The Court of Appeals for the Eleventh Circuit affirmed a district court decision (which had previously affirmed a bankruptcy court) that all funds in two of an individual’s IRAs and part of a third were not exempt from his bankruptcy estate under Bankruptcy Code (USC Title 11) section 522(b)(3)(C). These IRAs were held to be not exempt because the individual had engaged in prohibited transactions under IRC § 4975.
In March 1993, Ernest Willis transferred funds from his existing IRA into a self-directed IRA at Merrill Lynch. Willis was informed that transactions such as borrowing from his IRA could cause it to lose its tax-deferred status. Later that year, Willis authorized a transfer of $700,000 from his Merrill Lynch IRA to his personal account. He subsequently used these funds to acquire a mortgage on real property. In February 1994 Willis repaid the $700,000 he had borrowed from the Merrill Lynch IRA.
Three years later, Willis used funds from his IRA to cover negative balances in a joint brokerage account with his wife by using a series of check-swapping transactions. In each instance, he returned funds to the IRA within 60 days in an effort to avoid income tax on the IRA distributions. Willis also had two additional IRAs he had funded fully or partially with monies from the Merrill Lynch IRA.
In February 2007, Willis filed for protection under Chapter 7 of the Bankruptcy Code, claiming a bankruptcy exemption for his three IRAs, which totaled $1,499,000. On a challenge by the trustee and a creditor, the bankruptcy court determined that since Willis was managing the investments of his self-directed IRA, he was considered a “disqualified person,” and as such, he engaged in two prohibited transactions: (1) Income or assets of the plan had been transferred to him or made available for his use or benefit (section 4975(c)(1)(D)), and (2) he borrowed money from the plan (section 4975(c)(1)(B)). As Willis argued, IRAs and certain other tax-exempt retirement funds and accounts are presumed exempt from a bankruptcy estate under Bankruptcy Code section 522(b)(3)(C). But the presumption was successfully rebutted, the court held. As a result, both the Merrill Lynch IRA’s tax-exempt status under IRC § 408 and its bankruptcy estate exemption were disqualified as of the beginning of 1993, the year in which the first prohibited transaction occurred. Furthermore, the two additional IRAs, having been funded with monies from the Merrill Lynch IRA, were not exempt, since they were tainted with funds from the IRA.
Willis appealed the decision to the District Court for the Southern District of Florida, which affirmed the bankruptcy court’s decision. He then appealed to the Eleventh Circuit, which also affirmed.
By Karen M. Cooley, CPA, MBA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Business, both of the College of Business, West Texas A&M University, Canyon, Texas.
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