Clark v. Rameker: Inherited IRAs Are Not Protected from Creditors

Clients who have named a child or spouse with financial problems as the direct beneficiary of an IRA should reconsider their beneficiary designation. In June, the Supreme Court unanimously held that IRAs inherited from the original owner are not exempt from the bankruptcy estate. This means that if a holder of an inherited IRA files for bankruptcy, funds from the IRA will be accessible by a bankruptcy trustee to satisfy unpaid debts.

Section 522 of the Bankruptcy Code states that “an individual debtor may exempt from property of the estate [. . .] retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code.” This includes both traditional IRAs (section 408) and Roth IRAs (section 408A). Thus, when Heidi Heffron-Clark filed for Chapter 7 bankruptcy, she listed an IRA inherited from her mother as exempt property. The bankruptcy trustee disagreed, as did the Seventh Circuit. This case, Clark v. Rameker, affirmed the Seventh Circuit’s holding and resolved a conflict with the Fifth Circuit’s decision in In re Chilton, which had held that inherited IRAs did constitute exempt retirement funds.

The Court distinguished inherited IRAs from traditional and Roth IRAs in three ways. First, the holder of an inherited IRA cannot invest additional money in the account. Second, holders of inherited IRAs MUST withdraw from the accounts, regardless of proximity to retirement. Last, a person who holds an inherited IRA may withdraw all the funds at any time, without penalty.

The Court explained that the purpose of exempting retirement funds from the bankruptcy estate is to allow the debtor to meet his or her essential needs during retirement. Because funds in a traditional or Roth IRA are only accessible without penalty when the account holder reaches approximate retirement age, exempting these accounts comports with that goal. On the other hand, the holder of an inherited IRA can (and in fact, must) withdraw the funds over a prescribed time period, even if the person is many years away from retirement. As Justice Sotomayor pointed out,

“nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after her bankruptcy proceedings are complete. Allowing that kind of exemption would convert the Bankruptcy Code’s purposes of preserving debtors’ ability to meet their basic needs and ensuring that they have a ‘fresh start,’ into a ‘free pass.’”

This ruling means that inherited IRA funds are accessible by creditors in the bankruptcy context. Therefore, estate planners should counsel their clients with substantial retirement accounts not to name individuals with a history of insolvency in their beneficiary designations. A better option is to create a trust, which can be impenetrable to most types of creditors. Trusts can hold a variety of assets and can be designated as IRA beneficiaries. In addition, distributions to beneficiaries can be limited to prevent trust assets from being consumed by the creditors of an insolvent trust beneficiary. 

Lessons Learned, From Someone Else's Mistake

Tax Court Memorandum 2014-15, issued on January 27, 2014, is another example of a taxpayers falling far short of the requirements to substantiate a charitable income tax deduction resulting in the deduction for their contribution of a 34 unit apartment building to charity being denied.  The taxpayers, a doctor and his wife, provided false information and submitted appraisals that did not meet the substantive requirements of Code section 170 for submitting a “qualified appraisal,” hiring a qualified appraiser, and the appraisal summary requirements.  The result….well,  the judge absolutely denied their claim for a deduction, and that, readers, is the loss of real money.

When making large donations, failing to meet these requirements (which often occurs by failing to invest the time and money in hiring appropriate appraisers and advisors) can result in the loss of major dollars!  Unless a donation can be readily valued, such as donations of cash and marketable securities, it’s important to know the type of documentation you need.

Under Treasury Regulation 1.170A-13(c)(2), a taxpayer who claims a charitable deduction in excess of $5,000 must (1) obtain a qualified appraisal for the property contributed; (2) attach a fully completed appraisal summary to his tax return; and (3) maintain records containing certain information (as required by paragraph (b)(2)(ii) 13 of this section).

So, what is a qualified appraisal?  Under the regulations, a qualified appraisal must be made not more than 60 days before the gift and no later than the due date of the income tax return, it must be signed by a “qualified appraiser” (more on that later), must not involved a prohibited appraisal fee, and must include the following information:

1. A description of the property in sufficient detail for a person who is not generally familiar with the type of property to ascertain that the property that was appraised is the property that was (or will be) contributed;

2.  In the case of tangible property, the physical condition of the property;

3. The date (or expected date) of contribution to the charity;

4. The terms of any agreement or understanding entered into that relates to the use, sale, or other disposition of the property contributed;

5. The name, address, and the identifying number of the qualified appraiser;

6. The qualifications of the qualified appraiser who signs the appraisal, including the appraiser's background, experience, education, and membership, if any, in professional appraisal associations;

7.  A statement that the appraisal was prepared for income tax purposes;

8. The date (or dates) on which the property was appraised;

9. The appraised fair market value of the property on the date (or expected date) of contribution;

10. The method of valuation used to determine the fair market value; and

11. The specific basis for the valuation. (See Regulation §1.170A-13(c)(3)(ii))

A “qualified appraiser” is an individual who (1) “has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations….; (2) “regularly performs appraisals for which the individual receives compensation”; and (3) “meets such other requirements as may be prescribed by the [Treasury] Secretary in regulations or other guidance.”  Additionally, the individual must demonstrate verifiable education and experience in valuing the type of property subject to the appraisal and not be prohibited from practicing before the IRS.  (See IRC § 170(f)(11)(E)(ii) & (iii)).

Under the regulations, a qualified appraiser is an individual who includes on the appraisal summary a declaration that: (1) the individual either holds himself out to the public as an appraiser or performs appraisals regularly; (2) the appraiser is qualified to make appraisals of the type of property being valued; (3) the appraiser is not excluded from qualifying as a qualified appraiser under section 1.170A-13(c)(5)(iv), Income Tax Regs.; 21 and (4) the appraiser understands that an intentionally false or fraudulent overstatement of the value of the property described in the qualified appraisal or appraisal summary may subject the appraiser to a civil penalty under section 6701 for aiding and abetting an understatement of tax liability.  (See Regulation  § 1.170A-13(c)(5)(i)).

The rules surrounding charitable contributions and the required receipts and verifications needed for different types of property are complex.  It is important to discuss these issues with your CPA (because I assure you, they are not all covered here!) and ensure you take the steps necessary to protect the deduction you wish to take in April!