Summary
holding that funds "rolled-over" prepetition from an ERISA-qualified pension plan into an individual retirement account (IRA) lost their excluded status and were exempt only to the limited extent provided by the Virginia exemption for IRAs
Summary of this case from In re JohnsonOpinion
Case No. 99-10571-SSM
May 17, 1999
Thomas D. Hughes, IV, Esquire, Alexandria, VA, Of Counsel, for Debtor
MEMORANDUM OPINION
A hearing was held in open court on May 11, 1999, on the objection of the chapter 7 trustee, Robert G. Mayer, to the debtor's claim of exemptions. The debtor was present in person and was represented by counsel. The trustee was present and represented himself. The primary disputed issues were (a) whether funds "rolled over" from an ERISA-qualified pension plan into an Individual Retirement Account (IRA) were, on that basis alone, exempt in bankruptcy; and (b) if not, did the debtor's stepdaughter qualify as a "dependent" for the purpose of calculating the amount of the Virginia homestead exemption. At the conclusion of the hearing, the court ruled from the bench (a) that the IRA was exempt only to the extent provided in Va. Code Ann. § 34-34 plus the debtor's unused homestead exemption under Va. Code Ann. § 34-4; and (b) that the debtor's stepdaughter was not a dependent for the purpose of determining the available homestead exemption. An order was entered on the docket the following day sustaining the trustee's objection except to the extent allowed by the court. The purpose of this memorandum opinion is to set forth more fully the basis for the court's ruling, both for the benefit of the parties and in the event an appeal should be taken.
Facts
Russell Alien Ekanger, an accountant, filed a voluntary petition under chapter 7 of the Bankruptcy Code in this court on February 8, 1999. On the date he filed, he was 40 years old. On his schedules he listed and claimed exempt, among other assets, an IRA in the amount of $32,928.24, tax refunds in the amount of $2,320, and a life insurance policy in the amount of $416.55. On his schedules he listed one dependent, his 10 year old daughter Rachael. Robert G. Mayer was appointed as trustee. Prior to the meeting of creditors, the debtor filed two homestead deeds, one for real property and the other for personal property. Nominal $10.00 exemptions were claimed in the real estate and in seven listed items of personal property, including the IRA, the tax refunds, and the life insurance policy. The original homestead deeds stated that the debtor had no dependents. Following the meeting of creditors, the debtor filed an amended homestead deed for personal property on March 26, 1999, claiming the IRA exempt in the amount of $5,930.00. The amended homestead deed stated that the debtor had two dependents: his 10-year old daughter Rachael, and his 9-year old stepdaughter, Caelyn. On April 1, 1999, the trustee filed a timely objection to the debtor's exemption of the IRA, the tax refunds, and the life insurance policy.
The debtor testified that while employed for 6 years as a tax accountant by the Federal Home Loan Mortgage Corporation ("Freddie Mac"), he had participated in its 401(k) tax-deferred retirement savings plan. That plan, the debtor testified, was qualified under ERISA and contained the anti-alienation and anti-assignment provisions required by that statute. Upon leaving Freddie Mac's employ in October 1994, he had the option of keeping his savings in the 401(k) plan but would be required, as a non-employee, to pay the administrative expenses. Those expenses, he testified were significant and would have dramatically reduced the appreciation of the account even in good market years and would have resulted in a decrease in the value of the account in bad market years. Accordingly, he determined to move the funds from the 401(k) plan into an IRA at Legg, Mason. The funds were paid directly to Legg, Mason by the 401(k) plan administrator. They were subsequently again rolled over, this time into an IRA administered by The Guardian. After the funds were initially rolled over from the 401(k) plan, no further additions were made in order to preserve eligibility under Federal tax law for future rollover into a 401(k) plan.
ERISA is the common name for the Employee Retirement Income Security Act of 1974, which is codified at 29 U.S.C. § 1001 et seq.
The debtor's daughter Rachael lives with him one-half of each year and with his former wife the other half of the year under a "shared custody" arrangement. By agreement, each takes the Federal exemption for Rachael in alternate years. For 1999, the year of the bankruptcy filing, the debtor is entitled to the exemption. Also living in the debtor's house is his present wife's daughter, Caelyn. For each of the years preceding the bankruptcy filing, the debtor's income was greatly exceeded by his wife's. In 1997, the debtor's adjusted gross income was $9,971 and his wife's was $83,000. For 1998, the debtor's adjusted gross income was $12,150 and his wife's was $92,275.
Conclusions of Law and Discussion A.
The debtor first asserts that since the funds in the IRA are derived from a tax-qualified roll-over of funds that were in his 401(k) plan, they are thereby immune from claims by the trustee. As the debtor correctly notes, the Supreme Court held in Patterson v. Shumate, 504 U.S. 753, 112 S.Ct. 2242, 119 L.Ed.2d 519 (1992), that a debtor's interest in an ERISA-qualified retirement plan is excluded from property of the bankruptcy estate under § 541(c)(2). The trustee does not dispute that, had the funds remained in the 401(k) plan, they would be beyond his reach. However, nothing in Patterson even remotely suggests that once funds are withdrawn from an ERISA-qualified plan, they would thereafter remain immune from the claims of creditors. See In re Caslavka, 179 B.R. 141, 143 (Bankr. N.D. Iowa 1995) ( Shumate is limited to ERISA plans and not to funds transferred therefrom).
The result is that a debtor's interest in an ERISA-qualified plan is not property of the bankruptcy estate. In re Hanes, 162 B.R. 733 (Bankr. E.D. Va. 1994) (Bostetter, C.J.). It is worthwhile to keep in mind that ERISA is not, strictly speaking, an exemption statute, since exempt property is property of the estate which, once the exemption is allowed, passes out of the estate. § 522(b), Bankruptcy Code. The debtor's interest in an ERISA-qualified plan, by contrast, never becomes property of the estate.
The trustee points to the holding in In re Johnston, 2 18 B.R. 813 (Bankr. E.D. Va. 1998) (Bostetter, C.J.) as analogous to the matter before the court. Prior to filing a bankruptcy petition, the debtor in Johnston became entitled to distributions from her former husband's ERISA-qualified pension plan as a result of a qualified domestic relations order entered by a state divorce court. She argued, based on Shumate, that her interest in the pension plan was excluded from the bankruptcy estate since the funds were held in an ERISA plan. Like Mr. Ekanger, she essentially asked the court to look solely to the source of the funds to determine whether the § 541(c)(2) exclusion applied. Judge Bostetter rejected the argument advanced by the debtor in Johnston and held that, since the debtor was neither a plan participant nor a beneficiary, Shumate would not apply to any disbursements from the ERISA plan to the debtor.
In its analysis, Johnston cited to In re Cesare, 170 B.R. 37 (Bankr. D. Conn. 1994), where the court directly addressed the "tracing" argument. There, the debtor funded his IRA with proceeds from a pension plan which was terminated by his employer. The debtor claimed the IRA exempt under § 522(d)(10)(E), Bankruptcy Code — which allows a debtor to exempt a "right to . . . a payment under a . . . pension, profit-sharing, annuity, or similar plan . . . to the extent necessary for the support of the debtor" — based on the nature and source of the funds held in the IRA. Although Cesare is not strictly on point since it involved a specific exemption under § 522(d), Bankruptcy Code, which is not available to the debtor here, the analysis is nevertheless instructive. Cesare held that, unless the statute relied upon by the debtor provides otherwise, the origin of funds are irrelevant when determining the debtor's right to an exemption. Here, the debtor is asserting the § 541(c)(2) exclusion in an attempt to shield his IRA. However, ERISA contains no language imposing an anti-alienation requirement on funds withdrawn from a qualified plan or rolled-over to a tax-qualified IRA. It is solely because of the anti-alienation requirement that the debtor's interest in an ERISA-qualified plan does not come into the bankruptcy estate: essentially, the ERISA plan is treated like a spendthrift trust. IRA's, by contrast, are not subject to any legal restriction on alienation or anticipation. An IRA is simply of a creature of the Internal Revenue Code designed to encourage taxpayers to save for retirement. That an assignment or premature withdrawal of the funds in such an account might have adverse tax consequences does not, in and of itself, constitute a "restriction on the transfer of a beneficial interest of the debtor in a trust" such as to result in the exclusion of the funds from the debtor's bankruptcy estate. Accordingly, an IRA — even one funded by roll-over from an ERISA-qualified pension plan — is property of the bankruptcy estate.
A state is expressly permitted to "opt out" of allowing its residents to take advantage of the Federal exemptions. § 522(b)(1), Bankruptcy Code. Virginia has done precisely that. Va. Code Ann. § 34-3.1. Accordingly, residents of Virginia filing bankruptcy petitions may not elect the Federal exemptions under § 522(d) but may claim only those exemptions allowable under state law and general Federal law. In re Smith, 45 B.R. 100 (Bankr. E.D. Va. 1984). Here, the debtor is proceeding under Va. Code Ann. §§ 34-4 and 34-34.
At oral argument, the debtor, citing to Winkler v. Gorham (In re Winkler), 164 B.R. 728 (W.D. N.C. 1994), for the first time suggested that he actually never "received" any disbursement from the ERISA plan because he had no "control" over his funds when they were rolled over to the IRA. Winkler involved a debtor whose employment was terminated prior to the bankruptcy filing. As a consequence, the debtor's participation in the ERISA plan was terminated, but the funds were never disbursed prepetition. The court in Winkler ruled that the funds, not having been distributed, remained subject to the plan's anti-alienation provisions, and accordingly were excluded from the bankruptcy estate, because the debtor never had control over the monies. Id. at 730. The present case is easily distinguishable. Unlike Winkler, Mr. Ekanger exercised control over the funds by directing Freddie Mac to transfer his funds to an IRA of his selection. Instead of cashing out his 401(k), he voluntarily chose to roll over his retirement savings to avoid the taxes that would result from early withdrawal. Short of receiving disbursements in hand, it is difficult to conceive of a clearer example of "control." By exercising his ability to transfer the monies, the debtor had ample and actual "control" over the funds even though they never passed directly through his hands.
Finally, the debtor argues that he was "forced" to roll over his 401 (k) funds to the IRA because of the heavy administrative costs he would have incurred had he left them in the plan. The debtor cites to In re Donaghy, 11 B.R. 677 (Bankr. S.D. N.Y. 1981) for the proposition that equitable considerations can justify extending the protections of ERISA to funds that have been withdrawn from a qualified plan for compelling reasons. In Donaghy, the debtor battled cancer and opted to receive a lump sum payment from his pension plan, which was his only source of income, three weeks before filing his bankruptcy case. He claimed the lump sum payment exempt under § 522(d)(10)(E), Bankruptcy Code, which, as noted, exempts rights to payment under a pension plan. Looking beyond the literal reading of § 522(d)(10)(E), Donaghy resorted to congressional intent and held that the lump-sum payment was "intended to function as a wage substitute at some future period[.]" Id. at 680.
Donaghy is inapposite to the facts at hand. The precise issue in Donaghy involved interpretation of a specific statutory exemption that, as noted above, is not available to Virginia residents filing bankruptcy petitions. This court does not read Donaghy as standing for the proposition that the bankruptcy court may use its equitable powers to extend a statutory exemption beyond its intended reach. Even assuming that the debtor's interpretation of Donaghy were accurate, the court be hard pressed to find in this case anything even approaching the compelling circumstances present in Donaghy. Although court is sympathetic with the debtor's desire to avoid heavy administrative costs and to maximize the return on his retirement savings, the decision to transfer the funds was nevertheless voluntary. No rule or regulation required the transfer, nor was the debtor compelled to act by financial emergency or by illness or death in his family. Essentially, it was an investment decision. Accordingly, even if the court's equitable powers were sufficient to extend the protection of ERISA to funds withdrawn under compelling circumstances, the circumstances here simply do not rise to that level.
B.
Although the debtor's IRA is not exempt solely because the funds contained in it were rolled over from an ERISA-qualified plan, it may be claimed as exempt to the extent otherwise permitted by Virginia law. In this respect, there are two statutes under which an IRA may be claimed exempt in Virginia. The first is Va. Code Ann. § 34-34, which, with certain exceptions, allows a debtor to exempt funds in an IRA sufficient in amount to fund an annuity of $17,500 per year beginning at age 65. The statute contains an annuity table setting forth the cost of a $1.00 annual benefit based on the attained age of the debtor when the exemption is claimed. For a person aged 40, that cost is 0.9699. Accordingly, the amount that may be claimed exempt by the debtor under § 34-34 is $17,500 times 0.9699, or $16,973.25.
The exemption may not be claimed in amounts paid into the plan during the fiscal year that includes the year the exemption is claimed or the two prior fiscal years. Va. Code Ann. § 34-34(D). The evidence before the court is that all the funds in the debtor's IRA were paid in prior to October 1994.
In addition to the amount that may be claimed exempt under Va. Code Ann. § 34-34, the debtor may take advantage of the "homestead" exemption provided by Va. §§ 34-4 and 34-17. In re Cathcart, 203 B.R. 599, 602-03 n. 7 (Bankr. E.D. Va. 1996). Basically, a "householder" — defined as any resident of Virginia — may exempt up to $5,000 of real or personal property by filing for record an instrument known as a homestead deed. Va. Code Ann. §§ 34-4, 34-6, 34-13, and 34-14. This amount is increased by $500 for each dependent supported by the householder. Va. Code Ann. § 34-4. An additional $2,000 is allowed a disabled veteran. Va. Code Ann. § 34-4.1. In order to claim the exemption, a debtor in bankruptcy must file the homestead deed not later than five days after the date initially set for the meeting of creditors in the bankruptcy case. Va. Code Ann. § 34-17.
The debtor's original homestead deed, filed prior to the meeting of creditors, claimed only a nominal $10.00 exemption in the IRA. It is well-settled that such a claim of exemption exempts only the $10.00 claimed and not the entire value of the asset. Addison v. Reaves, 158 B.R. 53 (E.D. Va. 1993). It is also clear, however, that a bankruptcy debtor, having timely claimed a homestead exemption in specific property, may thereafter amend the value upward to the unused limit of the homestead exemption. In re Sherman, 191 B.R. 654 (Bankr. E.D. Va. 1995). The debtor in this case has done so and has claimed $5,930.00 of the IRA as exempt on his amended homestead deed.
C.
The trustee does not dispute the debtor's right to the $5,000 basic homestead exemption, nor does the trustee dispute the debtor's entitlement to an additional $500 based on the debtor's support of his daughter Rachael. The sole dispute is whether the debtor is entitled to a further $500 based on the assertion that his step-daughter Caelyn is a "dependent" for the purpose of Va. Code Ann. § 34-4.
Section 34-4 provides the following definition of "dependent":
For the purposes of this section, "dependent" means an individual who derives support primarily from the householder and who does not have assets sufficient to support himself, but in no case shall an individual be the dependent of more than one householder.
(emphasis added). In the present case, while Caelyn lives in the debtor's household, it is clear that her support is derived "primarily" from her mother (the debtor's wife), whose annual earnings in each of the two years preceding the filing of the bankruptcy were at least seven times the debtor's. The fact that Caelyn is listed as a dependent on their joint Federal income tax return is not dispositive: whatever may be the rule for claiming exemptions for income tax purposes, the language of Section 34-4 is clear that a person may be the dependent, for exemption calculation purposes, of only one person, that person being the one from whom he or she "primarily" derives support. Thus, the debtor is not entitled to an additional $500 homestead exemption based solely on the fact that Caelyn resides in his household.
On their Virginia income tax returns, where the debtor and his wife filed separately, Caelyn is claimed by the debtor's wife. The debtor did not list Caelyn as a dependent on his schedule of income (Schedule I) filed with his bankruptcy petition.
The debtor is therefore entitled to a total homestead exemption of $5,500. Of that amount, $70.00 was previously claimed exempt in other assets, leaving $5,430 available for the IRA. That, added to the $16,973.25 exemption available under § 34-34, permits the debtor to hold exempt a total of $22,403.25 in the IRA. The amount in the account on the date the bankruptcy petition was filed was $32,928.24 but has since increased, as a result of passive earnings since the bankruptcy filing, to approximately $39,750.00. The debtor is entitled to the "rents and profits" of property claimed exempt. Va. Code Ann. 34-18. Accordingly, the debtor is entitled to $22,413.25, plus a pro-rata share (68.04%) of the increase in value since the filing of the petition. The remainder of the IRA is not exempt and may be administered by the trustee.
Strictly speaking, § 34-18 only applies to that portion of the IRA which may be claimed exempt under the homestead exemption. § 34-34 is silent with respect to passive appreciation of value. Under the circumstances, the court believes it likely that the General Assembly intended that the same rule would apply to exempt pensions as to the homestead exemption.
Subsequent to the filing of the bankruptcy petition, the debtor — who had been working for an accounting firm as an independent contractor — became an employee of that firm and eligible to participate in its 401(k) plan. Approximately ten days prior to the hearing on the trustee's objection, he transferred the funds in the IRA into his new employer's 401(k) plan. He explained at the hearing that this was not done to put the funds beyond the reach of the trustee, but rather for tax reasons. Specifically, once the funds were in a 401(k) plan, he could pay the trustee any non-exempt portion by taking out a loan from the plan. Such a loan, he testified, would not have adverse tax consequences for him, whereas an early withdrawal from the IRA would have significant adverse tax consequences. As the trustee correctly observes, the tax consequences from liquidation of property of the estate in an individual case fall on the bankruptcy estate, which is a separate taxable entity, not on the debtor. 26 U.S.C. § 1398; 15 Collier on Bankruptcy ¶ 3.02 at TX3-4 n. 7. The trustee would liquidate the asset, pay the debtor his or her exemption, pay any taxes from the disposition of the asset, and distribute what remains to creditors. Hence, the post-petition transfer of the funds while the trustee's objection was pending was both technically improper and unnecessary. However, the court accepts, for the purpose of the present ruling, the debtor's testimony as to his innocent motive and assumes that the debtor will promptly pay the value of the nonexempt portion to the trustee.
A separate order has been previously entered consistent with this opinion disallowing the exemption of the IRA except to the extent stated.
The order also provided that the tax refunds and the life insurance policy were exempt only to the extent of the $10.00 exemption claimed on the original homestead deed. No determination was made as to how any tax refunds should be allocated as between husband and wife or as to whether the life insurance policy actually had a cash surrender value. If there is a dispute as to either such issue, it may be brought before the court by appropriate motion.