Bankruptcy in the United States courts has always been a battle between competing interests. On one hand, bankruptcy exists for the benefit of creditors; the bankrupt party (the “debtor”) generally works with the court and its officers to pay back creditors as much of the debt as possible. On the other hand, bankruptcy is designed to give debtors a fresh start. So while paying back creditors often requires debtors to turn over most of their assets, the bankruptcy laws also attempt to protect debtors from living on the streets.
The Bankruptcy Code allows debtors to exempt certain property from being turned over into the bankruptcy estate where creditors can reach it. “Exemptions” are available that allow debtors to, in most cases, keep things that are essential to starting over–a homestead, important personal property, tools necessary to do one’s job, etc. But to be fair to creditors, these exemptions are limited and often litigated as creditors and trustees try to obtain a maximum return. If you are facing bankruptcy, it is very important to know what you’ll be able to keep as you start planning your new post-bankruptcy life.
One issue that has been litigated with increasing frequency is whether a debtor who inherits an IRA after the debtor’s parent dies is allowed to exempt the parent’s IRA as “retirement funds.” In a recent case, the Seventh Circuit Court of Appeals decided this issue in direct conflict with the Fifth Circuit Court of Appeals. And while the bankruptcy bar awaits guidance from the Supreme Court, practitioners in other Circuits face uncertainty and unpredictability.
The Fifth Circuit, in In re Chilton, 674 F.3d 486 (2012) ruled that inherited IRAs are exempt property under Bankruptcy Code provisions 11 U.S.C. § 522(b)(3)(C) and (d)(12), which exempt retirement funds from creditors. The Seventh Circuit ruled just the opposite, in In re Clark, 2013 WL 1729600 (2013). Writing for the Seventh Circuit panel, Judge Easterbrook made the distinction between the IRA as a retirement account for the decedent, and the IRA as a more general fund for the beneficiary of the inheritance. Judge Easterbrook wrote, “Inherited IRAs represent an opportunity for current consumption, not a fund of retirement savings.” Clark at *3. In contrast, Judge Stewart, writing for the Fifth Circuit, stated: “…the defining characteristic of “retirement funds” is the purpose they are ‘set apart’ for, not what happens after they are “set apart.” Chilton at 489.
In short, the Fifth Circuit looked to the purpose of the fund at its origin, and the Seventh Circuit looked to the current nature of the fund after it had passed to the beneficiary of the inheritance. The result is consequential. In the Fifth Circuit, for now, a debtor in bankruptcy needn’t part with the money in an inherited IRA. But in the Seventh Circuit, funds can be taken out of the inherited IRA and put into the bankruptcy estate to be distributed to creditors.
If you are facing bankruptcy and live outside the Fifth or Seventh Circuit, and you happen to have inherited an IRA, it is critical to enlist the aid of an attorney who can work with you to press the court to follow Chilton rather than Clark. Even if you haven’t inherited an IRA, bankruptcy is a complicated process based on a very dense legal code. Issues turning on very fine points like this one come up all the time. A good bankruptcy attorney, with extensive knowledge of the Bankruptcy Code, can help you build a “fresh start” that will last.