the accounts were not retirement funds under 11 U.S.C. Sec. 522(b)(3)(C). The Eighth Circuit noted that the property of Lerbakken's bankruptcy estate had to be determined as of the date he filed for bankruptcy. It therefore focused on the Lerbakken's rights in the accounts as of January 23, 2018, the date of filing.

Applying the requirements in the Clark decision, the court found that the second requirement was not met because under the dissolution decree and the court-ordered attorney's lien, Lerbakken's interest in the IRA was treated a debt owed to Sieloff. The court found that under the decree and lien, Lerbakken was required to effectuate a transfer or renaming of his ex-wife's IRA to pay a debt, regardless of his proximity to retirement. The court noted that the dissolution of the IRA was obligatory, and Lerbakken's interest therefore did not satisfy the second characteristic of a retirement fund. The court also found that the third characteristic did not apply as of the filing date because no transfer of the IRA had occurred as of that date and Lerbakken's interest therefore was not subject to the rules for ordinary IRAs transferred incident to divorce under Code Sec. 408(d)(6) and Code Sec. 72(t). The court concluded that Lerbakken's IRA interest was not treated as an individual retirement account belonging to him; his interest was, in the court's view, a sum of money in his ex-wife's IRA, not an account set aside for the day when an individual stops working.

Regarding the 401(k), the court found that Lerbakken did not have a QDRO on January 23, 2018, and could not access his interest in the account without a QDRO. In the absence of a QDRO, the court found that state law - the dissolution decree and the court ordered attorney's lien - defined Lerbakken's interest in the 401(k) as a debt to Sieloff. Applying the Clark framework, the court observed that Lerbakken could not make additional contributions to the 401(k) on the filing date because contributions must be made by the employer or employee, not an ex-spouse. The court also noted that Lerbakken was obligated to withdraw the funds to pay Sieloff for legal services, not to use the funds for retirement. Third, the court found that without a QDRO, Lerbakken could not make a withdrawal on January 23, 2018. Lerbakken's conditional interest in the 401(k) therefore lacked the legal characteristics of ordinary retirement funds and was not exempt under Sec. 522(b)(3)(C).

The Eighth Circuit rejected all of Lerbakken's arguments. The court stated that, under Clark, the key features of retirement funds are the objective legal characteristics, and Lerbakken's interests in the IRA and 401(k) did not have the necessary legal characteristics. The court reasoned that even a surviving spouse (which Lerbakken was not) does not have "retirement funds" when the surviving spouse does not roll over the IRA into his or her own IRA. On this point, the court reiterated that Lerbakken failed to roll over the funds from his ex-wife's accounts into his own accounts by January 23, 2018, when exemptions were determined. The court found that the Clark decision explicitly prohibits a case-by-case, fact intensive examination of the subjective purpose or intent of the funds. Finally, the court concluded that policy considerations favored the court's conclusion. The court reasoned that the Bankruptcy Code effectuates a balance between debtors and creditors, and that allowing debtors to enjoy cash windfalls through exemption would turn the Bankruptcy Code's purpose of providing a "fresh start" into a "free pass."

For a discussion of the treatment of retirement accounts in a 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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