Inherited IRA’s May Be Exempt in Bankruptcy, Depending on from Whom the IRA was Inherited

One of the greatest areas of controversy regarding the exemption for individual retirement accounts (IRAs) is the inherited IRA. If a would-be bankruptcy debtor has inherited an IRA from a relative, as often happens between spouses and parents and children, can he or she exempt that IRA as if it were an IRA that they had funded? Or are inherited IRAs treated as most other inherited assets, subject to nominal, if any, exemption in bankruptcy? Whether a bankruptcy debtor may exempt an inherited IRA as one’s own IRA depends on whom they inherited the account from and what they did with the IRA upon inheritance.

Most IRAs are exempt when one files bankruptcy, meaning the retirement account is protected against creditor claims when a bankruptcy is filed. Stated otherwise, the debtor may file bankruptcy, receive a discharge of debts and keep their IRA account intact. This exemption for IRAs includes employer-sponsored IRAs, such as simplified employee pension plans (SEPs) and simple IRAs, as well as IRAs rolled over from 401(k), 403(b), or 457 (government) plans. While the exemption is currently limited at $1,171,650, the IRA exemption nevertheless applies whether the debtor elects the federal or Minnesota state exemption scheme. However a debtor should not to assume that all IRAs within the dollar limits are always exempt in bankruptcy, particularly if that IRA account was set up by someone other than themselves. In other words if the IRA is a result of a transfer, that IRA account may not be exempt in bankruptcy.

The availability of the exemption for an inherited IRA lies in from whom the IRA was inherited.  In 2014, the U.S. Supreme Court issued a decision in Clark v Rameker holding that inherited IRAs generally may not be exempted via the IRA exemptions provided under the Bankruptcy Code or state statute. However the case carved out an exception for IRAs inherited by a spouse. In essence, Clark v Rameker holds that while inherited IRAs are not exempt, there is a singular exemption for an IRA is inherited by one’s spouse (i.e., the bankruptcy debtor is the surviving spouse) provided the surviving spouse treats that IRA as if it is their own IRA by rolling it over directly into their own IRA. The rollover is critical to claiming the exemption, since by rolling over the IRA into one’s own account, the surviving spouse demarcates the IRA as one’s own IRA (i.e., not as an inherited IRA) under both the Internal Revenue Code and the Bankruptcy Code.

The opinion of Clark v Rameker, outlines the facts for creating the exception to the rule otherwise that inherited IRA’s cannot be exempted as one’s own IRA:

The third type of account relevant here is an inherited IRA. An inherited IRA is a traditional or Roth IRA that has been inherited after its owner’s death. See §§ 408(d)(3)(C)(ii), 408A(a). If the heir is the owner’s spouse, as is often the case, the spouse has a choice: He or she may “roll over” the IRA funds into his or her own IRA, or he or she may keep the IRA as an inherited IRA (subject to the rules discussed below). See Internal Revenue Service, Publication 590: Individual Retirement Arrangements (IRAs), p. 18 (Jan. 5, 2014). When anyone other than the owner’s spouse inherits the IRA, he or she may not roll over the funds; the only option is to hold the IRA as an inherited account. Clark v. Rameker, 134 S. Ct. 2242, 2245, 189 L. Ed. 2d 157 (2014)

This reasoning in Clark v. Rameker aligns with the singular exception created in the Internal Revenue Code, which treats an IRA as “inherited” only when the individual acquired such account by reason of the death of another individual, and such individual was not the surviving spouse of such other individual. See 26 U.S.C. § 408(d)(3)(C)(ii). See also Internal Revenue Service, Publication 590: Individual Retirement Arrangements (IRAs), p. 18 (Jan. 5, 2014)(“If you inherit a traditional IRA from your spouse… you can… [t]reat it as your own by rolling it over into your IRA.”  This IRC reference was the exclusive basis for reasoning used by the Supreme Court in deciding against the debtor’s claimed exemption in Clark v Rameker, since the debtor in that case was not the surviving spouse of the IRA’s owner and therefore could not exempt the IRA no matter what she did.

Pros and Cons of Small Business Chapter 7 Bankruptcy

It happens to many small businesses: Operations and sales start slumping. While a few creditors offer forbearance of payments of even short-term extensions of credit, it’s just not enough. Perhaps the business grew too quickly for the principals to manage operational demands under an increased debt load. Perhaps the business model wrongly assumes receivables will be timely paid to keep the cash flowing as needed for debt service. Or the taxing authority has come knocking for prior unpaid withholding or sales taxes. Or a lawsuit naming the business as defendant has forced the principals to confront the business’s future viability considering the costs of litigation defense, the possibility of a significant monetary judgment or repossession of critical equipment.

There are many precursors to business insolvency, with some factors beyond the control of even the most assiduous of small business owners. It’s always a difficult decision for an owner who has invested their time and personal savings into a business to wind-down operations and mitigate the consequences of unpaid debts.

Unfortunately, the closing of a small business often means the owner should file a personal bankruptcy proceeding to discharge their personal guarantees. But should the business also file a chapter 7 bankruptcy? The answer may be surprising.

Pros of Small Business Chapter 7 Bankruptcy:

  • Orderly liquidation of business assets. A trustee is assigned to liquidate the remaining assets of the business and use the net proceeds after the trustee takes their cut to pay down the liabilities in order of priority. This process is especially useful if the business’s principals are unable to liquidate the business assets and there is significant inventory to be dealt with.
  • A trustee takes over all existing operations. A trustee will immediately be assigned to manage and control the remaining operations of the business, taking the burden off the business principals and owners to terminate employees and leases, surrender collateral to secured creditors, manage bank accounts, etc. This can also be viewed as a negative consequence by some small business owners (see below).

Cons of Small Business Chapter 7 Bankruptcy:

  • A trustee takes over all aspects of the business. A trustee will take over management and control of the business and the principals will be sidelined to simply watch and see what happens. This can be beneficial if the business is still operational and the principals no longer wish to manage the business through its winding-down, or can be viewed as a negative if the principals still have an interest in operating the business for some longer period of time and do not wish to see the business ‘go dark’ under the management of a bankruptcy trustee.
  • No discharge of debts. Unlike a personal chapter 7 bankruptcy, there is no discharge of debts at the end of a business chapter 7 proceeding. At the end of chapter 7, the business will simply be defunct, dead in the water and typically still owing liabilities.
  • Assets will be liquidated. Since a trustee will be liquidating the business assets, those assets are likely to be sold as quickly and cheaply as possible. This could mean a loss of equity in the assets. A fire sale by the trustee may also mean that personally guaranteed debts may not be minimized if assets are sold for less than the owner could potentially sell for herself/himself to pay down the debts.
  • Attorney and filing fees for chapter 7 can run into the thousands of dollars.
  • Personal exposure and risk to the business principals/owners. There is always a chance that a business chapter 7 filing will result in exposure to avoidance actions brought by the trustee against the owners and/or principals of the business. One common example is when the trustee sues a principal to recover for the benefit of the business creditors any distributions or draws taken by that principal in the one year prior to filing. For this reason, it is imperative that the business hire an experienced business bankruptcy attorney who can evaluate the risk and exposure faced by the principals/owners if the business files chapter 7 and their possible defenses. Note that if a principal is sued by the trustee, the principal must hire separate counsel since the business bankruptcy attorney cannot represent both the business and its principals.

There are other, non-bankruptcy issues surrounding the winding down of failed business enterprise which may require the services of a business attorney. Even if chapter 7 does not make sense for the business—as often it does not make sense especially for smaller businesses—the small business owner may still wish to be advised on how to resolve personally guaranteed debts, personally assessed taxes unpaid by the business, as well as how to navigate and avoid potential issues of alter ego should the owner wish to form a new business entity that is free and clear of any of the failed business’s debts.

For the small business owner that contacts my firm for assistance, I suggest the following steps:

  • The business owner should evaluate what business debts are personally guaranteed and/or may be personally assessed. Personally owed debts may include business credit cards, leases and personally guaranteed SBA loans as well as unpaid business taxes. The answer to this may lead the owner to seek out personal bankruptcy representation.
  • Should the owners attempt to wind down the business themselves, with or without the assistance of an attorney, or does chapter 7 bankruptcy offer any significant benefits in spite of the fact that there is no discharge of debts.
  • Have an attorney evaluate the exposure and risk to the business owner, either in the event that a business bankruptcy is filed or under certain circumstances, for example the owner took possession and control of business assets and funds to the detriment of its creditors.

Qualifying for a Mortgage After (or During) Bankruptcy: What does it take and how long will I wait?

It should come as no surprise that qualifying for a new mortgage or refinance with a bankruptcy in your credit history is likely to complicate the process. But while a bankruptcy will stay on your credit report for a full ten years after your case is complete—which means up to fifteen years total for individuals who file chapter 13—bankruptcy takes its biggest bite on creditworthiness in the first two to three years after the case is first filed.

The good news is that bankruptcy does not automatically disqualify a borrower from obtaining a new mortgage or refinance, and the most available product after bankruptcy usually will be a FHA mortgage (as opposed to a conventional mortgage). The bad news is that eligibility for a mortgage will take time, usually two years or more with reestablished good credit.

As a general rule of thumb, a debtor can qualify for a FHA mortgage or refinance either during or after bankruptcy under the following guidelines:

Chapter 7 or Chapter 11 Bankruptcy: At least 2 years have elapsed since the date of discharge of debts and the borrower has a credit score at least a 640. In most chapter 7 cases, the discharge of debts is entered three months after the case is initially filed.

Chapter 13 Bankruptcy: At least 1 year has elapsed since the filing chapter 13 bankruptcy and the borrower has a credit score at least 640, plus the borrower can provide lender with a verified perfect payment history of their chapter 13 plan. Some lenders may also require the chapter 13 trustee’s approval of the loan.

Note: For conventional mortgage products and rural housing, the typical waiting period may be extended to three years or more and often with higher credit score requirements.

If you filed a chapter 7 or chapter 13 bankruptcy, or you are still in an active chapter 13 plan, work now to increase your odds to qualify for a mortgage product by doing the following:

  • Reestablish a good credit score now. The better the credit score, the lower the interest rate will be. While it won’t happen quickly, you do not have to wait until bankruptcy is complete to work on improving a credit score. Pay your mortgage, student loans, vehicle leases and auto loans on time each month so that you get the benefit of the positive credit reporting. If your student loan is in default, get it back on track with an Income Based Repayment program. Don’t let new debts and bills fall into collection. Check your credit report annually for errors that negatively impact your score. And consider a secured credit card or even a traditional credit card with a low limit—use it sparingly, keep the balance below 10% of the available credit limit or, better yet, pay it off in full each month. If your bankruptcy case is already complete, have the state court docket updated to show any pre-bankruptcy judgments were discharged in your bankruptcy case.
  • If you are in an active chapter 13 plan, ensure your monthly chapter 13 plan payment is made on time each month. For debtors with cash flow problems, this may mean that you set up your monthly plan payments to be automatically deducted from your wages or otherwise have your plan payment made via ACH deduction from a bank account.
  • Be prepared and be patient. At a minimum, most borrowers will have to wait at least two years from when a bankruptcy was filed before they will qualify for a FHA mortgage.

As an alternative for homeowners looking to refinance an existing mortgage who do not meet the underwriting requirements for a traditional refinance, the Making Home Affordable program administered through the federal government may offer a better solution. Obtaining a HAMP or HARP mortgage modification essentially provides the benefit of a cost-free refinance with market interest rates however without the strict credit score/financial history requirements or mandatory post-bankruptcy waiting periods. These programs will not exist indefinitely and as of the date of this post, Congress has approved the Making Home Affordable program only through the end of 2016. To identify the various programs and requirements for a mortgage modification, see the official HUD website on Making Home Affordable.

DISCLOSURE: This information is intended as a general guideline only and is not meant to be a definitive response on any individual qualification for a mortgage or refinance. Mortgage underwriting standards change frequently and only a banking institution or loan officer can determine eligibility for mortgage products.

While Bankruptcy Are Filings Down, Debts Are Still Up—Get Practical Bankruptcy Advice Sooner Rather than Later

According to the National Association of Consumer Bankruptcy Attorneys, the number of people filing for bankruptcy in 2011 has dropped as much as 30% in some states from 2010 to 2011. It speculates that the reason for the decline in bankruptcy filings may be due to the costs associated with filing bankruptcy, rather than an indication that people’s debts are becoming more manageable. In Minnesota, the court filing fee for Chapter 7 is $299 and the attorney fees in a typical Chapter 7 case can average $2,000 or more for a simple case. While bankruptcy attorneys should be especially busy in a downturned economy, their clients are scrambling to make mortgage payments and keep up with routine living expenses on less and less income, thus leaving little funds available for the expense of actually getting long term debt relief in bankruptcy.

However, the irony that bankruptcy is expensive shouldn’t prevent people from understanding the ramifications of debt and getting educated on their bankruptcy and non-bankruptcy options. Most bankruptcy attorneys offer free, no commitment consultations where they will review your circumstances and give you guidance and advice on how much bankruptcy will cost and how long it will take. The last thing most people want is to find themselves in the midst of a foreclosure, lawsuit or facing a wage garnishment and not having known there were options available to them to avoid that sticky situation, including filing for bankruptcy and sometimes options that don’t even involve bankruptcy. It never hurts to educate yourself especially if the only cost is a couple hours of your time.

Debts don’t go away fast, as we all know. Bankruptcy is your constitutional right to  relief from struggling under debt. Find out what bankruptcy can do for you and then decide if it makes sense.

Wartchow Law Office represents consumer and business bankruptcy clients in Chapter 7, Chapter 13 and Chapter 11 business reorganizations.