In re Clark

• Decision Date: 23 April 2013
• Docket Number: 12–1255.,Nos. 12–1241,s. 12–1241
• Parties: In the Matter of Brandon C. CLARK and Heidi Heffron–Clark, Debtors–Appellees. Appeal of William J. Rameker, Trustee.
• Court: U.S. Court of Appeals — Seventh Circuit

714 F.3d 559

In the Matter of Brandon C. CLARK and Heidi Heffron–Clark, Debtors–Appellees.

Appeal of William J. Rameker, Trustee.

Nos. 12–1241, 12–1255.

United States Court of Appeals,Seventh Circuit.

Argued Sept. 6, 2012.

Decided April 23, 2013.

Denis P. Bartell, Sean Michael Murphy (argued), Attorneys, DeWitt, Ross & Stevens, S.C., Madison, WI, for Debtors–Appellees.

Stephen L. Morgan (argued), Attorney, Murphy & Desmond, S.C., Madison, WI, for Trustee.

Roger Sage, Attorney, Madison, WI, for Appellant.

David P. Leibowitz, Attorney, Lakelaw, Waukegan, IL, Tara A. Twomey, Attorney, San Jose, CA, for Amicus Curiae.

Before EASTERBROOK, Chief Judge, and FLAUM and WILLIAMS, Circuit Judges.

EASTERBROOK, Chief Judge.

Congress has decided that funds set aside for retirement need not be used to pay pre-retirement debts. This policy is implemented through 11 U.S.C. § 522(b)(3)(C) and (d)(12), which exempt retirement funds from creditors' claims in bankruptcy. This appeal presents the question whether a non-spousal inherited individual retirement account (“inherited IRA” for short) is exempt.

Section 522(b)(3)(C) and (d)(12) are identical. Each exempts from creditors' claims any “retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under sections 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986.” An individual retirement account by which a person provides for his or her own retirement meets this requirement. If a married holder of an IRA dies, the decedent's spouse inherits the account and can keep it separate or roll it over into his or her own IRA. Either way, the money remains “retirement funds” in the same sense as before the original owner's death: the surviving spouse cannot withdraw any of the money before age 59 1/2 without paying a penalty tax and must start withdrawals no later than the year in which the survivor reaches 70 1/2. Because the money entered the IRA without being subject to the income tax, all withdrawals are taxed at ordinary rates.

Different rules govern inherited IRAs. We illustrate using the facts of this case. At her death, Ruth Heffron owned an IRA worth approximately $300,000. Ruth's daughter Heidi Heffron–Clark was the designated beneficiary. Ruth's account passed to Heidi. It remains sheltered from taxation until the money is withdrawn, but many of the account's other attributes changed. For example, no new contributions can be made, and the balance cannot be rolled over or merged with any other account. 26 U.S.C. § 408(d)(3)(C). And instead of being dedicated to Heidi's retirement years, the inherited IRA must begin distributing its assets within a year of the original owner's death. 26 U.S.C. § 402(c)(11)(A), incorporating 26 U.S.C. § 401(a)(9)(B). Payout must be completed in as little as five years (though the time can be longer for some accounts). In other words, an inherited IRA is a time-limited tax-deferral vehicle, but not a place to hold wealth for use after the new owner's retirement. This statutory treatment allows the beneficiary to avoid paying income tax immediately after the original owner's death (recall that money in a normal IRA is pre-tax dollars; unlike assets that pass with a decedent's estate, the contents of an inherited IRA are taxable) while limiting the duration of tax deferral. If recipients of inherited IRAs could hold the wealth until their own retirement, tax deferral might become tax exemption, as capital held in IRAs could pass down through the generations without ever being subject to income tax.

In the bankruptcy proceeding initiated by Heidi Heffron–Clark and her husband Brandon Clark (“the Clarks”), Bankruptcy Judge Martin held that an inherited IRA does not represent “retirement funds” in the hands of the current owner and so is not exempt under § 522(b)(3)(C) and (d)(12). 450 B.R. 858 (Bankr.W.D.Wis.2011). The bankruptcy judge concluded that money counts as “retirement funds” (a term that the Bankruptcy Code does not define) only when held for the owner's retirement, while an inherited IRA must be distributed earlier. A district judge reversed, 466 B.R. 135 (W.D.Wis.2012), adopting the view, first articulated in In re Nessa, 426 B.R. 312 (8th Cir. BAP 2010), that any money representing “retirement funds” in the decedent's hands must be treated the same way in successors' hands. The fifth circuit has since agreed with that approach, In re Chilton, 674 F.3d 486 (5th Cir.2012), observing that § 522(b)(3)(C) and (d)(12) refer to “retirement funds” without providing that they must be the debtor's. It is enough, Chilton concludes, if they were ever anyone's retirement funds.

Sometimes assets are exempt in bankruptcy because of how they function in someone else's hands. Suppose Heidi Heffron–Clark were the trustee of a retirement account for the benefit of her sister. Trustees are legal owners of the assets they administer, but the Clarks' creditors could not reach retirement assets that Heidi was holding as trustee. So we followChilton in observing that exemptions in bankruptcy do not (necessarily) depend on whether an asset is a retirement fund (or an agricultural tool, or one of the other categories of exemption) as the debtor uses it. But by the time the Clarks filed for bankruptcy, the money in the inherited IRA did not represent anyone's retirement funds. They had been Ruth's, but when she died they became no one's retirement funds. The account remains a tax-deferral vehicle until the mandatory distribution is completed, but distribution precedes the owner's retirement. To treat this account as exempt under § 522(b)(3)(C) and (d)(12) would be to shelter from creditors a pot of money that can be freely used for current consumption.

To see this, suppose Ruth had withdrawn the entire $300,000 from her IRA, paying the penalty tax if necessary, waited a month, then given the money to Heidi. The money would have been “retirement funds” while in Ruth's IRA, but not thereafter; in Heidi's bank account the money would be no different from any other assets she could save or spend at will. And that would have been true during the month Ruth banked the funds before sending them to Heidi. Ruth's creditors could have reached the money, notwithstanding the fact that it formerly was part of her retirement account. Why should it make a difference whether the money passed to Heidi on Ruth's death or a little earlier? Either way, the money used to be “retirement funds” but isn't now. We doubt that Chilton would think that money expressly withdrawn from an IRA retains its character as “retirement funds.” Section 522(b)(3)(C) and (d)(12) provides that the exemption depends on the conjunction of tax deferral and assets' status as “retirement funds”; that an inherited IRA provides tax benefits is not enough.

Chilton and Nessa give weight to the phrase “inherited individual retirement account.” It includes the word “retirement,” after all. True enough, but the “IRA” part of “inherited IRA” (as the Internal Revenue Code uses the phrase) designates the funds' source, not the assets' current status. As we have observed, an inherited IRA does not have the economic attributes of a retirement vehicle, because the money cannot be held in the account until the current owner's retirement.

Chilton and Nessa also give weight to the fact that many of the other exemptions in § 522 refer to “the debtor's” interests, while § 522(b)(3)(C) and (d)(12) does not. For example, § 522(b)(3)(B) exempts “any...