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Protect Your Estate from Beneficiary Bankruptcy: Lessons from Clark v. Rameker

In the preparation of a comprehensive estate plan for a client, an attorney must consider the size of the estate, the manner in which assets are titled, transfer and income tax issues, and family dynamics.  In light of the recent United States Supreme Court decision in Clark v. Rameker[1], ("Clark") there is now one more area of concern.

Before Clark

Prior to the Clark decision, the owner of an individual retirement account ("IRA" or "account") would work with the custodian of the IRA to identify his or her named beneficiaries and ensure that they would receive the balance of the IRA upon the owner's death.  Following the owner's death, the beneficiaries have some options with regard to the distribution of the balance of the inherited IRA, if the owner has not directed otherwise; these include (i) taking a lump-sum payment, which may result in a large income tax liability; (ii) taking the required minimum distributions, based on the beneficiary's life expectancy; or (iii) if the owner's spouse is the named beneficiary, treating the inherited IRA as his or her own, thus deferring or extending the required minimum distributions, assuming that the spouse's age allows for this.

Clark v. Rameker Decision

In Clark, the Supreme Court considered whether an inherited IRA is subject to creditors' claims asserted in an IRA beneficiary's bankruptcy proceeding, or whether an inherited IRA is protected as a retirement fund. The bankruptcy exemption provided by 11 U.S.C. §522(b)(3)(C) is intended to allow debtors to protect certain IRA funds needed to meet their basic retirement needs.

The Supreme Court identified three characteristics of an inherited IRA that establish an inherited IRA is not objectively set aside for retirement purposes: (i) additional money can never be invested into the inherited IRA account by the named beneficiary; (ii) withdrawals can be taken from the account regardless of the beneficiary's proximity to retirement; and (iii) the entire balance can be withdrawn for any purpose and without penalty by the beneficiary.[2]

The Supreme Court rejected the argument that a debtor-beneficiary has the option to take only required minimum distributions, leaving the remaining funds available to provide retirement benefits, noting that the same argument could be made for funds held in any account, such as a checking account.[3] The Court further stated that the statute is not intended to allow a "free pass" for the debtors after the bankruptcy concludes.[4]  Ultimately, the Court held that an inherited IRA is not subject to the protection of the provisions of 11 U.S.C. §522(b)(3)(C), and that the funds may be reached by a bankruptcy trustee to pay creditors of the bankruptcy estate.  This holding is limited, however, to non-spouse beneficiaries.

Planning for IRA Distribution

When planning for the distribution of assets, the lawyer and client should consider whether an IRA beneficiary who is not the spouse of the owner has issues with creditors that may lead to the beneficiary filing bankruptcy.  For example, if the sole beneficiary of an IRA is the owner's daughter and the owner dies within the first six months following the daughter's initiation of a Chapter 7 bankruptcy, in the absence of proper planning, the bankruptcy trustee will be able to reach the inherited IRA to pay the creditors of the daughter, and the inheritance intended to secure the daughter's future, to the extent of her debt, would be lost.[5]

One alternate planning technique for an owner who wishes to designate a non-spouse IRA beneficiary is to name a trust as the beneficiary, specifically, a See-Through Trust ("STTrust").[6]  A STTrust is revocable during the owner's lifetime, but becomes irrevocable upon his or her death.  In the IRA documents, the owner may designate the STTrust as the IRA beneficiary.  When a STTrust is named as a beneficiary, the required minimum distributions from the IRA, when received by the STTrust, may be held as principal of the STTrust and need not be distributed immediately to the STTrust beneficiary.

Further, the STTrust should be drafted so that distribution of principal for the beneficiary's health, education, maintenance or support occurs only upon the exercise of the Trustee's discretion.  If a STTrust beneficiary seeks bankruptcy protection, the bankruptcy trustee would be able to reach only those STTrust assets that the beneficiary has a right to receive, e.g., trust income.  This may be a better planning alternative than a Conduit Trust, which provides that the required minimum distributions from the IRA be distributed to the beneficiary immediately upon receipt. [7]

Setting Up Your STTrust 

To ensure that an STTrust can be the beneficiary of an IRA, the Internal Revenue Service ("IRS") requires that a trust meet the following four tests:  (i) the STTrust must be valid under state law; (ii) the STTrust must be "irrevocable or will, by its terms, become irrevocable upon the death of the owner;"[8] (iii) the beneficiaries of the STTrust who will receive the interest in the IRA must be readily identifiable in the STTrust; and (iv) certain documentation must be provided to the custodian of the IRA.[9]  Further, all STTrust beneficiaries must be individuals.  It is important to note that if a charity is named as a beneficiary of the STTrust, the STTrust does not qualify as a beneficiary of an IRA.

Consequences if You Don't Plan Ahead

The lack of a plan for the distribution of IRA benefits can lead to serious income tax consequences for a beneficiary who is subject to creditor's claims. Some owners may try to avoid the consequences of Clark by not designating an IRA beneficiary.  However, if no beneficiary is designated at the time of the owner's death, the IRA will be distributed as part of the owner's estate, which then passes to the beneficiaries of the owner's Last Will and Testament ("Will"); or if no Will was executed, the IRA is distributed based on the intestacy laws of the state.  Typically, those assets may also be available to satisfy the claims against the estate, and, once distributed to the beneficiaries, would be subject to claims of the beneficiary creditors.

If an owner's death occurs within approximately six months of a bankruptcy filing under Chapter 7 by a beneficiary named in the owner's Will or an intended heir of the owner, the portion of the estate distributable to that individual could still be reached  by the Bankruptcy Trustee as a simple inheritance.[10]  Further, under IRS regulations, an estate cannot be a beneficiary of an IRA.  Therefore, if no beneficiary is named, depending on whether or not the owner was taking the required minimum distributions at the time of his or her death, the entire balance of the IRA may have to be distributed over five years, which can increase the recipients' income tax burden.

If you believe that your family may be affected by the Clark decision, it is imperative to review the manner in which you have designated the beneficiaries under your IRA. 

[1] Clark v. Rameker, 134 S. Ct. 2242 (2014).

[2] Id. at 2247.

[3] Id. at 2249-2250.

[4] Id. at 2242, 2243.

[5] 11 U.S.C. §541(a)(5).

[6] Natalie B. Choate, Life and Death Planning for Retirement Benefits 141 (Ataxplan Publications 2011) (2010).

[7] Id. at 433.

[8] Id. at 414.

[9] Id. at 414.

[10] 11 U.S.C. § 541(a)(5)

Copyright © 2021 Ryley Carlock & Applewhite. A Professional Association. All Rights Reserved.National Law Review, Volume IV, Number 260

About this Author

Mark H. Boscoe, Ryley Carlock Law Firm, Corporate Attorney
Of Counsel

Following a 20-year career at an international law firm, Mark Boscoe joined Isaacson Rosenbaum P.C. in 2006 working in both the real estate, and tax and estate planning practice areas.  In 2011 he joined Ryley Carlock & Applewhite in the corporate practice group.  He has a broad background, including helping clients with real estate acquisition, development and finance, tax increment finance, entity formation and general transactional and corporate representation.  In addition, he assists individual clients and families with estate and charitable planning matters, including preparation...

Amber Curto, Estate Planning, trust administration lawyer, Ryley Carlock Law Firm

Amber is an attorney in the corporate practice group. Her practice focuses on the areas of Estate Planning, Probate, and Trust Administration. She also practices in the area of business formation. Before joining Ryley Carlock & Applewhite, Amber worked as an associate attorney at a small Arizona estate planning firm and also clerked at the Arizona Superior Court for the Honorable Judge Glenn Davis.

In January 2015, Amber was elected to serve as Chair of the Maricopa County Bar Association's Estate Planning, Probate and Trust Section.