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Asset Protection and Individual Retirement Accounts Part II | Bankruptcy Protection for IRAs Not Absolute

by Douglas Lineberry on January 22, 2010

In the previous post I discussed statutory protections that apply to IRAs.  One obvious point is that an account is only protected as long is it actually is an IRA.  This post discusses what can happen when the IRA owner engages in certain conduct known as “prohibited transactions.”

What is a prohibited transaction?  It’s a tax rule.  It’s all in Sections 408 and 4975 of the Internal Revenue Code, but I’m going to try to save you some of the pain of reading code citations and give this to you in English.  Here we go ….

  • Certain transactions with an IRA account are prohibited if a “disqualified person” is involved in the transaction.
  • Disqualified persons include the IRA owner, certain family members any other fiduciary and certain service providers (among others).
  • Prohibited transactions include the following:
    • a transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person;
    • any act of a fiduciary by which plan income or assets are used for his or her own interest;
    • the receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets;
    • the sale, exchange, or lease of property between a plan and a disqualified person;
    • lending money or extending credit between a plan and a disqualified person; and
    • furnishing goods, services, or facilities between a plan and a disqualified person.
  • If a prohibited transaction occurs, the IRA ceases to be an IRA as of the first day of the tax year in which the transaction took place.

We often see the potential for prohibited transactions with self-directed IRAs investing in real estate or closely held entities.  However, it is possible to create a prohibited transaction with traditional IRA accounts invested in stocks, bonds and mutual funds.

TIP!  Prohibited transactions can occur with any kind of IRA account owning any category of investment.

In a recent bankruptcy case, In re Ernest W. Willis, Debtor, Case No. 07-11010-BKC-PGH, a creditor argued that the debtor’s IRAs should not be exempt and should be part of the bankruptcy estate available for distribution to creditors.  The creditors assertion was based on transactions that had taken place over ten years before the bankruptcy case was filed.  In the first transaction (in 1993) the debtor withdrew funds from IRA #1, used the funds to acquire an investment and returned the funds to IRA #1 64 days later.  In the second series of transactions (in 1997) the debtor swapped checks between IRA #1 and his regular brokerage account.  The debtor also had separate IRAs #2 and #3, both of which contained funds deposited in rollover transfers from IRA #1.

The court noted that the debtor (as the account owner) was a disqualified person.  Analyzing the two transactions, the court first concluded that the first transaction amounted to transferring funds from IRA #1 to the debtor, which was a prohibited transaction and the IRA therefore ceased to be an IRA in 1993.  The court also said that the transaction could also be viewed as borrowing from IRA #1, which was also a prohibited transaction.

As to the second transaction in 1997, the court found that the check swapping scheme also amounted to borrowing from IRA #1 and that the IRA therefore ceased to be an IRA as of the beginning of 1997 (which would only make a difference if the court was incorrect about the transactions in 1993).

Having concluded that the prohibited transactions occurred and that IRA #1 was not an exempt asset, the court also found that a certain portion of IRAs #2 and #3 were not exempt because those accounts held amounts rolled over from IRA #1.

I doubt that the IRS would agree that the 1993 transactions were actually prohibited transactions, but they were clearly in violation of the 60 day rollover rules and therefore subject to an excise tax.  I think, however, that the court was correct in its conclusion as to the 1997 transactions.

So what does this mean to you?  Simply this.  Creditors are becoming more aggressive when it comes to exemptions.  They will not hesitate to dig up any available information to attempt to convince a court that exemption claims should be set aside.  While self-directed IRAs are a more likely arena for prohibited transactions, they can occur in any circumstance.  If you are considering any kind of transaction with your IRA other than buying and selling in traditional stocks, bonds and mutual funds you need to consider consulting with counsel experienced and knowledgeable in this area.

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