Creditors Can Reach Profit Sharing Plan Assets After All ….. But Only in Certain Situations

Asset protection planning attorneys are often asked about protections that are available for qualified retirement plans and whether retirement plan assets are subject to claims of creditors. As a general rule the account of a participant in a qualified retirement plan, such as a profit sharing plan or 401(k) plan, is exempt from creditor claims with limited exceptions. For example, a spouse in a divorce can seek a qualified domestic relations order to reach the participant spouse’s interest in the account and the IRS can access the account for unpaid taxes. But typically banks and judgment creditors cannot reach the debtor’s interest in a qualified plan.

A 2013 Bankruptcy Case has now identified a set of circumstances where the general rule is not applicable and where the debtor’s interest in the plan is fully accessible by his general creditors (Daniels v. Agin, 736 F.3d 70 (2013)).

In order for a plan to be qualified the language of the plan must be in compliance with established pension law. But merely having the required language in the plan documents is not enough. It is essential that the plan operate in compliance with the requirements of the plan and ERISA law. The protection afforded a debtor with an interest in a qualified plan is premised on the plan’s continued qualification. Indeed, if the plan loses its qualified status the account balance of the participant/debtor is no longer afforded any special protection and it becomes available to his creditors.

Daniels involved a debtor who filed for a Chapter 13 bankruptcy (it was subsequently converted to a Chapter 7 bankruptcy) and was eventually granted a discharge. The trustee objected to Daniels’ claim of exemption for his plan assets arguing that the plan was not exempt from the bankruptcy estate because Daniels had engaged in multiple prohibited transactions. Essentially, the trustee identified numerous material violations of ERISA in the operation of the plan and claimed that such violations would disqualify the plan thereby making the debtor’s account part of the bankruptcy estate. Each side made arguments to support its respective position.

Daniels argued that the IRS had made a favorable determination with respect to the plan’s qualified status and that the bankruptcy court was bound to honor it. Furthermore, the plan had been subject to an IRS audit and although several issues were raised by the IRS in the course of the audit they were eventually resolved and the plan’s qualified status remained intact. Based upon these IRS actions Daniels claimed the trustee had no basis to independently challenge the plan’s qualified status. The trustee argued that the favorable determination was founded upon information submitted to the IRS by Daniels and about which it was aware. It further argued that based upon information developed in the context of the bankruptcy case it became clear that the plan was not operating in compliance with ERISA and therefore the bankruptcy court could treat the plan as if it no longer was qualified.

As we find in many of these cases, the improper conduct of a debtor during the course of the bankruptcy case and even prior to filing severely undermines his position. Daniels repeatedly, through submission of false schedules, by way of incomplete disclosures to the trustee during discovery and in creditor meetings, failed to disclose that he was the beneficiary of 2 substantial IRA accounts. Separately, Daniels transferred money from several nonqualified joint accounts to the profit sharing plan. Thereafter the heir of the deceased joint tenant sued Daniels claiming he did not have the right to the monies in the joint accounts and obtained a judgment against him that with interest totaled over $400,000 at the time of the bankruptcy filing.

The court found that the repeated prohibited transactions of which the IRS had no knowledge and that had not been disclosed during the bankruptcy case provided an appropriate basis for the court to reach an independent decision regarding the plan’s qualified status and to override the favorable determination previously granted by the IRS. As a result, the plan assets as well as the IRA’s into which the tainted assets transferred were deemed part of the bankruptcy estate and available to Daniels’ creditors.

The bankruptcy court revoked Daniels’ discharge. In doing so it based its finding on the fact that Daniels demonstrated a reckless indifference to the truth of material information during the proceedings. Over several pages the court painstakingly analyzed the many communications from debtor where he intentionally concealed or failed to disclose plan assets. Daniels argued that the total amount stated to be his plan account balance as scheduled on court filings was actually the total of his plan account balance plus the balance in his 2 IRA’s and thus there was no misstatement of his total assets. Daniels’ argument was quickly rejected. The court responded that mere disclosure of the amount of debtor’s assets is insufficient. The trustee has the right to know where the assets are, how they are titled and what transfers have occurred.

What is particularly interesting in this case is that the First Circuit affirmed the Bankruptcy Court’s summary judgment even though this meant the court construed every inference in Daniels’ favor. So a key take away here is that where there is clear and serious misconduct a court will not hesitate to rule in the creditor’s favor – even on a summary judgment motion – when it might not have had the debtor’s conduct been less offensive.