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Does Your Firm's Standard Lien Language Create a Possibility that Your Customer IRAs May Lose Their Tax Exempt Status and Protection from Third-Party Creditors?

It is not uncommon for firms to use standard language in their account agreements that creates liens on Individual Retirement Accounts (IRAs). Two recent federal court decisions, however, suggest that granting such a lien on an IRA may constitute a prohibited transaction that causes these accounts to lose their tax exempt status, which in turn could potentially make IRAs subject to third-party creditor claims. These two decisions could have far-reaching implications for any firm that has used or still uses similar lien-creating language in their account agreements.

In the first case, In re Daley, 459 B.R. 270 (Bankr.E.D. Tenn. 2011), the Bankruptcy Court for the Eastern District of Tennessee sustained the chapter 7 trustee’s objection to an exemption claimed by the debtor for his Merrill Lynch IRA. Normally, because an IRA generally is exempt property under the bankruptcy code, it will be protected from creditor claims against the IRA owner. In Daley, the debtor scheduled his IRA as exempt from property of his bankruptcy estate pursuant to Tennessee Code Annotated § 26-2-105(b),1 which provides that a retirement plan that is qualified under Section 408 of the Tax Code is exempt from claims by creditors. Years before the debtor’s bankruptcy filing, Merrill Lynch, the debtor’s brokerage firm, had obtained a determination letter from the Internal Revenue Service that indicated the Merrill Lynch IRA “satisfie[d] the requirements of Code section 408[].” This determination letter created a rebuttable presumption under the Bankruptcy Code that the debtor’s IRA satisfied the terms of the Tax Code and was therefore exempt from property of the bankruptcy estate. See 11 U.S.C. 522(b)(4).2

The trustee contended that the IRA was not exempt because the Merrill Lynch Relationship Agreement gave rise to a “prohibited transaction” under 26 U.S.C. §4975. Certain prohibited transactions can cause retirement plans to lose their qualification under Section 408. One such prohibited transaction is by the IRA owner granting an extension of credit from the IRA. See 26 U.S.C. § 4975. In denying the debtor’s claim of exemption, the court found that certain language contained in the Terms and Conditions of the Merrill Lynch Client Relationship Agreement that created a lien on the IRA was tantamount to an extension of credit. Accordingly, the court found that the IRA lost its tax exempt status which, in turn, caused the debtor to forfeit the right to claim it as exempt under the Bankruptcy Code.

The court, in finding that the trustee had successfully rebutted the presumption that the IRA was exempt, relied heavily on an October 27, 2009 advisory opinion letter from Louis J. Campagna, Chief, Division of Fiduciary Interpretations, Office of Regulations and Interpretations for the Department of Labor, which definitively stated that granting a security interest in an IRA constitutes an extension of credit and a prohibited transaction. Ultimately, the result reached in Daley likely may be a function of the arguments raised — and, perhaps even more importantly, those not raised — by counsel, the paucity of law surrounding Section 522(b)(4), and a potential gap in the statutory scheme.

First, in light of the advisory opinion letter and because the debtor failed to even raise the issue, the Daley Court did not probe into whether the grant of lien by the debtor was a legitimate extension of credit within the meaning of Section 4975. As the court acknowledged, any lien granted by the debtor was conditional because the debtor never opened other accounts with Merrill Lynch nor attempted to borrow on his IRA. Generally speaking, a lien only attaches to property to the extent that it secures an obligation. If there is no obligation, then arguably the significance of that lien is greatly diminished. Yet still, in Daley, the court found that even the conditional lien eliminated the debtor’s ability to exempt his IRA.

Second, because the parties stipulated to the point, the court never examined whether the letter from the Internal Revenue Service to Merrill Lynch in fact constituted a “favorable determination” within the meaning of Section 522(b)(4)(A).3 Importantly, the Congressional intent behind Section 522(b)(3) and (b)(4) was “to expand the protection for tax-favored retirement plans.” H. Report No. 109-31 to accompany S. 256, 109th Cong., 1st Sess. (2005) pp. 63-64 (emphasis added). The Daley holding, however, did the exact opposite by effectively penalizing the debtor for having an IRA that arguably had received a "favorable determination.” Indeed, the presence of a “favorable determination” precluded the debtor from making an argument that the IRA was exempt under Section 522(b)(4)(B). Although it was not enough to change the court’s ruling, the court did acknowledge that the result it reached seemed “incongruous.”

In the second case, Yoshioka v. Charles Schwab Corp., 2011 WL 6748984 (N.D.Cal. 2011), the plaintiff class alleged that its IRAs’ tax exempt status had been put at risk based on lien-creating language contained in Charles Schwab’s account agreements. Charles Schwab’s IRA account agreement at issue provided that “each Schwab IRA account holder grants [Charles Schwab] a continuing security interest in and lien on . . . all securities and other property . . . maintained for any purpose in or through the Schwab IRA . . . .” The class alleged that such language caused it to engage in a prohibited transaction which, in turn, caused its IRAs to lose their tax exempt status. In response to the plaintiff’s complaint, Charles Schwab agreed to retroactively amend the IRA agreement to remove the lien-creating language.

The Northern District court, in a November 22, 2011 Order, denied final approval of the settlement, questioning whether the non-monetary settlement was sufficient to compensate the class for its purported, yet-unrealized “damages.” Although the court did not reach the merits of the allegations, by denying class settlement it inferred that the language contained in the agreement might be interpreted as having effectively voided the tax exempt status of the IRAs notwithstanding Charles Schwab’s attempt to retroactively amend the agreement. The court questioned whether retroactively amending the agreement would be permitted by the Tax Code; and even if permissible, if it would function to avoid creating a prohibited transaction resulting in the permanent loss of the accounts’ tax exempt status. The court did not answer these questions, however, and they remain open for further conjecture.

These holdings have potentially far-reaching implications for firms whose standard account agreements currently (or used to) contain language similar to the language in the agreements referenced above. At a minimum, these cases may give disgruntled customers ammunition to argue, as incongruous as it may sound, that they lost the tax exempt status of their IRAs simply by opening an account that grants a lien on the IRA assets.

1 Under the Bankruptcy Code, the debtor’s bankruptcy estate generally includes all property owned by the debtor at the time the debtor files for bankruptcy. See 11 U.S.C. § 541. Section 522 provides various exemptions of property from the bankruptcy estate; however, Section 522(b) provides an “opt out” provision, which allows states to require debtors to use the state’s exemption rather than the federal exemptions. Tennessee, like many states, is an “opt out” state. Accordingly, Tennessee’s exemptions, not the federal exemptions, applied in Daley. 
2 Under Section 522(b) of the Bankruptcy Code, if retirement funds are in a fund that has received a “favorable determination” through means such as a determination letter, the funds are presumed exempt. If the fund has not received a favorable determination, however, the debtor has the burden to show that no prior determination to the contrary has been made by a court or the IRS and either (i) the fund is in substantial compliance with the Internal Revenue Code or (ii) the fund is not in substantial compliance, but the debtor was not materially responsible for the failure. See 11 U.S.C. § 522(b)(4). 
3 Notably, the letter from the Internal Revenue Service explicitly declined to express any opinion as to whether the IRA language created a prohibited transaction; and because Section 522(b)(4) was added to the Bankruptcy Code in 2005, there is little case law to shed light on the meaning of a “favorable determination.”

©2021 Greenberg Traurig, LLP. All rights reserved. National Law Review, Volume II, Number 60

About this Author

Alex Rosenthal, Greenberg Traurig Law Firm, West Palm Beach, Litigation Attorney

Alex "AJ" Rosenthal is an associate in the Securities Litigation Practice Group of Greenberg Traurig’s West Palm Beach office.


J.D., cum laude, University of Florida Levin College of Law, 2011

  • Book Awards: Corporations, White Collar Crime
  • Dean's List

B.S.B.A., Finance, University of Florida, 2008