Excess Contribution to IRA Precludes Annuity from Being Exempt in Bankruptcy Estate

(Parker Tax Publishing May 2022)

A bankruptcy court held that a debtor could not exclude an individual retirement annuity from her bankruptcy estate because, while the account was not an inherited individual retirement account (IRA) as the bankruptcy trustee had argued, the account was funded with an IRA that was not tax-exempt. The initial IRA account, the court observed, was funded by an inheritance from the debtor's father but that amount was in excess of the contribution allowable under Code Sec. 219, thus precluding the IRA from qualifying as a tax-exempt account. In re Farber, 2022 PTC 119 (E.D. Pa. 2022).

Background

In filing for bankruptcy under Chapter 7 of the Bankruptcy Code, Stephanie Farber disclosed that she had an individual retirement account (IRA) in the form of an individual retirement annuity, which she claimed was exempt from the bankruptcy estate under Bankruptcy Code Section 522(d)(12). The Bankruptcy Trustee concluded that the IRA was inherited by Farber and was set up in April of 2018, and because inherited IRAs may not be exempted from a bankruptcy estate, the Trustee filed an objection. The Trustee alleged that Farber had previously admitted that the IRA was inherited.

In response, Farber offered proof to support her position that the IRA was not inherited but was originated by her. Farber's proof was the court testimony of a single witness: the insurance broker, Mr. Leayman, who sold her an individual retirement annuity. Leayman served as the go-between for Farber to purchase the individual retirement annuity with Allianz. His involvement was limited to obtaining the information that Allianz would need from Farber to sell her the annuity. Leayman testified that he did not believe that the funds used to open the annuity were rolled over from an inherited IRA because that would not have been permitted. He also said that he knew only that Farber had an account at Wells Fargo but he did not believe it was an inherited IRA. He assumed, he said, that Farber already had an IRA in her name at Wells Fargo. In response to the Trustee asking him why he indicated on his paperwork to Allianz that the source of the funds was "death benefit proceeds," Leayman confessed that he "wasn't really understanding what was taking place at Wells Fargo with the titling of the accounts." The court found Leayman's testimony lacking probative value since nothing he said shed light on either (1) the Trustee's premise that Farber improperly rolled over an inherited IRA; or (2) Farber's explanation that she used funds from the inherited IRA to purchase her own IRA. Farber rested her case.

The Trustee then called her expert (and sole) witness: Charles Persing, CPA. Persing opined on the legality of Farber's IRA for purposes of tax exemption. It was his opinion that the IRA did not qualify as tax exempt based on his review of the 2018 Annual Summary of Tax Information of Farber's IRA contributions. He noted that, on line 2 of the form, Allianz disclosed that Farber made a rollover contribution in the amount of $41,447 for that year. Under the Internal Revenue Code, Persing stated, Farber was permitted to rollover funds only from an account in her name. Because he was unaware of any pre-existing IRA in Farber's name alone, Persing opined that the contribution was illegal under applicable tax law. He said that the most that Farber was permitted to contribute to a new IRA in her name would have been $6,000 to $7,000 for 2018.

The bankruptcy court judge then sought to clarify the cryptic testimony by questioning Farber. In response, Farber testified that her father passed away in December 2017; that at the time of his death he had an account at Prudential Life Insurance; that she did not know what type of account her father had at Prudential; that her father left her an interest in that account; that after getting a medallion signature from her bank (Wells Fargo), she received a check from Prudential for $41,000; that she physically took the funds to Wells Fargo; and that there she used it to set up an IRA in her name.

Analysis

The bankruptcy court held that Farber's IRA was not exempt from being included in Farber's bankruptcy estate. However, the court did not agree with the Trustee that what Farber owned was an inherited IRA. The court found that instead of seeking to exempt an inherited IRA, Farber was instead seeking to exempt an IRA in her own name that was funded by the inheritance from her father and which was then rolled over to fund her current IRA at Allianz.

The evidence, the court said, called into question the tax-exempt status of the original IRA at Wells Fargo. If that account was not tax-exempt, the court observed, then neither was the individual retirement annuity at Allianz. That would likewise mean, the court noted, that the annuity was not exempt from the bankruptcy estate because, under 11 U.S.C. Section 522(d)(12), a debtor may exempt retirement funds to the extent that those funds are in a fund or account that is exempt from tax under Code Secs. 401, 403, 408, 408A, 414, 457, or 501(a).

Before Farber opened the annuity with Allianz, she testified to having opened an IRA with Wells Fargo. Among the requirements for a qualified IRA, the court noted, is a limit on annual contributions to the account. Specifically, under Code Sec. 219(b)(1)(A), contributions will not be accepted for the tax year on behalf of any individual in excess of the amount in effect for such tax year. For 2018, the court observed, the annual contribution limit was $6,500, including the $1,000 catch-up contribution. The court noted that because Farber testified that she took the entire $41,000 and used all of it to open her IRA at Wells Fargo, then she contributed more than what was allowed under applicable tax law.

Further, the court said, like annual contributions to an IRA, the amount of the annual premium payable to an individual retirement annuity is also limited by Code Sec. 219. The court found that, if Farber rolled over the entire $41,000 from her Wells Fargo IRA into the annuity at Allianz, as the testimony indicated she did, then she contributed more than what was allowed under applicable tax law.

The court rejected Farber's argument that, while she opened the annuity with the entire inheritance which was well in excess of the applicable contribution limit of $6,500, four years have passed and had she instead contributed the allowed amount for each year then she would have a tax-exempt annuity in the total amount of $27,500.

The court also rejected the Trustee's assertion that Farber engaged in a prohibited transaction, as described in Code Sec. 4975(c), which, under Code Sec. 408, would disqualify Farber's account from tax exempt status. According to the court, while there was enough evidence to find that Farber was a fiduciary, there was nothing to show that she engaged in a prohibited transaction. Farber, the court noted, was alleged to have contributed too much money into her own account and that, the court said, is not a prohibited transaction as defined by Code Sec. 4975(c).

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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