Resolution of the Conflict--Patterson v. Shumate

The U.S. Supreme Court has now resolved the conflict, and in a manner favorable to those whose benefits are held in qualified pension and profit sharing plans. In Patterson v. Shumate, decided June 15, 1992, the Court held that benefits in an ERISA-qualified pension plan are not subject to creditors of a bankrupt individual. As a result, such amounts will be available for the use of the participant, even if the participant is forced into bankruptcy.

The case involved Joseph Shumate, who was president and chairman of the board of Coleman Furniture Corporation. Coleman Furniture maintained a tax-qualified pension plan for its employees. Both Coleman Furniture and Shumate filed for bankruptcy, and the trustee in bankruptcy for Shumate's estate tried to attach Shumate's pension benefits. The recitation of facts in the case indicates that the pension plan was terminated, and the benefits of all participants except Shumate were distributed to the plan participants. Mr. Shumate's benefits remained in the plan, and the trustee in bankruptcy sought to obtain those benefits for Shumate's creditors.

The trustee made a number of arguments in support of his position that the assets could be reached by creditors. All the arguments made were rejected by the Court, which was unanimous in its decision that ERISA- qualified benefits can not be reached by creditors of a bankrupt individual.

Effect of the Decision

Because decisions of the U.S. Supreme Court are binding throughout the country, it is now absolutely certain that benefits held in a qualified pension or profit sharing plan are not subject to creditors. The Court in Patterson indicated it sought to further an important policy underlying ERISA, the "uniform national treatment of pension benefits."

Individuals facing serious liability concerns, such as owners of failing businesses and medical professionals, now know with certainty that the benefits held in their qualified pension or profit sharing plans can not be reached by their creditors. This is true even if the plan loses its qualification under IRC Sec. 401(a), although the loss of qualification would have potentially adverse tax consequences.

Individual Retirement Accounts

The creditor protection provided to benefits under a qualified plan does not extend at the Federal level to IRAs, including rollover IRAs. The section of the bankruptcy law interpreted by the Court in Patterson is 541(c)(2), which excludes from a bankrupt's estate property of the debtor that is subject to a restriction on transfer enforceable under applicable non-bankruptcy law.

In Patterson, the Court concluded that ERISA Sec. 206(d)(1) and IRC Sec. 401(a)(13), which was added by ERISA, are therefore determinative for purposes of the bankruptcy law. Neither applies to IRAs, and the Court notes that Sec. 1051(6) of ERISA specifically exempts IRAs from its anti-alienation provisions.

The three primary differences in treatment of assets held in qualified plans as opposed to IRAs are:

1. Distributions from IRAs cannot qualify for lump sum averaging treatment. This means that the more favorable tax rates that apply when five or ten year averaging is applied to determine the tax on a lump sum distribution are not available to distributions from IRAs. However, since most people do not take distributions in a lump sum and pay income taxes immediately, this difference does not normally affect the decision to transfer the benefits to an individual retirement account.

Since Congress is considering the repeal of five and ten year averaging, this difference would have no significance should the repeal pass.

2. Assets held in IRAs may not be invested as broadly as assets held in a qualified plan. Even rollover IRAs which permit directed investments generally include some restrictions on the types of investments which can be made. Under a qualified plan, the only restrictions applied are those preventing the plan from engaging in prohibited transactions. For example, the purchase of second mortgages or stock in a closely held corporation is generally prohibited to an individual retirement account but can be made by a qualified plan.

3. Monies held in IRAs cannot be invested in life insurance. As a result, should planning with life insurance be indicated for an individual who has money in an individual retirement account, that money can be used to pay premiums on a policy only after it is withdrawn from the individual retirement account and subjected to income tax.

The decision of the Supreme Court in Patterson v. Shumate adds another difference between the treatment of IRAs and monies held qualified plans. That difference, as indicated earlier, is that monies held in qualified plans are protected from creditors no matter where the participant resides, while monies held in IRAs may not be protected from creditors with certainty, even in states ostensibly providing that protection.

The IRA Risk

Because the Patterson decision does not apply to IRAs, the protection afforded IRAs will be determined under applicable state law. Many states provide no protection for IRAs; some attempt to provide that protection by treating IRAs as spendthrift trusts, which under Federal bankruptcy law are exempt from creditors. Most states do not exempt IRAs to the extent that they do not constitute rollover IRAs (amounts rolled from a qualified plan).

An individual who resides in a state which treats individual retirement accounts as spendthrift trusts has a degree of protection for IRA assets not available to an individual who resides in a state without such a law. An individual who moves from a state that has protected IRAs as spendthrift trusts to a state that does not do so loses the protection upon the change in domicile. An individual whose monies are held in a qualified pension or profit sharing plan retains the protection no matter where he or she resides in the U.S.

Although the Federal bankruptcy law exempts assets held in spendthrift trusts from the reach of creditors, some Federal courts have cast doubt upon the validity of state laws treating benefits subject to ERISA as spendthrift trusts. These courts have argued that ERISA pre-empts state law, and as a result no state can make a law affecting the alienation of benefits subject to ERISA. Since ERISA does not protect IRA benefits from creditors, it could be argued that the state law attempting to do so by treating IRA assets as part of a spendthrift trust is invalid. This would expose the IRA benefits to creditors.

Requalifying for the Protection

An individual who has rolled benefits into an IRA can roll those benefits back into a qualified plan.

When an individual rolls benefits from a qualified plan into an IRA, that individual is permitted to roll the amounts transferred to a rollover IRA into another IRA or qualified plan at any time. However, once a rollover from a rollover IRA to another IRA or a qualified plan occurs, subsequent rollovers are not permitted until the amount has remained in the IRA or qualified plan for at least one year. Anyone who contemplates obtaining the protection offered by Patterson for monies held in a rollover IRA must first determine whether the monies can be rolled back, and when the rollover will be possible.

If the amounts came from a qualified plan, and were never mingled with IRA money that did not come from a qualified plan, other than earnings on the rollover, the amounts can be rolled back to a qualified plan. However, the timing of the rollback will depend upon whether the monies have remained in the original IRA to which they were rolled, or have been transferred.

Assuming the amounts can currently be rolled back into a qualified plan, the individual must be a participant in a qualified plan which permits rollovers. If the company maintaining the qualified plan originally still exists, that company can establish a profit sharing plan to hold the rolled-over money. If the individual is employed by a company which maintains a qualified plan and permits rollovers, the money can be rolled into a qualified plan maintained by that company.

However, if a new profit sharing plan is established and no contributions are made to the plan (other than the rollover contributions) it is not clear that this plan will be treated as a qualified profit sharing plan and there may be some risks that the rollover would be taxable.

If a profit sharing plan is to be established to permit the rollback from the IRA to the qualified plan, the plan must be bona fide. This means that contributions to the plan must be substantial and recurring. While there is no minimum contribution required for profit sharing plans, employers should contribute for all employees (other than those who have reached their 415 limit) a minimum amount of 3% of compensation. Three percent is the amount required as a top heavy minimum contribution to a defined contribution plan, and should be sufficient to establish the plan as a bona fide benefit program.

The Wasting Trust

If an employer has a profit sharing plan to which contributions were made in the past, but is not now making contributions because it cannot afford to do so, the plan can be used as a rollover vehicle even though no current contributions are made.

Some years ago the IRS suggested that a qualified plan could not retain its qualification unless the sponsoring employer continued to exist. The argument made by the IRS was that a plan, by definition, is a program maintained by an employer for its employees and if an employer ceases to exist are condition for continued qualification of the plan would not exist.

The American Society of Pension Actuaries contacted the IRS to discuss the impact of this position. Apparently, the IRS had not recognized that a significant number of Keogh plans were maintained without a sponsor, either because the unincorporated professional had incorporated or simply ceased to practice his or her profession. In addition, there were a large number of corporate plans in a similar position.

The IRS then indicated, although not in writing, that it would not continue to press its argument that a sponsorless wasting trust was not a qualified plan. The Districts were instructed not to disqualify such plans if they did come to their attention, and Rev. Rul. 89-87 was subsequently published dealing with frozen plans, another term for the wasting trust. That revenue ruling simply provided that a frozen plan had to continue to satisfy the qualification conditions imposed by changes in the law and had to be restated by December 31, 1989, to comply with TEFRA, DEFRA or REA, or terminated, and the assets distributed by that date.

The IRS indicated, again not in writing, that a second ruling would soon be published describing the procedures to follow with reference to sponsorless wasting trusts. That ruling was under development some years ago, but has yet to be issued. Based on the assurances received from the IRS at the time, and the position taken on audits since that time, it now appears that a sponsorless wasting trust (frozen plan) is qualified and could be a vehicle for a rollback of amounts held in a rollover IRA.

Insurance Planning

One of the difficulties confronting individuals who have money accumulated in IRAs and who wish to purchase life insurance is that life insurance policies cannot be held in IRAs. As a result, any life insurance purchased for such an individual using the monies held in the tax deferred retirement program must first be subjected to income tax.

Many individuals with monies held in IRAs recognize the desirability of purchasing life insurance for their planning purposes. However, they are unwilling to withdraw money from the IRA to pay the premiums, since the withdrawal requires the payment of income taxes on the premium amount. If the protection of assets from creditors is important to such a person, the Patterson decision provides additional reason for moving the money back to a qualified plan, making the monies available for the purchase of insurance.