In re Chilton – Bad News for Creditor Protection for Inherited IRAs

If only it were this simple…

As previously discussed in this post, KYEstates strives to provide fair and balanced coverage, so when we are biased, we will let you know.  To that end, we previously warned readers that we are biased in favor of the taxpayer.  (Apparently, when we made this (not-so-shocking) disclosure, the IRS noticed, because shortly afterwards we started registering hits on the site from their servers.  Welcome, readers from the Service!)

Likewise, please be advised that KYEstates is biased in favor of the debtor.  Why is that?  Don’t get us wrong, we’re all for enforcement of contracts and honoring obligations.  But we also believe society benefits when entrepreneurs, investors, and business owners are insulated from complete personal ruin in the event of a business reversal or random catastrophic litigation.  Asset protection is a form of safety net for the risk-takers that we need in a free society.  Without risk-taking, we’ll have fewer startups, less job creation, and lower economic growth.  And that’s why at KYEstates, as we continue to monitor the Spy v. Spy/Cat v. Mouse/Roadrunner v. Coyote that is Debtor v. Creditor, we’re rooting for debtors.

We were happy to bring you good news on creditor protection for inherited IRAs in In re Nessa in this post.  Now, we’re disappointed to share bad news with In re Chilton, 2010 WL 817331 (Bkrtcy.E.D.Tex.) (Mar. 5, 2010), 105 A.F.T.R.2d 2010-1271.  On very similar facts to Nessa, Chilton reached an opposite result, finding that a debtor’s inherited IRA was not exempt from the debtor’s bankruptcy estate. Nessa applied Minnesota law. Minnesota is a state that “opts in” to Federal bankruptcy exemptions (Kentucky also “opts in”).  Texas allows debtors to choose between state and Federal exemptions.  In Chilton, the debtors elected Federal exemptions.  Accordingly, Chilton analyzed Federal exemptions, and its analysis could be applied against debtors in Kentucky, in opposition to Nessa‘s pro-debtor analysis.

KYEstates is sorry to report that Chilton provides a more thorough analysis of inherited IRAs in bankruptcy than Nessa, one that cites to a deeper and broader range of statutory and case law authority and legislative history.  In short, for Kentucky clients with IRA assets and beneficiaries with actual or potential creditor concerns (doesn’t everyone have potential creditor concerns?), Chilton could be a problem.  Even if we don’t like Chilton‘s holding, we’d better understand the threat it poses.  Let’s begin, shall we?

The facts of Chilton were as follows: a debtor couple filed for Chapter 7 bankruptcy protection.  Prior to the filing, the wife’s mother had established an IRA at RBC Dain Rauscher.  The wife was the designated beneficiary of the account.  The mother died in November, 2007.  In January, 2008, the wife established an IRA at RBC to receive funds from her mother’s IRA.  The account was titled “[Daughter], Beneficiary, [Mother], Decedent.”

The assets of the mother’s IRA were transferred directly to this account, and the daughter contributed no funds to the account.  The wife/debtor is 52, and “must begin taking lifespan-measured distributions from the inherited IRA in 2010, or she may chose to take the entire distribution by 2013 or earlier.”

The debtors filed for protection under Chapter 7 in December, 2008.  In their bankruptcy schedules, the debtors disclosed a community property interest in the IRA. The total value of the debtors’ interest as of the petition date was $170,000. The debtors claimed this property as exempt from their creditors pursuant to 11 U.S.C. section 522(d)(12).

[As astute readers might expect], the Chapter 7 trustee objected to the debtors’ claim of exemptions. The case was converted to a Chapter 13, and the Chapter 13 trustee adopted the Chapter 7 trustee’s objection to the debtors’ claimed exemption of the inherited IRA.

Some readers are seasoned in bankruptcy law, but others may not be.  Because the Bankruptcy Court did a nice job of summarizing the applicable law in relatively straightforward language, KYEstates excerpts that summary below:

Upon the filing of a bankruptcy petition, an estate is created. The bankruptcy estate includes nearly all legal and equitable rights of the debtor as well as those interests recovered or recoverable through transfer and lien avoidance provisions. See 11 U.S.C. section 541. The Bankruptcy Code excludes certain property from this estate, see 11 U.S.C. sections 541(b) and (c), and the Bankruptcy Code permits a debtor to “exempt” certain additional property, see 11 U.S.C. section 522(d). The Supreme Court has described an exemption as “an interest withdrawn from the estate (and hence from creditors) for the benefit of the debtor.”

Section 522(d) establishes a minimum set of federal exemptions. Although subsection (b)(2) empowers the states to “opt out” of the federal exemption scheme by prohibiting their citizens from selecting the exemptions set out in subsection (d), Texas permits a debtor in bankruptcy proceedings to choose between the federal and state exemptions…The debtors in this case elected the federal exemption scheme, and they claim that the inherited IRA is exempt under section 522(d)(12).

Section 522(d)(12) allows the exemption of “[r]etirement 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 of 1986.” In order to determine whether funds are exempt under section 522(d)(12), the Court must engage in a two-part test. First, the Court must determine whether the funds are “retirement funds.” Second, if the funds are retirement funds, the Court must determine whether the funds are exempt from taxation under the applicable provisions of the Internal Revenue Code.

The Bankruptcy Court first analyzed the central question: Were the funds in the inherited IRA “retirement funds” for purposes of the Bankruptcy Code?  It first referenced statutory history:

As an initial matter, the Court recognizes that an inherited IRA is fundamentally different from an IRA. Congress enacted section 408(a) of the Internal Revenue Code, which provides for the creation of IRAs, as part of the Employee Retirement Income Security Act of 1974 (“ERISA”)….In enacting this provision of ERISA…the goal of Congress was to create a system whereby employees not covered by qualified retirement plans would have the opportunity to set aside at least some retirement savings on a tax-sheltered basis.

It then provided an extremely brief summary of income tax treatment of IRAs.  Readers, KYEstates knows this is a review, but bear with us:

Under the statutory framework established by Congress, the IRA owner must begin taking distributions following the later of the calendar year in which the individual retires or April 1st of the calendar year in which the individual attains the age 70 1/2. See 26 U.S.C sections 401(a)(9)(C)(i), 408(d)(1). IRA owners are not required to take distributions prior to the age 70 1/2, and they incur a 10% penalty for early withdrawal. See 26 U.S.C. sections 72(t), 408(d)(1). Distributions from an IRA are taxable as gross income unless the distributions qualify as rollover contribution to another exempt account. See 26 U.S.C. sections 408(d)(1) and (3).

The Bankruptcy Court then provided a brief overview of income tax treatment of inherited IRAs:

In the event of the original account holder’s death, the Internal Revenue Code allows the contents of the IRA to go to a beneficiary who is not the spouse of the account holder. The beneficiary may avoid immediately paying taxes on the full amount of the distribution if “a direct trustee-to-trustee transfer is made to an individual retirement plan … established for the purposes of receiving the distribution” of the inheritance. 26 U.S.C. section 402(c)(11). An “inherited IRA” is the vehicle used to receive this distribution. The inherited IRA must be set up and maintained in the name of the deceased IRA owner for the benefit of the beneficiary. See 26 U.S.C. section 402(c)(11)(A); Publication 590 at 20. The beneficiary may make no contributions to the new account, nor may he or she rollover the inherited funds into another retirement plan. See 26 U.S.C. sections 402(c)(11)(A)(ii), 408(d)(3). Beneficiaries of inherited IRAs may make withdrawals at any time, without penalty and must either start taking lifespan-measured withdrawals within one year or take the entire amount within five years. See 26 U.S.C. sections 401(a)(9)(B)(ii), 402(c)(11)(A)(iii), 408(a)(6). See also Publication 590 at 37.

With this background in mind, the Court focused on the meaning of “retirement funds” within section 522(d)(12) of the Bankruptcy Code.  (It soon becomes clear that things are not going to go well for the debtor.):

Turning to section 522(d)(12), the term “retirement funds” is not defined in the Bankruptcy Code. In their brief in support of the claimed exemption, the debtors argue that the plain meaning of “retirement funds logically means those funds legally authorized to be in a tax exempt account.” The Court rejects this interpretation for several reasons. First, the debtors’ argument violates a fundamental tenet of statutory construction-that all the words of a statute should be given meaning-by reading the word “retirement” out of “retirement funds.” Moreover, the debtors’ argument collapses the question of whether an inherited IRA is a tax exempt account with whether an inherited IRA contains retirement funds….

The Court concludes that, viewing the words “retirement funds” in their entire context, they cannot reasonably be understood to authorize an exemption of an inherited IRA. The funds contained in an inherited IRA are not funds intended for retirement purposes but, instead, are distributed to the beneficiary of the account without regard to age or retirement status.


The Bankruptcy Court supported its analysis by referring to the Bankruptcy Code’s legislative history and case law predating the 2005 Bankruptcy Act (BAPCPA), including Patterson v. Shumate, 504 U.S. 753 (1992) and Rousey v. Jacoway, 544 U.S. 320 (2005).  Notwithstanding In re Nessa, which was issued on January 11, 2010, the Court claimed: “This Court has not discovered any published cases that address the exemption of an inherited IRA under section 522(d)(12).”  [Court, KYEstates wishes you’d searched harder!]  Accordingly, the Bankruptcy Court reviewed several decisions interpreting the application of state exemption statutes to inherited IRAs, including In re Sims, 241 B.R. 467 (Bankr.N.D.Okla.1999) and In re Jarboe, 365 B.R. 717 (Bankr.S.D.Tex.2007).  The Chilton court believed that:

…[w]hile Congress did not expressly adopt the analysis of these courts in its amendments to section 522, the language of the new section 522(b)(12) accords with their distinction between IRAs and inherited IRAs. Congress did not exempt all funds in qualifying accounts, but only “retirement” funds. Moreover…the statutory framework governing IRAs distinguishes between an original IRA and an inherited IRA.

Not content to dispose of the case on the grounds that the “retirement funds” condition for protection under section 522(b)(12) was not met, the Bankruptcy Court next found that the inherited IRA was not exempt from taxation, thereby also failing the second statutory condition for protection.

Assuming, arguendo, that the funds at issue in this case are “retirement funds,” the funds must also meet the second prong of the section 522(d)(12) test-the “retirement funds” must be “exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code.” 11 U.S.C. section 522(d)(12)…the debtors argue that the inherited IRA is an eligible rollover under Internal Revenue Code section 402(c)(11) and, therefore, is exempt from taxation under section 408(e)(1).

The Court explained why it did not agree with the debtors’ argument:

The debtors are intermingling two separate concepts-the tax treatment of accounts and the tax treatment of distributions-in arguing that an inherited IRA is exempt from taxation under section 408(e)(1). The Internal Revenue Code separately discusses the tax-exempt status of an IRA and the taxability of distributions from an IRA. Internal Revenue Code section 408(d) deals specifically with the taxability of distributions from an IRA, including rollovers, while section 408(e) governs the disqualification and taxability of the fund itself. An inherited IRA, which is a vehicle for receiving distribution from a tax exempt account, does not fit within the definitional scope of section 408(e)(1). [emphasis added]

Further, the Court determined that although “the debtors are correct in their assertion that an inherited IRA is exempt from taxation under Internal Revenue Code section 402(c)(11)”, this was not sufficient to find in their favor, because “in order to be exempt from creditors under Bankruptcy Code section 522(d)(12), the inherited IRA must be exempt from taxation under sections 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code. Section 402(c)(11), which provides for the creation and treatment of the inherited IRA at issue in this case, is not one of these enumerated provisions.”

The Bankruptcy Court summarized its findings as follows:

Although there is no dispute that [Mother’s] IRA was exempt from taxation, her death and the distribution of the funds from her IRA to her daughter transformed the nature of the IRA…Similar to the treatment of inherited IRAs under the state exemption statutes discussed in Sims and Jarboe, an inherited IRA is not equivalent to an IRA for purposes of determining whether the account contains “retirement funds” that may be exempted from the estate under section 522(d)(12).

Even assuming, arguendo, that the inherited IRA contains “retirement funds,” the account established by [the daughter/debtor] to receive the distribution of funds from [the mother’s] IRA is not a traditional IRA exempt from taxation under section 408(e)(1). For these and all of the foregoing reasons, the Court concludes that the…IRA inherited by [the daughter/debtor] from her mother is a non-exempt asset of the debtors’ bankruptcy estate.


Readers, there you have it.  Chilton‘s a problem for inherited IRAs and successful creditor protection in Kentucky.  One solution to the Chilton problem is to name a trust as the designated beneficiary of an IRA, rather than the account owner’s descendants, outright.  [KYEstates cautions that this trust should be drafted very carefully, to avoid unintentional loss of the ability to stretch distributions from the IRA (instead of taking them over only five years).]

KYEstates will continue to monitor issues of creditor protection in inherited IRAs closely, and keep you posted.  We hope to bring you better asset protection news in the future.


(Thanks to Greg Herman-Giddens at North Carolina Estate Planning Blog for alerting the community of T&E bloggers to Chilton.)

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