Eighth Circuit Has No Per Se Rule Disallowing Exemptions for IRAs in Divorce

In substance, the Bankruptcy Appellate Panel for the Eighth Circuit ruled in October 2018 that an individual retirement account or a 401(k) transferred in divorce can never be an exempt asset under Section 522(b)(3)(C). By extension, the BAP’s opinion implied that an IRA or 401(k) inherited from a deceased spouse cannot be exempt property.

Although the Eighth Circuit upheld the BAP on February 7 by ruling that the debtor was not entitled to an exemption, the circuit based its ruling on the peculiar facts of the case. The appeals court may have been unwilling to adopt a per se rule disallowing exemptions for retirement accounts transferred in divorce. The opinion leaves open the possibility that retirement accounts conveyed in a divorce might be exempt in normal cases.

The Atypical Facts

The facts did not engender sympathy for the debtor-husband, who was claiming the exemption.

In divorce proceedings, the husband was awarded his wife’s 401(k) and half of her IRA. The divorce court directed the husband to submit a qualified domestic relations order, or QDRO, but he refused.

Two months later, the divorce court granted the husband’s counsel a lien for attorneys’ fees and explicitly allowed the firm to recover the unpaid fees from the husband’s interest in his former wife’s IRA and 401(k). The fees secured by the lien were larger than the funds in the retirement accounts.

Six months later, the husband filed a chapter 7 petition and claimed an exemption under Section 522(b)(3)(C) covering the IRA and the 401(k). The law firm objected to the claimed exemption.

The bankruptcy court sustained the objection and was upheld in the BAP. Lerbakken v. Sieloff & Assoc. PA (In re Lerbakken), 590 B.R. 895 (B.A.P. 8th Cir. 2018). To read ABI’s report on the BAP opinion, click here.

The case, of course, turned on Clark v. Rameker, 573 U.S. 122 (2014), where the Supreme Court ruled that a retirement account inherited from the debtor’s mother was not exempt under Section 522(b)(3)(C). That section exempts “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation” under specified provisions in the Internal Revenue Code.

Writing for the high court in Clark, Justice Sotomayor employed what she called an “objective” analysis of the “legal characteristics” of an individual retirement account, not whether the bankrupt individual planned to use the IRA for retirement. Saying that the court must analyze the “text and purpose” of the exemption statute, she held that the inherited IRA was not exempt, even though it fell within the enumerated sections of the tax code listed in Section 522(b)(3)(C).

In the husband’s bankruptcy, the BAP concluded that the retirement accounts were not “retirement funds” as required by Section 522(a)(3). Relying on Clark, the BAP said that an exemption only applies to the person who created and contributed to the retirement accounts.

The Circuit Takes a Different Approach

For the appeals court, Circuit Judge Duane Benton took a different approach by focusing on the peculiar facts of the case. As a general proposition, however, he agreed with the BAP that retirement accounts must represent “retirement funds” under Section 522(b)(3)(C) even if they qualify under the IRS Code.

Clark, he said, defined “retirement funds” to be “sums of money set aside for the day an individual stops working.” Clark, 537 U.S. 131. According to Clark, he said, the characteristics of retirement funds are: (1) the ability to make additional contributions; (2) the lack of an obligation to make withdrawals; and (3) the imposition of a penalty for making withdrawals before age 59 ½.

To shoehorn his IRA within the definition of “retirement funds,” the debtor alluded to Section 408(d)(6) of the IRS Code, which provides that an IRA transferred in divorce is treated as an IRA of the recipient, not of the donor.

To evaluate the exemption for the IRA, Judge Benton focused on the facts as of the filing date. At that time, he said, the debtor’s interest in the IRA was based on an “unperformed condition,” namely, that it had not been transferred into an IRA in the debtor’s own name. The judge then proceeded to examine whether the debtor’s conditional interest in the IRA satisfied the legal characteristics of “retirement funds.”

First, the debtor could not make additional contributions. Second, state law (i.e., the order of the divorce court) obligated the debtor to make withdrawals in payment of his counsel fees. Third, the IRA had not been transferred by the filing date. Thus, the IRA had not yet qualified for treatment as retirement funds transferred as an incidence of divorce under Section 408(d)(6) of the IRS Code.

Judge Benton therefore ruled that the IRA did not qualify as an exempt asset.

Turning to the 401(k), Judge Benton said that the debtor did not have access to the account without a QDRO. He cited Eighth Circuit authority for the proposition that the debtor could not enforce his interest in the account until obtaining a QDRO.

In the absence of a QDRO, state law determined the debtor’s interest in the 401(k) as of the filing date. Under state law, the debtor’s interest at that time was a debt owed to his attorneys.

The debtor’s interest in the 401(k) therefore did not satisfy the Clark standards, Judge Benton said. First, the debtor could not make additional contributions. Second, he was obligated to withdraw the funds in payment of legal fees, and, third, he could not make withdrawals on the filing date without a QDRO.

Observations

The opinion by the Eighth Circuit does not sweep as broadly as the BAP’s. Significantly, the opinion leaves the door open for contending in a later case that an IRA conveyed in divorce can be exempt if the transfer into a new IRA was completed by the filing date. It is less clear from the opinion whether a 401(k) taken in divorce can ever be exempt. The circuit’s opinion might also be read to imply that an IRA inherited from a deceased spouse may sometimes qualify for exemption.

Although the circuit court ruled on more narrow grounds, it is still possible that the appeals court eventually might adopt the BAP’s broad proscription against an exemption. Or, it is possible the appeals court might depart from the BAP and uphold an exemption in retirement accounts transferred in divorce.

To be sure, this writer’s interpretation of the circuit’s opinion is not free from doubt. It may be best to confine the opinion to the peculiar facts of the case, where the debtor was attempting to deprive his counsel of attorneys’ fees even after the divorce court had granted the lawyers a lien. It may also be fair to view the opinion as rejecting a per se rule, at least for the time being.

There are policy reasons in a “normal” case for upholding an exemption for retirement accounts transferred in divorce. Especially in the instance of a nonworking bankrupt spouse, retirement accounts may be the only sustenance in old age aside from meager Social Security benefits. If spouses decided to use their income to create retirement accounts for their retirement, perhaps an account transferred in divorce will fall within the rubric of “retirement funds.”

A blanket disallowance of exemptions could have devastating results depending on how a divorce settlement was structured. Sometimes, a divorce court will convey retirement accounts in lieu of support and maintenance. If retirement accounts are not exempt, a divorced spouse could end up in bankruptcy with nothing from his or her former spouse.

The circuit court’s focus on state law is a bright spot in terms of leaving a glimmer of hope in later cases. Even taking Clark at face value, perhaps the debtor’s interest under state law would be different if the transferred retirement account was held by a spouse than if the retirement account was held by a non-spousal relative. A spouse might have an inchoate interest in a husband or wife’s retirement account under state law that does not exist with respect to an inheritance from a non-spouse. It may also matter if the state is a community property state.

This writer believes that Congress should revisit the issue by considering amendments to the Bankruptcy Code or the IRS Code. Otherwise, a divorced or surviving spouse might be left out in the cold. We doubt that Congress intended to impoverish divorced or surviving spouses in bankruptcy.