Loan Transaction Costs IRA its Bankruptcy Exemption

A recent case illustrates a common problem with IRAs when their participants declare bankruptcy.

Generally, IRAs are exempt assets in bankruptcy proceedings, and are thus beyond the reach of the bankrupt individual’s creditors. This exemption in the Bankruptcy Code is tied to the tax-exempt status of the IRA. 11 USC §522(d)(12) provides an exemption to “[r]etirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section ... 408 ... of the Internal Revenue Code of 1986.”

Code §497(c)(1) prohibits loan transactions between an IRA and a disqualified person. If an IRA engages in a prohibited transaction with the beneficiary or creator of the account, the IRA will lose its exempt status pursuant to Code §408(e)(2).

While the IRS has an interest in policing the prohibited transaction rules, in my experience I have seen these issues come up more in bankruptcy proceedings than in tax audits and controversies. This is because the bankruptcy trustee is always on the lookout to void the exempt status of IRA accounts. If the trustee can convince the bankruptcy court that a prohibited transaction occurred in regard to the IRA like a loan transaction, they then argue that the IRA is no longer exempt under Code §408(e)(2) and thus there is no bankruptcy exemption. I have seen this in regard to straight loan transactions, and even in circumstances when the participant receives a distribution from an IRA and rolls it back into the same IRA within the tax-free 60 day rollover period – the trustee argues that this is in fact a loan, even though such a rollover transaction back to the same IRA is expressly authorized in the Code.

In the case at issue, the IRA was an investor in a partnership. As what typically happens in these cases, the parties fight it out in bankruptcy court as to whether a transaction was a “loan.” In the instant case, the partnership itself went through bankruptcy, in addition to the IRA participant. In the filings of the partnership, it submitted schedules showing the IRA as an unsecured creditor – the bankruptcy court relied on those schedules to find that the IRA had made a loan to the partnership and thus the IRA lost its exempt status.

Kellerman v. Rice,116 AFTR 2d 2015-6133 (DC AR)