Check clients' IRA agreements

After several lost court battles, James Daley Jr. finally won his case allowing his individual retirement accounts to be protected in bankruptcy. The 6th U.S. Circuit Court of Appeals ruled last month that certain cross-collateralization language in the custodian's IRA agreement won't be a prohibited transaction and that the IRA will be protected from bankruptcy creditors. Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, clients' retirement accounts generally are exempt from their bankruptcy estate. In other words, when a bankruptcy court determines what debts a client will have to repay and whether to wipe out any or all outstanding liabilities, the court won't factor in any exempt retirement assets in its analysis. But when clients commit a prohibited transaction, the bankruptcy exemption shield can be pierced, thus allowing retirement funds to be accessed by creditors. This case, and others, show how a cross-collateralization provision, common in many IRA agreements, can be a prohibited transaction and put the bankruptcy protection at risk. For Mr. Daley, it began in August 2010 when he filed for bankruptcy. At that time, he had a self-directed IRA with Bank of America Merrill Lynch worth almost $62,000. This was the only account Mr. Daley held with Merrill. His IRA was opened when he signed a “Merrill Lynch client relationship agreement” in May 2008 that established his self-directed IRA, which was then funded with a rollover deposit.

MARGIN LOAN

When Mr. Daley completed the documents, he didn't check any of the “decline margin lending” boxes in the accounts section of the agreement. This effectively allowed a margin loan that he owed in any other Merrill account — including a non-IRA account — to be covered by assets held in his IRA. By signing the account agreement, Mr. Daley pledged his IRA as collateral for a potential loan made outside his IRA. This is technically a prohibited transaction. However, Mr. Daley never borrowed any money from his IRA and he never requested a margin loan against his IRA funds. There was never even a possibility of Mr. Daley's IRA assets being used to cover debts of a non-IRA account because he had no other Merrill accounts. Nevertheless, along with other arguments, the bankruptcy trustee claimed that the cross-collateralization language in the Merrill IRA documents created a prohibited transaction, leading to the loss of the IRA's qualified status. The bankruptcy trustee also argued that if the funds in the IRA lose their qualified status for tax purposes, they should also be available to creditors in the bankruptcy process. Mr. Daley's attorney argued that he didn't engage in any prohibited transaction because no outside loan was ever funded. But he still lost. The court ruled that Mr. Daley's IRA was disqualified and thus wasn't exempt in bankruptcy. In 2011, the U.S. Bankruptcy Court determined that the part of the Merrill Lynch document containing the cross-collateralization language created a prohibited transaction, even though it wasn't executed. The court concluded that simply signing IRA documents that contain a cross-collateralization agreement, including language that mentions “liens” on the IRA, is an extension of credit between an IRA owner and the IRA, which causes a disqualification of the entire IRA under the prohibited-transaction rules. Mr. Daley appealed and lost again last September. He appealed to the U.S. District Court for the Eastern District of Tennessee, which ultimately upheld the bankruptcy court's previous decision. Once again, he appealed, this time to the 6th U.S. Circuit Court of Appeals, where he finally won. The court stated: “The mere existence of a "cross-collateralization agreement,' as the Internal Revenue Service calls it, doesn't by itself disqualify an IRA from exempt status. At most, it is the actual use of such an agreement and the prohibited extension of credit through it in a later transaction that might disqualify a retirement account.” Although Mr. Daley eventually won his case, financial advisers should check clients' IRA agreements for cross-collateralization language that could disqualify their IRAs and expose them to bankruptcy creditors. Have that language removed, as some custodians are already doing, or move the funds to another custodian. Ed Slott (irahelp.com), a certified public accountant, created The IRA Leadership program and Ed Slott's Elite IRA Adviser Group.