Part 1: Asset Protection

Part 1: Asset Protection

By David A. Handler and Alison E. Lothes
Originally written for WealthManagement.com

In re Reuter (499 B.R. 655, Sept. 12, 2013), the U.S. Bankruptcy Court for the Western District of Missouri held that the assets of a debtor’s wife’s revocable trust weren’t an asset of the bankruptcy estate.

Nathan Reuter and his wife Kathleen established revocable trusts in 2005. Nathan was a trustee and beneficiary, along with Kathleen, of both trusts. The bankruptcy trustee sought a declaratory judgment that Nathan’s powers over and interests in Kathleen’s revocable trust caused the property of her trust to be included in his bankruptcy estate.

However, the Bankruptcy Court held that the assets weren’t reachable by the trustee. First, Nathan was a discretionary beneficiary of the trust. Discretionary interests aren’t interests in property subject to the claims of the bankruptcy trustee.

Second, Nathan didn’t have the right to revoke the trust; under the terms of the trust agreement, only Kathleen could revoke her trust. The bankruptcy trustee unsuccessfully tried to argue that the Missouri Uniform Trust Code (MUTC) granted Nathan the power to revoke because he was a “settlor” of Kathleen’s revocable trust. The MUTC provides that a settlor of a revocable trust can revoke the trust with regard to the property attributable to her respective contribution. However, the definition of “settlor” under the MUTC turns on the right to revoke: It provides that each person who contributes property to a trust is a settlor of the property he contributes, but not if another person has a power to revoke that portion of the trust pursuant to the trust terms. Therefore, although Nathan had contributed property to Kathleen’s trust, he wasn’t a settlor of the trust under the MUTC because Kathleen retained the sole right to revoke the trust. Thus, as a non-settlor, he couldn’t revoke the trust under the MUTC. The court distinguished this case from others in which the debtor shared the power, in some manner, to revoke a trust with a spouse.

Third, the trust contained a valid spendthrift clause, which restricted the transfer of Nathan’s beneficial interest in the trust. The court refused to accept the bankruptcy trustee’s argument that the spendthrift clause shouldn’t apply due to Nathan’s dominion and control over the trust assets, noting that Nathan served as a co-trustee with Kathleen and that the trust agreement required the trustees to act by majority decision. Lastly, the court refused to grant the bankruptcy trustee any equitable relief.

The holdings regarding Nathan’s beneficial interests and powers as trustee aren’t surprising. The key to the spendthrift protection in the case turned on the interpretation of Missouri law that Nathan wasn’t a settlor of the trust.

Clark v. Rameker

U.S. Supreme Court holds that inherited individual retirement accounts aren’t excluded from the bankruptcy estate

In a unanimous decision, Clark v. Rameker, 573 U.S. ______ (2014), the U.S. Supreme Court resolved the question of whether inherited IRAs are included in the bankruptcy estate and, ultimately, subject to the claims of creditors. There was a conflict between the U.S. Courts of Appeals for the Fifth Circuit and the Seventh Circuit; the issue was whether an inherited IRA in the hands of a beneficiary should be given the same creditor protection as an IRA in the hands of the original owner.

In Clark, Heidi Heffron-Clark held funds in an inherited IRA. She inherited the IRA (valued at about $450,000 at the time) from her mother and elected to take the minimum distributions from the account. The Supreme Court interpreted 11 U.S.C. Section 522(b)(3)C), which exempts “retirement funds to the extent 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.”

Because the account was clearly one protected by the enumerated IRC sections, the court interpreted the meaning of “retirement funds.” It reasoned that “retirement funds” are funds set aside for when an individual stops working. It noted three characteristics of inherited IRAs that indicated that they weren’t retirement funds as to the beneficiary: (1) the beneficiary of the inherited IRA may never contribute funds to it; (2) the beneficiary is required to withdraw money from the accounts, no matter how many years he may be from retirement; and (3) the beneficiary could withdraw the full balance of the account at any time, without penalty. These characteristics are very different from an IRA in the original owner’s hands. The original owner’s fund may not be withdrawn without penalty before age 59½, and his minimum required distributions only begin after he reaches retirement age.

As a policy matter, the court also noted that protecting retirement funds for owners allows them to have a “fresh start” without depleting the reserves that weren’t easily accessible to them and which they established for themselves later in life. Since the beneficiary of an inherited IRA is able to access the account at any time without penalty, this objective isn’t met by exempting the funds from the bankruptcy estate. Instead, it simply gives the debtor a “free pass” to keep those assets and access them as he wishes.