In line with one of bankruptcy’s vaunted goals, providing debtors with a fresh start, the Bankruptcy Code specifically authorizes debtors to exempt retirement funds held in a compliant retirement account from property of the estate. When done properly, investing funds in a compliant profit-sharing plan can be a powerful financial-planning and asset-protection tool, putting almost unlimited funds out of creditors’ reach. However, for the funds to be exempt from the bankruptcy estate, the fund or account in which they are held must be properly maintained pursuant to applicable Federal tax laws. Otherwise, a bankruptcy trustee may demand turnover of the assets and distribute them for the benefit of a debtor’s creditors. Daniels v. Agin, 736 F.3d 70 (1st Cir. 2013), a recent decision from the U.S. Court of Appeals for the First Circuit, underscores the grave consequences for a debtor whose retirement funds are invested in a non-conforming plan or account.
A profit-sharing plan is a savings plan designed to “enable employees or their beneficiaries to participate in the profits of the employer’s trade or business.”[1] Properly established and maintained profit-sharing plans are exempt from the bankruptcy estate.[2] While there are no limits as to what types of investments a plan may make, a plan is prohibited from engaging in certain prohibited transactions with disqualified persons, essentially a plan’s fiduciaries and their relatives. Prohibited transactions include: (1) the sale or lease of property between the plan and a disqualified person; (2) lending money between the plan and a disqualified person; (3) exchanging goods or services between the plan and a disqualified person; (4) transferring the plan’s assets or income to a disqualified person; or (5) self-dealing between the plan and its fiduciary.[3]
William M. Daniels (the debtor) was the trustee, administrator, employer and sole participant in a company profit-sharing plan. While administering the plan, the debtor caused it to (1) accept the debtor’s spouse’s beneficial interest in a realty trust, (2) accept funds from a joint account held by the debtor and his then-deceased uncle, (3) loan money to the debtor’s son, (4) lease, sell and gift property to the debtor’s son, (5) accept a loan from the debtor’s spouse’s trust, (6) loan money and sell property to a disqualified person, and (7) invest in a company in which the debtor personally invested. The chapter 7 trustee asserted that these transactions were prohibited and beyond the limitations established in the Internal Revenue Code, thus, the trustee posited, disqualifying the plan’s exempt status under the Bankruptcy Code. The trustee objected to the claimed exemptions and initiated an adversary proceeding seeking turnover of the plan’s assets. Based on the discussed transactions, the First Circuit Court of Appeals determined that the debtor failed to maintain the plan in substantial compliance with the Internal Revenue Code. This ruling meant that the plan’s assets, worth approximately $440,000, were not exempt from the debtor’s bankruptcy estate and were available to satisfy creditors’ claims.
Daniels v. Agin serves as a cautionary tale to debtors and their counsel and underscores both the (1) potential unlimited asset protection that a profit-sharing plan may afford individuals and (2) importance of conducting due diligence to ensure that an individual’s profit-sharing plan is properly created and maintained prior to filing a bankruptcy petition. Conversely, the decision reminds bankruptcy trustees that just because a profit-sharing plan or retirement account appears facially compliant on the petition date, pre-petition violations may cause the fund or account to lost its potential exempt status and yield a potentially substantial source of recovery for the estate.
[1] Daniels v. Agin (In re Daniels), 452 B.R. 335 (Bankr. D. Mass. 2011). The author served as judicial law clerk to Hon. William C. Hillman of the Bankruptcy Court of the District of Massachusetts, who decided Daniels v. Agin at the trial level following the author’s tenure as his law clerk.
[2] 11 U.S.C. § 522(b)(3)(C).
[3] 26 U.S.C. § 4975(c).