Protecting The Nest Egg – Recent Developments Expose Retirement Assets For Florida Debtors
By Richard S. Amari © 2003 All Rights Reserved
CAUTION: THIS ARTICLE WAS PUBLISHED IN 2003 AND THERE HAVE BEEN SIGNIFICANT DEVELOPMENTS IN FEDERAL BANKRUPTCY LAW, STATE STATUTORY LAW AND CASE LAW SINCE THEN. THIS ARTICLE WAS THE BASIS FOR STATUTORY AMENDMENTS TO FL. STAT. § 222.21, WHICH WERE PRINCIPALLY WRITTEN BY THE AUTHOR OF THIS ARTICLE. THIS ARTICLE SHOULD NOT BE RELIED UPON WITHOUT REFERENCE TO THESE MORE RECENT DEVELOPMENTS.
Estate planning is a process whereby the planner solicits factual data from the client and then makes planning recommendations designed to avoid or minimize potential adverse consequences of certain risks the client may face, such as incompetency or lawsuits, and the eventuality of death. Planning to avoid collection of judgments resulting from unforeseen future creditors should be a significant focus of the estate planner.
Certain clients present far greater risks than others. Obviously, a practicing neurosurgeon is at much greater risk than the retired artist. The estate planner not only must consider how a proposed plan may alter a client’s exposure to lawsuits, but he or she must also consider implementing various strategies designed to reduce the likelihood that a future, unforeseen creditor might attempt to seize or garnish assets belonging to the client. Indeed, failure to properly address asset protection issues with the client could expose the estate planner to claims for malpractice. Thus, the estate planner’s own asset protection strategies will take on particular significance.
Understanding how retirement assets may be exposed to seizure or attachment by a creditor is a necessary prerequisite to properly advising the client regarding asset protection. Retirement assets often form a significant portion of an individual’s net worth. In fact, retirement assets have been recognized as having rapid and substantial growth, affecting the well-being and security of millions of employees and their dependents, affecting a national public interest, and becoming an important factor affecting the stability of employment.2 It is no wonder that Florida, as well as many other states and the federal government, would enact laws designed to protect these assets from involuntary alienation.
This paper discusses the Federal and Florida laws that relate to creditor protection of a Florida debtor’s retirement assets. More specifically, this paper will reveal how recent case law developments expose Florida debtors’ retirement assets to creditors and threatens the Florida and Federal statutory schemes designed to protect those assets. Finally, the potential impact of pending bankruptcy legislation will be considered.
II. Types Of Retirement Assets
Retirement assets typically consist of investments that are funded through a plan designed to provide a source of support after retirement. A retirement plan may be established by an employer for the benefit of its employees, by a company for the benefit of its owners, or by the individual who will benefit by the investments made through the plan. Retirement plans come in many different shapes and sizes, including the following:
A. Employer Provided Plans
Among the myriad types of retirement plans are those established by employers for the benefit of employees. Employer provided plans may be “qualified” or “non-qualified”. A plan that is “qualified” meets the requirements of § 401(a) of the Internal Revenue Code of 1986, as amended (“Code”).3 From this status, special tax treatment is afforded. Current contributions to the plan are deductible by the employer and not currently included in income of the employee. Furthermore, the income and gains of the trust which holds the benefits are not currently taxed. An employer may receive a determination letter from the IRS that determines the plan is in compliance with the requirements of § 401(a) of the Code. The plan may lose its qualified status by failing to adopt certain amendments required by law or by failing to operate in accordance with the requirements of law. Employer provided plans may be categorized into two basic types – defined contribution plans and defined benefit plans. Defined contribution plans are plans which define the amount of contribution to be made to the employee’s individual account. Typical defined contribution plans include profit sharing plans, which allow the employer to select from year to year the amount of contribution to the plan, and money purchase pension plans, which establish a fixed annual contribution to the plan. Other types of defined contribution plans include thrift plans, stock bonus plans and employee stock ownership plans. A popular type of profit-sharing plan or stock bonus plan is the cash or deferred arrangement (“CODA”), also referred to as a “401(k),” which refers to the section of the Code under which these arrangements are granted special tax status.4 Defined benefit plans, commonly referred to as pension plans, do not provide for contributions to an individual account of the employee. Rather, they define the amount of benefit that a retired employee will receive from the plan. Plans may be funded or unfunded. Funded plans require the employer to currently contribute to the plan to provide the employee’s retirement benefit so that the assets contributed by the Employer are no longer available to the general creditors of the Employer. Funded plans provide for a trust to receive the employer’s contributions. Included among the laundry list of employer provided plans are the following:
- Church and Governmental Plans
A governmental plan is:
. . . a plan established or maintained for its employees by the Government of the United States, by the government of any state or political subdivision thereof, or by an agency or instrumentality of which the Railroad Retirement Act of 1935 or 1937 applies, and which is financed by contributions required under the Act and any plan of an international organization which is exempt from taxation under the provision of the International Organizations Immunities Act. 5A church plan is “ . . . a plan established and maintained . . . for its employees (or their beneficiaries) by a church or by a convention or association of churches which is exempt from tax under § 501 (of the Code).” 6
Governmental and church plans may be afforded special tax treatment under §§ 401(a), 403(b) or 457 of the Code.
- Plans That Only Cover Owners and Their Spouses
Plans may be established by a sole proprietor for his or her benefit and the benefit of his or her spouse. Similarly, plans may be established by a corporation for the benefit of a sole shareholder, for several shareholders, and for their respective spouses. Plans are also established by partnerships for the benefit of partners and their spouses. These plans may only provide benefits for owners, or they may provide benefits for employees in addition to owners. Plans that are established by unincorporated entities are known as “HR-10″ or “Keogh” plans.
- Top Hat Plans
Top hat plans are unfunded plans “maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.”7
- Excess Benefit Plans
An excess benefit plan is “a plan maintained by an employer solely for the purpose of providing benefits for certain employees in excess of the limitations on contributions and benefits imposed by § 415 of (the Code) on plans to which that section applies, without regard to whether the plan is funded.”8
A SEP is a Simplified Employee Pension which provides for contributions by an employer to an individual retirement account or individual retirement annuity owned by the employee. The preferential tax treatment and requirements for a SEP are set forth in § 408(k) of the Code.
- SIMPLE Plan
A Simple Plan is a plan, called a Savings Incentive Match Plan for Employers, introduced in 1997. 9 Under a Simple Plan, the employer makes contributions to a separate IRA owned by the employee. The Simple Plan provides for cash or deferred arrangements, similar to a § 401(k), and replaces the “SARSEP” provisions for SEPs for years after 1996. Only employers having no more than 100 employees who earn $5,000 or more in compensation may maintain a SIMPLE plan. The preferred tax treatment for these plans is provided by § 408(p) of the Code.
B. IRA’s (Traditional, Roth and Educational)
An IRA is an individual retirement account, individual retirement annuity or a group individual retirement account sponsored by an employer or labor union. An “individual retirement account” is a trust created or organized in the United States for the exclusive benefit of an individual or his or her beneficiaries which meets certain requirements of the Code.10 An “individual retirement annuity” means an annuity contract, or an endowment contract, issued by an insurance company which meets certain requirements of the Code.11 IRA’s that meet the requirements of § 408 of the Code also are afforded special income tax treatment. A Roth IRA is an IRA, treated in the same manner as an IRA, with certain exceptions set forth in § 408A of the Code. An educational IRA is different than other IRA’s in that it is not intended as a retirement account. The educational IRA, also known as a “Coverdell Education Savings Account”, is a trust created for the purpose of paying qualified education expenses of an individual who is designated beneficiary of the trust, if the trust meets certain requirements of the Code.12 Unlike qualified plans maintained by employers, an individual cannot obtain a determination letter from the IRS determining that any particular IRA meets the requirement of the Code. The IRS will not challenge the deductibility of contributions that meet the requirements of the Code to an IRA that is an IRS model IRA trust or custodial agreement or is a prototype agreement or annuity contract approved by the IRS.13 Although the IRS won’t issue determination letters to individual account owners, it will issue a determination letter to an IRA sponsoring organization that acts as custodian or trustee or to a mass submitter.14 Like employers who maintain qualified plans, IRA sponsoring organizations and mass submitters are required to make timely amendments to their documents to assure continued compliance with § 408 of the Code.
C. Retirement Plans Covered by ERISA
Enacted in 1974, the Employee Retirement Income Security Act (“ERISA”) was enacted to regulate employee welfare benefit plans and employee pension benefit plans. Among its chief purposes, ERISA was designed to encourage the maintenance and growth of single-employer pension systems, to protect employers’ retirement assets from mismanagement and misuse by employers and plan fiduciaries and to improve career and financial planning for employees.15 ERISA was enacted in four titles. Title I provided for substantive rules for protection of employee benefit rights through provisions for reporting and disclosure, participation and vesting, funding, fiduciary responsibility and administration and enforcement. Title II of ERISA provides the amendments to the Internal Revenue Code of 1954 that establish the qualification rules for tax-favored treatment. There are many provisions in Title II of ERISA, such as those dealing with participation, vesting and funding, that mirror the provisions in Title I. Title III of ERISA contains the provisions for jurisdiction, administration and enforcement. Title IV of ERISA creates plan termination insurance requirements for pension plans.
For the uninitiated, looking for provisions of ERISA in the United States Code can be confusing at best. When enacted, Titles I, III and IV were codified as part of Title 29 of the United States Code. Because Title 29 already contained many sections dealing with labor laws, the section numbers that were assigned to the ERISA provisions do not match the ERISA section numbers. ERISA was enacted as Chapter 18 of Title 29 and when looking at the references to the subchapters, subtitles and parts of Chapter 18, there are no corresponding references to titles or sections of ERISA. Thus, for example, the preemption provisions of § 514 of Title I of ERISA were codified as Title 29, Chapter 18, Subchapter I, Subtitle B, Part 5, § 1144 of the United States Code. Unfortunately, most publications dealing with ERISA make references to the original ERISA sections and titles, which makes an already difficult subject matter even more difficult to follow and understand. Those seeking enlightenment in matters of ERISA would be best served by obtaining a table that links the ERISA sections to their corresponding Title 29 section numbers. To avoid adding to this confusion, references to ERISA in this paper will be to the sections in Title 29 of the United States Code, except for references to titles of ERISA, since not all titles of ERISA have corresponding references in Title 29 (e.g., Title II of ERISA was codified in Title 26 of the United States Code rather than Title 29).
Determining which provisions of ERISA a retirement plan may be subject to is critical to an assessment of whether the retirement assets under that plan are exposed to creditors’ process (see discussion at Section IV.E.). Plans that are subject to the provisions of ERISA are said to be “covered by ERISA.” The term “covered by ERISA” is the subject of much confusion. That is because certain plans may be covered by only parts of ERISA while others may be covered by all of ERISA.
- Plans Covered By All of Title I of ERISA
Certain plans are covered by, or subject to, all of the provisions of Title I of ERISA, which are found in Subchapter I, Chapter 18, Title 29, United States Code. With certain exceptions, those provisions apply to any “employee benefit plan” established or maintained by any employer, any employee, organization or organizations representing employees or both.16 An “employee benefit plan” is an “employee welfare benefit plan” or an “employee pension benefit plan”.17 An “employee welfare benefit plan” is a plan maintained by an employer on an employee organization or both for the purpose of providing for its participants or their beneficiaries medical, surgical or hospital care or benefits in the event of sickness, accident, death, or unemployment and similar type benefits.18 An “employee pension benefit” plan is a plan maintained by an employer, an employee organization or both which provides retirement income to employees or results in deferral of income by employees for periods extending to the termination of covered employment or beyond.19
- Plans Not Covered At All By Title I of ERISA
Plans specifically excepted from coverage of Title I include governmental plans, church plans that have not elected to be subject to Title I of ERISA under Code § 410(d) (“non-electing church plans”)20 and unfunded excess benefit plans.21 Also, with the exception of certain SEP or SIMPLE IRA’s (see discussion at Section IV.E.), IRAs are not covered by Title I of ERISA because they are not maintained by employers or employee organizations. A few § 403(b) plans that do not have sufficient employer involvement should also not be covered.
- Plans Covered by Only Parts of Title I of ERISA
Certain plans may be subject to some but not all of Title I of ERISA. For example, top hat plans and funded excess benefit plans are not excluded from coverage of all of Title I, but are excluded from coverage from Part 2 of Title I (participation and vesting). Top hat plans are also excluded from Part 4 of Title I (fiduciary responsibility), whereas funded excess benefit plans are subject to Part 4 of Title I. The preemption rules which preempt state laws that relate to employee benefit plans, found in Part 5 of Title I of ERISA, apply to all employee benefit plans other than those specifically excluded under § 1003(b).22
- Schizophrenic Plans – Those Covering Only Owners and Owners’ Spouses
Some plans only cover owners or owners and their spouses. These include “Keogh” plans maintained by sole proprietors and partnerships for their owners and plans maintained by corporations for their shareholders. Because Title I of ERISA only covers “employee benefit plans,” and because employee benefit plans, by definition, only include plans maintained by employers for the benefit of employees, regulations promulgated by the Secretary of Labor administratively exclude from Title I plans that only cover owners or owners and their spouses.23 Owners and their spouses are not considered employees for this purpose.24 What about the plan that once covered owners and common law employees, but due to attrition currently only covers owners? Plans that only cover owners or owners and their spouses can have dual personalities and the courts have struggled with the question of whether a plan remains subject to Title I of ERISA if the plan never had or no longer has a participant other than an owner or a spouse of an owner. Many courts have held that plans that only benefit owners or owners and their spouses are not covered by Title I of ERISA, while others have held that Part 5 of ERISA (containing preemption provisions) continues to apply to those plans. Indeed, Professor Donna Litman makes a very cogent and scholarly argument that the labor regulations which exclude plans covering only owners and spouses from Title I coverage are invalid to the extent they purport to exclude those plans from coverage of certain parts of Title I of ERISA, including the provisions of Part 2 prohibiting assignment and alienation of benefits.25 Whether certain parts of ERISA apply to a plan will be determinative of whether the assets in those plans are exempt from creditors’ claims (see discussion at Section IV.E.2.). Therefore, this distinction of whether plans that cover only owners or owners and their spouses that have been “administratively removed” from coverage of all or certain parts of ERISA takes on particular significance.
III. Applicable Laws Regarding Creditors’ Access To Retirement Assets.
Trying to make sense out of the laws governing creditors’ and debtors’ rights relating to retirement assets is like trying to wade through quick sand. You can suddenly find yourself rapidly sinking in the muck of confusion caused by the several bodies of law that govern this area. These laws include state spendthrift laws, state exemption laws, federal bankruptcy laws, federal tax laws and federal spendthrift laws. Yet the only way to get to the other side is to cross through it. First, a general discussion of these laws will be outlined to initiate the reader with the various laws that might apply to protect retirement assets from creditors. Then, the specific application of these laws will be discussed in detail.
A. State Spendthrift Laws
Most retirement assets provided through funded employer plans and IRA’s are held in trusts or custodial plans. The terms of the trust or custodial plan are contained within the plan document or custodial account. Plan documents will typically provide that the participant’s benefits held in trust may not be assigned or alienated for the benefit of anyone other than the participant and the participant’s beneficiaries. These antialienation provisions are also known as “spendthrift” provisions. A trust provision that prohibits alienation of a beneficiary’s interest in a trust is enforceable under Florida law.26 As to a trust held for the benefit of the settlor, called a “self-settled trust,” however, spendthrift provisions will not be enforced. The Florida courts have refused to extend spendthrift protection in favor of a beneficiary who is the settlor of the trust or in situations where the beneficiary can exercise control over trust principal.27
B. State Statutes
Florida has adopted legislation that specifically exempts pension money and retirement or profit-sharing benefits from legal process. Florida Statutes § 222.21(2)(a) provides:
Except as provided in paragraph (b), any money or other assets payable to a participant or beneficiary from, or any interest of any participant or beneficiary in, a retirement or profit-sharing plan that is qualified under s. 401(a), s. 403(a), s. 403(b), s. 408, s. 408A or s. 409 of the Internal Revenue Code of 1986, as amended, is exempt from all claims of creditors of the beneficiary or participant.
C. Federal Bankruptcy Laws
- The Bankruptcy Estate
§ 541(a) of the Bankruptcy Code creates a bankruptcy estate for any debtor who has had a bankruptcy case commenced, which encompasses all legal or equitable interests of the debtor in property as of the commencement of the case.28 Therefore, unless excluded or otherwise exempt from legal process in the bankruptcy case, all of the debtor’s property is reachable by the debtor’s creditors.
- Property Excluded From the Bankruptcy Estate
Section 541(c)(2) of the Bankruptcy Code excludes from the debtor’s bankruptcy estate any beneficial interest of the debtor in a trust that is subject to a restriction on transfer enforceable under “applicable non-bankruptcy law.”29 3. Property Exempt From the Bankruptcy Estate Section 522 of the Bankruptcy Code provides further exemptions for property not excluded from the bankruptcy estate.30 §522 (d)(10)(E) provides an exemption for:
a payment under a stock bonus, pension, profitsharing, annuity, or similar plan or contract on account of illness, disability, death, age, or length of service, to the extent reasonably necessary for the support of the debtor and any dependent of the debtor, unless –
(i) such plan or contract was established by or under the auspices of an insider that employed the debtor at the time the debtor’s rights under such plan or contract arose;
(ii) such payment is on account of age or length of service; and
(iii) such plan or contract does not qualify under section 401(a), 403(a), 403(b), 408 of the Internal Revenue Code of 1986.
The exemption provided by § 522(d)(10)(E) is far inferior to the exclusion offered by §541(c)(2). If a debtor’s retirement assets qualify for exclusion under § 541(c)(2), then all of that property is excluded from the bankruptcy estate. The exemption under § 522(d)(10)(E), however, only exempts that portion of the debtor’s retirement assets that are “reasonably necessary for the support of the debtor.”31 Thus, a debtor claiming exemption of retirement assets under § 522(f)(10)(E) is subjected to a factual determination of the extent to which the debtor’s retirement assets are reasonably necessary for the debtor’s support. This leaves obvious openings in the debtor’s chink of armor for the creditor to attack.
There is, however, more to the exemption story. §522(d)(10)(E), which provides a limited exemption for certain retirement assets, is but one of several broader categories of exemptions granted by § 522(d). § 522(d) provides limited exemptions for certain real or personal property used as a residence, personal property held primarily for personal, family or household use, or used in the trade of the debtor or of a dependent of the debtor, life insurance, professionally prescribed health aids, the right to receive social security, unemployment compensation, local public assistance, veterans or disability benefits or alimony or child support. §522(b) of the Bankruptcy Code allows a debtor to elect exemption of the debtor’s property under § 522(d), or in the alternative, the debtor may choose to apply exemptions under Federal law other than § 522(d) or under state law.32 If a state enacts legislation providing exemptions and if that legislation does not specifically authorize the use of the exemptions under §522(d), then the debtor loses the option and is forced to utilize the exemption scheme adopted by the state. Thus, a state may choose to “opt-out” of the federal exemption scheme and force its residents to use its own statutorily adopted exemption scheme. Alternatively, a state having “opted-out” by providing its own exemption scheme may also “opt-in” by specifically allowing in its exemption legislation for its residents to elect under § 522(b) whether to choose between the federal or state exemption schemes. Initially, Florida “opted-out” in 1979 by precluding the use of the federal exemptions in § 522(d).33 Fla. Stat. § 222.20 states that:
in accordance with the provision of s. 522(b) of the Bankruptcy Code of 1978 (11 U.S.C. s. 522(b)), residents of this state shall not be entitled to the federal exemptions provided in s. 522(d) of the Bankruptcy Code of 1978 (11 U.S.C. s. 522(d)). Nothing herein shall affect the exemptions given to residents of this state by the State Constitution and the Florida Statutes.
Florida then later partially “opted-in” by allowing its residents to utilize the exemptions in Bankruptcy Code § 522(d)(10), which includes in addition to the limited exemption for retirement assets provided by § 522(d)(10)(E), exemptions for social security, unemployment, local public assistance, veterans’, disability or illness compensation or benefits and alimony or child support to the extent reasonably necessary for the support of the debtor.34 Clearly, a Florida resident does not have the choice to use both the state provided exemptions and the complete array of federal exemptions allowed by §522(d) because § 522(b) requires a choice. It could be argued, then, that by allowing Florida residents to use state exemptions and the limited federal exemption listed in § 522(d)(10), Fla. Stat. § 222.201 is inconsistent with federal bankruptcy law that requires a choice. This argument has been rejected by the courts that have considered it and it appears settled that Fla. Stat. § 222.201 was not intended to give Florida residents a choice to use both federal and state exemption schemes. Rather, the reference in the Fla. Stat. § 222.201 which allows Florida residents to use, in addition to state exemptions, the limited exemptions in § 522(d)(10), is an incorporation by reference of the language found in §522(d)(10) into the Fla. Stat. § 222.201. Thus, that language becomes additional state exemption law.35 Therefore, to untangle this tangled web, to the extent a Florida resident’s retirement assets are exempt under Fla. Stat. § 222.21(2)(a), those retirement assets will be exempt in the bankruptcy estate under Bankruptcy Code § 522(b) and that exemption is unlimited and of equal utility to the exclusion provided by Bankruptcy Code § 541(c)(2). Technically, if the debtor’s retirement assets are excluded from the bankruptcy estate under § 541(c)(2), we never get to the exemption question under § 522(b), because you can’t exempt what is never included. So one might argue that whether a Florida resident’s assets are excluded or exempted is largely academic. It will be seen, however, that this distinction is of far more than academic importance when this paper later discusses the subjects of (1) whether retirement assets are “ERISA Qualified” as necessary to fall within the § 541(c)(2) exclusion (see discussion at Section IV.D.), and (2) whether ERISA preempts the exemptions provided by Fla. Stat. § 222.21(2)(a) (see discussion at Section IV.E.).
D. Federal Spendthrift Law
- ERISA Non-alienation Provision
Most retirement assets provided through funded employer plans are held in trust. Part 2 of Title I of ERISA, which was codified as Title 29, Chapter 18, Subchapter I, Subtitle B, Part 2 of the United States Code, requires any pension plan to contain a clause prohibiting assignment or alienation of benefits provided under the plan.36 As discussed earlier, Part 2 of Title I of ERISA does not cover, or apply to, all employee pension benefit plans which are covered by Title I of ERISA. Top hat plans and funded excess benefit plans are not excluded from Title I coverage, but are excluded from coverage of Part 2 of Title I of ERISA. Thus, these plans are not required by ERISA to contain nonalienation provisions. Plans that cover only owners and their spouses have been administratively excluded from coverage by Title I of ERISA.37 It is less than clear whether plans that cover only owners and their spouses, but at one time had common law employee participants in addition to owners and their spouses, continue to be subject to Title I. Furthermore, to the extent the regulations promulgated by the Secretary of Labor purport to exclude these plans from the requirements of Part 2 of Title I, their validity has been called into question (see discussion at Section II.C.4.). So, whether or not ERISA requires a plan that only has owners and their spouses as participants to contain a nonalienation provision is subject to question. The provision in Part 2 of Title I of ERISA that requires a pension plan covered by Part 2 to contain an antialienation provision reads as follows: “Each pension plan shall provide that benefits provided under the plan may not be assigned or alienated”.38 ERISA provides certain exceptions to the antialienation requirement, including voluntary assignments of up to 10% of any benefit payment and assignments pursuant to a qualified domestic relations order.39
The question of whether a retirement plan contains a restriction on transfer of plan assets pursuant to Part 2 of Title I of ERISA is significant for two reasons. First, if such a restriction is enforceable under ERISA, then any state statute purporting to allow legal process against the assets of the plan would be preempted by ERISA.40 Second, the restriction could be a restriction on transfer enforceable under “applicable non-bankruptcy law,” thus forming the basis for exclusion of the plan’s assets from the debtor participant’s bankruptcy estate.41 It is notable that Part 2 of ERISA requires plans subject to its coverage to contain a non-alienation provision, but does not specifically state that benefits in a plan that is required to and has a non-alienation provision may not be involuntarily alienated. In other words, it could be argued that the ERISA requirement that a plan contain an antialienation clause is not itself an enforceable spendthrift provision prohibiting involuntary alienation. This argument has been rejected by the Supreme Court decision in the now infamous Patterson v. Shumate, 504 U.S. 753 (1992), cert. denied, 505 U.S. 1239 (1992). In that case, the Supreme Court considered whether a restriction on transfer of a participant’s interest in a plan required by Part 2 of Title I to contain that restriction was a restriction on transfer enforceable under applicable non-bankruptcy law within the meaning of Bankruptcy Code § 541(c)(2). Prior to Shumate, there was a split among the Circuits, with some holding that only antialienation provisions enforceable under state spendthrift laws would qualify a plan’s assets for exclusion under § 541(c)(2). Although Shumate has left unanswered questions regarding protection of retirement assets in bankruptcy which will be discussed in detail later, it is now well settled that an antialienation provision in a plan required by Part 2 of Title I of ERISA to contain that provision is enforceable under ERISA and can form the basis of an exclusion under Bankruptcy Code § 541(c)(2). The Supreme Court pointed out that ERISA gives participants, beneficiaries and fiduciaries the right to sue to enjoin acts that violate the statute or the plan’s terms.42
- Federal Tax Law Antialienation Provisions
To be qualified for special tax treatment under § 401(a) of the Code, a pension plan must contain language prohibiting a participant’s benefits from being assigned or alienated.43 Is this tax law provision requiring plans to contain a nonalienation provision an enforceable spendthrift provision that can, by itself, be enforced to prohibit involuntary alienation of a debtor’s interest in a tax-qualified plan? Would it make a difference whether the plan in fact contained the required antialienation provision? It is clear that the tax code does not provide the participant, the plan administrator, the plan trustee or any other individual a power to enforce any proscribed alienation. Contrast this with the antialienation requirement of ERISA which is enforceable by plan participants, beneficiaries or fiduciaries.44 The tax code does empower the Internal Revenue Service to disqualify a plan or assess excise taxes for certain prohibited actions. Professor Litman again makes a pointed argument that the tax law antialienation provision should, by itself, be construed to be an enforceable spendthrift provision.45
IV. Application Of Laws To Retirement Assets Of Florida Debtors
Now comes the difficult part, wading through the morass of laws to determine how they apply to creditors’ and debtors’ rights to retirement assets owned by Florida debtors. This area will be dealt with by first discussing areas of certainty, and then by digressing gradually to areas of far less certainty.
A. Plans Tax Qualified Under Code § 401(a) and Subject To Title I of ERISA
Certain employee pension benefit plans are subject to all of Title I of ERISA (see discussion at Section II.C). Others may be only subject to certain parts of ERISA. The real distinction lies in which plans are subject to Part 2 of Title I of ERISA, because that is the part of ERISA that requires plans subject to its coverage to contain antialienation language that is enforceable under Part 5 of Title I of ERISA.46 Furthermore, plans subject to the antialienation provisions of Title I of ERISA may or may not be tax qualified under § 401(a) of the Code. In Shumate, the Supreme Court ruled that a debtor’s retirement assets in a tax qualified plan that contained the required antialienation clause and that was subject to Part 2 of Title I requiring that clause were excluded from the debtor’s bankruptcy estate under § 541(c)(2) of the Bankruptcy Code.47 Recall that § 541(c)(2) excludes a debtor’s assets that are subject to a restriction on alienation that is enforceable under applicable non-bankruptcy law. Prior to Shumate, the Eleventh Circuit had adopted a majority line of cases that held the term “applicable non-bankruptcy law” in § 541(c)(2) referred only to state spendthrift laws.48 The Supreme Court overruled the Eleventh Circuit’s decision by holding that a nonalienation provision enforceable under Title I of ERISA is applicable non-bankruptcy law and thus could form the basis of exclusion under § 541(c)(2). Likewise, plans qualifying for this exclusion will be exempt from legal process in state courts pursuant to the enforcement provisions in Part 5 of Title I of ERISA.49 Plans definitively falling under this category include all defined contribution and defined benefit plans that are tax qualified under § 401(a), other than governmental plans, non-electing church plans, top hat plans and excess benefit plans. IRA’s do not fall under this category. As discussed more fully below, plans that only cover owners and their spouses may not fall into this category. Furthermore, plans that are tax qualified and subject to Title I of ERISA will also be exempt from creditor’s claims under Fla. Stat. § 222.21(2)(a). Retirement assets of tax qualified plans that are subject to Parts 2 and 5 of Title I of ERISA are clearly exempt from creditors’ process in state courts and will be excluded from the bankruptcy estate. Therefore, it is not necessary to consider whether state or federal spendthrift provisions will protect these plans.
B. Plans Qualified Under Code §§ 401(a), 403(a), 403(b), 408, 408A or 409 and Not Subject to Title I of ERISA
It is well settled in Florida that to qualify for exclusion under Bankruptcy Code § 541(c)(2), a plan must be subject to Part 2 of Title I of ERISA and contain the antialienation provisions required by that clause (see discussion at Section IV.D.). Therefore, a tax-qualified plan that is not subject to any part of Title I of ERISA will not qualify for exclusion under § 541(c)(2). Fla. Stat. § 222.21(2)(a) exempts from legal process retirement assets in plans that are tax-qualified under Code §§ 401(a), 403(a), 403(b), 408, 408A or 409. Any plan that is tax qualified under one of these code provisions and not subject to Title I of ERISA will not call into question the issue of whether Fla. Stat. § 222.21(2)(a) has been preempted by ERISA (see discussion at Section IV.E.2.). Therefore, retirement assets in any such plan will be exempt from legal process in Florida state courts under Fla. Stat. § 222.21(2)(a) and exempt from the bankruptcy estate of the debtor under Bankruptcy Code § 522(b)(2)A. Plans falling under this category include governmental plans and non-electing church plans that are tax qualified under one of the quoted Code sections. IRA’s, with the exception of certain SEP IRA’s (see discussion at Section IV.E.2.) and rollover IRA’s (see discussion at IV.D.), also fall under this category. Tax qualified plans that are not subject to any part of Title I of ERISA are clearly exempt from creditors’ process under Fla. Stat. § 222.21(2)(a) and exempt in the bankruptcy estate under Bankruptcy Code § 522(b). Therefore, it is not necessary to consider whether state or federal spendthrift laws apply to protect these plans.
C. Plans Which Are Non-Qualified
There are many different types of plans established by employers for their employees which do not qualify for the tax preferred treatment extended to those plans that are qualified under § 401(a) of the Code. Typically, these “nonqualified” plans are deferred compensation arrangements where the employer promises to pay the employee in the future. In order to be “qualified,” a plan must meet several stringent requirements, including funding, coverage, nondiscrimination and other requirements. Often times, employers wish to discriminate in their deferred compensation plans in favor of highly compensated employees. Those plans may be unfunded promises to pay, or they may be funded by some type of security arrangement, such as a trust intended to place the plan’s assets beyond the reach of the employer’s creditors. It is this latter characteristic, an arrangement which places the assets beyond the reach of the employer’s creditors, which distinguishes the plan as a “funded” plan. Most funded plans will meet the definition of “pension benefit plans” and thus will be subject to the provisions of Title I of ERISA50, but not all will be subject to Part 2 of Title I of ERISA. For example, funded excess benefit plans are subject to Parts 1 (reporting and disclosure), 4 (fiduciary responsibility) and 5 (enforcement) of Title I ERISA. They are not subject to Parts 2 (vesting and participation), or 3 (funding) of Title I of ERISA. Therefore, excess benefit plans will not get the benefit of the nonalienation provisions contained in Part 2, a necessary prerequisite for exclusion under Bankruptcy Code § 541(c)(2). Also, the “top-hat” plan, a plan that is unfunded and maintained by the employer primarily for the purpose of providing deferred compensation to a select group of management of highly compensated employees, is exempt from Parts 2, 3 and 4 of Title I.51
In order to avoid the burdensome requirements of complying with Title I of ERISA, most employers will design their nonqualified plans to meet one of the exceptions to ERISA’s coverage rules. Consequently, most nonqualified plans will not be subject to the nonalienation rules of Part 2 of Title I, will not qualify for exclusion under Bankruptcy Code § 541(c)(2) and will not be able to rely on ERISA’s antialienation enforcement provisions for protection from creditors’ process in state courts. Likewise, because by definition nonqualified plans are not qualified under §§ 401(a), 403(b), 408, 408A or 409 of the Code, they are not exempt under Bankruptcy Code § 522(b) or under Florida Statutes § 222.21(2)(a).
Can the debtor rely on Florida’s state spendthrift laws to exempt nonqualified plan assets? Florida common law will enforce spendthrift provisions within a trust document created by a settlor for the benefit of another (See discussion at III.A). An example of a Florida case enforcing a spendthrift clause in a retirement plan is In re Lawson, 67 B.R. 94, 98 (Bankr. M.D. Fla. 1986). In Lawson, the bankruptcy court recognized as enforceable under Florida law a restriction in an ESOP prohibiting alienation of plan benefits. The court cited the fact that the plan only allowed distribution upon retirement, death or termination of employment, no loans were permitted and the plan did not allow the debtor to exercise absolute dominion over the stock in the ESOP. Interestingly, the Court ordered turnover to the trustee of 56 shares of stock that under the terms of the plan were immediately distributable to the debtor, but excluded the remainder of the debtor’s 587.588 shares in the ESOP under Bankruptcy Code § 541(c)(2) due to the spendthrift provision found enforceable under state law. Although the plan in Lawson was a tax qualified plan, the case predated Shumate and the enactment of Fla. Stat. § 222.21(2)(a). Thus, the Court was forced to engage in an analyses of state spendthrift law and that analyses is equally applicable to nonqualified plans.
The bulk of the Florida cases, however, are quick to latch on to some type of “control” by the debtor to deny spendthrift protection. Thus, the Florida courts have refused to recognize spendthrift protection for retirement plan assets where the debtor was the settlor of the trust holding those assets,52 where the debtor had the power to terminate the plan and thus receive a distribution of the plan’s assets53 and where the debtor had the power to borrow from the plan or receive distributions in the case of hardship.54 Typically, the participant in a nonqualified plan will be given the ability to amend or terminate the plan, borrow or receive distributions in the case of hardship, seek early distribution on severance of employment or other similar types of control. As a result, the assets of those plans will usually not qualify for state spendthrift protection.
Finally, by definition, nonqualified plans are not subject to the non-alienation rules of Code § 401(a)(13) and, thus, would not benefit from the spendthrift protection, if any, afforded by those rules.
D. Plans That Are Subject to Part 2 of Title I of ERISA, But May Have Lost Tax Qualified Status
An employee pension benefit plan may have originally qualified under Code § 401(a) and subsequently lost its tax qualified status. This may occur because the employer has failed to timely adopt required amendments. Disqualification may also occur because of operations of the plan which are not in compliance with Code § 401(a). Post Shumate case law has cast a shadow of doubt as to whether retirement assets in these plans may be protected from creditors in either Florida state or federal bankruptcy courts. This shadow looms due to a divergence in opinions of courts that have interpreted Shumate. In considering whether the antialienation clause in that case was “applicable non-bankruptcy law” qualifying the plan’s assets for exclusion under Bankruptcy Code § 541(c)(2), the Supreme Court stated, “The antialienation provision contained in this ERISA-qualified plan satisfies the literal terms of § 541(c)(2)” (emphasis added).55 The controversy arises from the Supreme Court’s use of the term “ERISA-qualified.” That term is not defined in the Internal Revenue Code, the Bankruptcy Code or by the Supreme Court in Shumate. One line of cases, the line that has been adopted by the bankruptcy courts in Florida, holds that for a pension plan to be “ERISA-qualified” it must (1) be subject to Part 2 of Title I of ERISA, which requires an antialienation clause, (2) contain the required antialienation clause, and (3) be tax qualified under § 401(a) of the Code.56
The other line of cases, which the Florida Courts have uniformly rejected, holds that the term “ERISA-qualified” as used in Shumate means the plan (1) is covered by Part 2 of Title I of ERISA, and (2) contains the required non-alienation clause.57
Persuasive arguments can be made that tax qualification is not a prerequisite to exclusion under Bankruptcy Code § 541(c)(2). To qualify for the exclusion, the assets of the plan must be subject to restrictions on transfer that are enforceable under applicable non-bankruptcy law. Shumate determined that the non-alienation provision required by Part 2 of Title I of ERISA is enforceable under Part 5 of Title I of ERISA and will qualify for exclusion under § 541(c)(2). Consider a previously tax qualified pension plan that covers several common law employees which is disqualified for failing to adopt required amendments. It makes no sense to argue that the restriction against alienation, designed to protect the interests of those employees, is no longer enforceable merely because the plan sponsor failed to follow the necessary requirements of the Internal Revenue Code for continued tax qualification. Nothing in ERISA or its legislative history suggests this is the intended result. If the restriction on transfer remains enforceable despite tax disqualification, the basis for exclusion under § 541(c)(2) continues. Nevertheless, it is clear that absent federal legislation or resolution of the conflict among the circuits by the Supreme Court, tax qualification will continue to be a pivotal issue for exclusion of retirement assets under § 541(c)(2) for Florida debtors.
If plans that are subject to Part 2 of Title I of ERISA are not excluded under § 541(c)(2) because of loss of tax exemption, it raises the question of whether they are exempt under § 522(b) and whether these plans are exempt from legal process in state courts by reason of Fla. Stat. § 222.21(2)(a). A plain reading of Fla. Stats. § 222.21(2)(a) clearly indicates that tax qualification under §§ 401(a), 403(a), 403(b), 408, 408A or 409 of the Code is a prerequisite to exemption from legal process. This concept has been uniformly applied by the Florida courts.58
If loss of tax qualification is a basis for finding a plan’s assets not excluded from the bankruptcy estate or non-exempt from legal process, either in state or federal bankruptcy courts, to what extent should these courts be able to inquire regarding that tax status of plans whose assets are claimed excluded under Bankruptcy Code § 541(c)(2) or exempt under Bankruptcy Code § 522(b) or Fla. Stat. § 222.21(2)(a)? Logic might dictate that courts must necessarily inquire and test the tax qualification of these plans. This very issue, however, has sparked controversy among the courts that have considered it. Again, two divergent lines of authority exist.
The Fifth Circuit in In the Matter of William Youngblood, 29 F. 3d. 225 (5th Cir. 1994), ruled that the bankruptcy court must defer to the IRS on the issue of determining tax qualification. In Youngblood, the debtor’s corporation had been issued a favorable determination letter ruling its pension plan qualified under § 401(a) of the Code, and a second favorable determination letter was received with respect to proposed amendments to the plan. Subsequently, the plan was audited by the IRS. Although excise taxes were assessed for prohibited transactions, the plan’s qualified status was not revoked. The debtor filed bankruptcy and claimed an exemption under a Texas statute that was similar to Fla. Stat. § 222.21(2)(a). In refusing to allow the trustee to challenge the plan’s tax-qualified status, the Fifth Circuit said:
We are persuaded that the legislature intended for its own state courts (or bankruptcy courts applying Texas law) to defer to the IRS in determining whether a retirement plan is “qualified” under the Internal Revenue Code. We see no reason that the legislature would want its courts, which are inexperienced in federal tax matters, to second guess the IRS in such a complex, specialized area.59
Tax qualification for deferred compensation plans is one of the most complicated and detailed subjects dealt with by the Internal Revenue Code. It is an area of the law best left to highly specialized tax lawyers. Not only is the subject matter complex, it is subject to constant change. It is no surprise that bankruptcy lawyers and judges will “get it wrong” while trying to navigate the complex structure of the tax code. For example, see In re Sutton, 272 B.R. 802 (Bankr M.D. Fla. 2002), where the Bankruptcy Court mistakenly concludes that a debtor’s retirement assets fails the exemption test of Bankruptcy Code § 522(d)(10)(E) for failure to qualify under § 401(a) of the Code. In Sutton, there were no facts indicating the plan failed tax qualification in form or in operation. Rather, the Court appears to base its conclusion on the fact that the plan was a “Keogh” plan in which the debtor was the sole participant. Although failing to benefit common law employees other than the owner is a basis for finding the plan is not covered by Title I of ERISA, it is not a basis for finding the plan fails to be tax qualified under § 401(a) of the Code.
A plan that no longer meets the tax qualification rules is said to be “disqualified”. The IRS can disqualify a plan retroactively to the year in which the plan failed to meet a qualification requirement. A plan can be disqualified for containing a provision or failing to contain a provision required by the Code (“plan document failure”).60 A plan document failure can occur for failing to timely adopt plan amendments required by new legislation.61 A plan may also be disqualified for failure to comply with a plan provision (“operational failure”).62 Furthermore, a plan may be disqualified for failure to comply with certain code requirements and for misuse or mismanagement of plan funds.
The tax effects of disqualification can be severe. The trust of the disqualified plan loses its tax exemption status under § 501(a) of the Code. The employer will lose deductions for contributions to the plan for years open to the statute of limitations to the extent the employees are not vested in their benefits.63 Participants in the plan will be required to pay tax on the vested contributions for years open to the statute of limitations.64
Recognizing the harsh effects of plan disqualification, Congress provided different relief mechanics for employers to avoid the undesirable results of failing to maintain or operate its plan in accordance with Code qualification requirements. Those include adoption of retroactive remedial amendments to address a plan document failure65, availing of discretionary relief provisions built into various Code provisions66, relief from the retroactive affect of IRS interpretations of the Code under Code § 7805(b) and reaching a settlement with the IRS by entering into a “closing agreement” pursuant to § 7121 of the Code.
Furthermore the IRS published Rev. Proc. 2002-47,67 updating its comprehensive system of correction programs for sponsors of retirement plans intended to be qualified under §§ 401(a), 403(a), 403(b) on 408K of the Code. Rev. Proc. 2002-47 updates a system, known as Employee Plans Compliance Resolution System (“EPCRS”). The general principles underlying EPCRS include encouraging employers to (1) establish administrative practices and procedures that ensure plans are operated in compliance with the Code, (2) operate their plans in compliance with plan documents and requirements of the Code and (3) make voluntary and timely correction of plan failures. The EPCRS adopts a voluntary compliance scheme that provides a graduated series of fees and sanctions to provide employers with an incentive to make prompt corrections and a consistent and uniform administration of sanctions. The program enables employers to rely on its provisions to maintain the tax-favored status of their plans, thereby reducing the uncertainty regarding potential tax liability for employers and plan participants.
The Fifth Circuit’s decision in Youngblood leaves the jurisdiction for determining tax compliance with the Internal Revenue Service and the tax courts. There is much wisdom in that approach. The IRS has “a wealth of experience” in applying the complex tax laws of the Code and regulations promulgated under the Code. To the contrary, lawyers and judges experienced primarily in the area of debtors’ and creditors’ rights lack the necessary experience to appreciate the intricate nuances of our tax laws. Indeed, Congress and the Internal Revenue Service have enacted laws and the EPCRS designed to encourage voluntary disclosure of plan document failures and operational failures, to provide certainty regarding tax ramifications of disqualification and to provide consistent and uniform administration of sanctions. Allowing state and federal bankruptcy courts to have the power to “disqualify” plans undermines these purposes. Query whether a bankruptcy court’s determination that a plan is disqualified should be given any weight in a subsequent administrative or tax court determination? Is an employer subject to civil litigation from its employees because a plan that has been found to be disqualified by a bankruptcy court exposes the employee’s retirement assets to legal process? Would it make any difference if the employer subsequently complied with EPCRS and avoided disqualification of the plan by the IRS? A plan that has not been disqualified for tax purposes ought not to be disqualified for purposes of avoiding an exemption that relies on its tax qualification.
Unfortunately, the Florida courts have not been quick to embrace the Youngblood concept. In In re Harris, 188 B.R. 44 (Bankr. M.D. Fla. 1995), the Bankruptcy Court was asked to consider whether improper investment of plan assets (substantially all assets invested in undeveloped land) and prohibited transactions (plan purchase of a diamond ring from a member of the debtor’s family) caused the plan to lose its tax qualified status, thus failing the necessary prerequisites for exclusion or exemption under the Bankruptcy Code and Fla. Stat. § 222.21(2)(a). The Court dispensed with the issue of whether Youngblood was binding on the Court, correctly finding that Youngblood has no binding precedential value on bankruptcy courts in Florida. Then, when considering the policy considerations expressed by Youngblood, the Court stated:
While the Bankruptcy Court is not competent to determine whether or not the ERISA-qualification should be revoked or terminated for non-compliance for purposes of the Internal Revenue Code, it is certainly competent to determine whether or not the Plan under consideration is within the holding of Patterson and excluded from the Debtor’s estate by virtue of § 541(c)(2).68
At first blush, it might appear that the Court in Harris was merely saying it has the right to find the plan was not “ERISA-qualified” under the Shumate test. After all, the debtor in Harris was, at the time the bankruptcy petition was filed, the sole participant in the Plan. The Florida courts have uniformly held that plans that only benefit their owners or owners and their spouses are not subject to Part 2 of Title I of ERISA, and thus not excluded under § 541(c)(2) of the Code. (See discussion at Section IV.E.2.) At closer inspection, however, it is clear that the Court was squarely rejecting Youngblood by determining it could and should consider whether the plan lost its tax qualified status for operational failures. Indeed, the Court said: “It is the general failure to administer this Plan in compliance with ERISA and the Internal Revenue Code, and the use of the Plan as a personal bank, which justifies the treatment of this Plan as property of the estate”.69
No reported state court decision has been found that discusses Youngblood. Every bankruptcy decision in Florida that has been faced with the issue of whether evidence of plan document failures or operational failures should be heard when the Plan has not been disqualified by the IRS has not hesitated to do so. They have either refused to follow Youngblood, or have been quick to distinguish its facts on the ground that although the debtor may have received a determination letter or two finding the plan was qualified, the IRS had never audited the plan for operational failures.70 In fact, one bankruptcy court was willing to rule that a debtor’s assets were neither excluded nor exempt under the Bankruptcy Code because the plan sponsor failed to timely adopt plan amendments required by the Code, despite the fact that (1) the IRS had previously issued a determination letter finding the plan in compliance with § 401(a) of the Code, (2) there was not evidence of operational failures and (3) at the time the Court considered the case, the debtors had an outstanding application for recognition of remedial amendments under the “Closing Agreement Program,” in accordance with Rev. Proc. 98-22, 1998 – 12 I.R.B. 11(3/23/98).71
If a plan that has lost its tax qualified status fails to qualify for exclusion or exemption under Bankruptcy Code §§ 541(c)(2) or 522(b), or for exemption under Fla. Stat. § 222.21(2)(a), then the assets of that plan will be similarly situated to nonqualified plans. See the discussion at Section IV.C. which concludes these assets will rarely be protected by state spendthrift laws.
Query whether assets from a plan which has been disqualified for tax purposes may be saved from creditors’ process by rolling those assets into an IRA? An IRA is exempt from creditors claims under Bankruptcy Code § 522(b) and Fla. Stat. § 222.21(2)(a). The Florida courts have been quick to rule that the assets transferred to the IRA from a disqualified plan are tainted with the disqualified status and will fail to qualify for exemption under Fla. Stat. § 222.21(2)(a). A good example is found in In re Banderas, 236 B.R. 837 (Bankr. M.D. Fla. 1998). In Banderas, the debtor was a participant in a defined benefit pension plan which was established by his wholly owned corporation. That plan had as participants other employees in addition to the debtor. The debtor, an orthopaedic surgeon, sold the assets of his corporation to an unrelated professional association and went to work for that company. When he sold the assets of his corporation, the debtor terminated his pension plan and distributed to all six of his employees their partially vested interests. During an audit of the plan, ths IRS determined the plan was involuntarily terminated and that the debtor’s former employees should have been 100% vested in their accounts. As a result, the debtor made supplemental distributions to his employees of their vested interests and the IRS subsequently issued a favorable Letter of Determination finding the plan, as terminated, was qualified. The debtor had reopened his corporation and all of the assets of the defined benefit plan were rolled into a newly formed profit sharing plan. The debtor was the sole participant in the new profit sharing plan and no additional contributions were ever made to that plan. Then, approximately 6 months later, the debtor rolled the assets of the profit sharing plan over to an IRA. Although the Court acknowledged the defined benefit plan was qualified, the Court determined that the profit sharing plan was not qualified because at the time it was established the corporation had no employees and never made any contributions to the plan other than the rollover. The court then found that the assets in the IRA were not qualified because they came from the profit sharing plan which was not qualified. Thus, the Court ruled the assets in the IRA were not exempt under Fla. Stat. § 222.21(2)(a). It is ironic that, had the debtor left the assets in the defined benefit plan, or rolled them over from the defined benefit plan directly to the IRA, they would have been exempt in the bankruptcy estate.
E. Plans Covered By Parts of Title I of ERISA Other Than Part 2
- Statutorily Excluded Plans
Certain plans fall within the definition of “employee benefit plans” covered by Title I of ERISA, but are specifically excluded from the coverage provisions of Part 2 of Title I.72 Plans in this category include top hat plans and funded excess benefit plans. Neither top hat plans nor excess benefit plans qualify for special tax treatment under §§ 401(a), 403(a), 403(b), 408, 408A or 409 of the Code. Therefore, no retirement assets under these plans will qualify for exclusion under § 541(c)(2) of the Bankruptcy Code or exemption under § 522(b) of the Bankruptcy Code or Fla. Stat. § 222.21(2)(a). This follows because (1) they are not subject to the antialienation rules of Part 2 of Title I of ERISA, and (2) they do not quality for special tax treatment under any of the cited Code sections. Furthermore, they are not likely to qualify for protection under state spendthrift laws (see discussion at Section IV.C.).
- Administratively Excluded Plans
Plans that cover only owners or owners and their spouses have been administratively excluded from the coverage of Part 2 of Title I of ERISA (see discussion at Section II.C.4.). If the labor regulations that exclude these plans are valid, these plans are not subject to the antialienation requirements of Part 2 of Title I of ERISA. Retirement assets in these plans fail the “ERISA-qualified” requirement of Shumate for exclusion under § 541(c)(2) of the Bankruptcy Code. This follows because they are not subject to a restriction on transfer that is enforceable under “applicable non-bankruptcy law.” The Florida courts have strictly adhered to this conclusion.73 A much more troubling question is whether retirement assets in a plan that only covers owners or owners and their spouses are exempt under § 522(b) or Fla. Stat. § 222.21(2)(a). There is nothing in the wording of Fla. Stat. § 222.21(2)(a) or its legislative history which indicates that a plan must be “ERISA Qualified” to be eligible for exemption from legal process under that statute. In fact, the bankruptcy court got it right in In re Luttge, 204 B.R. 259 (Bankr. S.D. Fla. 1997). When deciding that an SEP/IRA qualified for exemption under Fla. Stat. § 222.21(2)(a), the court in Luttge stated:
. . . there is no justification under either the case law, or legislative history of Fla. Stat. § 222.21, which suggests that the exemption is limited only to retirement, pension, or other plans which must be qualified under ERISA. Thus, in the event that a plan does not qualify as retirement plan under ERISA, it may nevertheless be exempt under Fla. Stat. § 222.21 so long as it complies with the applicable provisions of the Internal Revenue Code.74
From a plain reading of Bankruptcy Code § 522(b), it is obvious that Congress chose to allow each state the authority to decide for its citizens which assets may be exempted in the bankruptcy estate75 Yet, despite this relatively straight-forward and unambiguous statutory scheme, federal bankruptcy courts continue to read in a requirement that a plan be covered by Part 2 of Title I of ERISA before its assets may be exempted under Fla. Stat. § 222.21(2)(a). In re Harris, 188 B.R. 444 (Bankr. M.D. Fla. 1995), involved a corporate profit sharing plan that had a single participant who was also the corporation’s sole shareholder. Although the plan only covered the sole shareholder at the time he filed his bankruptcy petition, it had previously covered participants other than the debtor. Referring to the exemption under Fla. Stat. § 222.21(2)(a), the court stated:
It is apparent that the exemption under this statute is limited to monies or assets payable to the participant of retirement plans or profit sharing plans which are qualified under ERISA and the applicable provision of the Internal Revenue Code … Since ERISA-qualification is a condition precedent to the application of the statute relied on by the Debtor, the exemption under this statute is not available, having already concluded that the Plan is not an ERISA-qualified Plan (Emphasis added).76
The Court had earlier concluded that exclusion under § 541(c)(2) was unavailable for several reasons, including the debtor was the sole participant and had made impermissible investments and loans to himself and his wife. The dicta quoted above was unsupported by any explanation or precedent. What was “apparent” to the Court in that case is in reality not supported by a plain reading of the statute. Of course, the better position is that the plan lost its qualified status due to the debtor’s conduct with the plan’s assets and for this reason did not qualify for the exemption under Fla. Stat. § 222.21(2)(a). Similarly, In re Fernandez, 236 B.R. 483 (Bankr. M.D. Fla. 1999), involved employee benefit plans that had a single participant who was the sole shareholder of the sponsor corporation. Admitting that Fla. Stat. § 222.21 does not “specifically” mention ERISA, the Court nevertheless said: “. . . it is now uniformly agreed that the reference to the statute in the exemption requires that the plan in question be ERISA-qualified before the debtors can invoke the exemption granted by Fla. Stat. § 222.21″ (Id. At 486). Fernandez is also a case where the court determined the debtor engaged in improper transactions with plan assets. If what the Court is saying is that the loss of tax qualification is what causes the loss of exemption, then the decision is correct because of the Florida courts’ refusal to follow Youngblood. The Court’s poor choice of words, however, only further muddies already stained waters by implying that a plan must be “ERISA qualified” to invoke the exemption under Fla. Stat. § 222.21.
Assume a factual scenario of a debtor who has an account in a plan which is tax qualified under Code § 401(a), the debtor is the owner of the company sponsoring the plan and the sole participant in the plan. If the labor regulations excluding the plan from Part 2 of Title I are valid, on its face the assets should be exempt in state court under Fla. Stat. § 222.21(2)(a) and in bankruptcy under Bankruptcy Code § 522(b). This is where the issue of preemption by ERISA rears its ugly head. Although a plan that covers only owners or owners and their spouses is not covered by Part 2 of Title I, it is covered by part 5 of Title I. § 1144(a) of Part 5 reads as follows:
Except as provided in subsection (b) of this section, the provisions of this subchapter and subchapter III of this chapter shall supersede any and all State laws insofar as they may now or hereafter relate to any employee benefit plan described in section 1003(a) of this title and not exempt under section 1003(b) (non-ERISA Plans) of this title. This section shall take effect on January 1, 1975.77
Clearly, Fla. Stat. § 222.21 relates to an employee benefit plan. Therefore, without more, it would appear that this statute has been preempted by ERISA. There is, however, more to the story. § 1144(d) of Part 5 reads as follows:
Nothing in this subchapter shall be construed to alter, amend, modify, invalidate, impair, or supersede any law of the United States (except as provided in sections 1031 and 1137(c) (preemption savings clause) of this title) or any rule or regulation issued under any such law.78
Indeed, this was exactly the issue the 11th Circuit Court of Appeals decided in In re Schlein, 8 F. 3rd 745 (11th Cir. 1993). Schlein involved a SEP plan set up by a self-employed physician. At the time Schlein was decided, there was a split in the three circuits that had considered whether ERISA preempts state law pension plan exemptions relied upon by debtors in federal bankruptcy cases. The Fifth and the Eighth Circuits had ruled that § 1144(d) saves the state shield laws from preemption.79 The Ninth Circuit had reached the opposite conclusion.80 Schlein adopted the approach of the 5th and 8th Circuits in ruling that Fla. Stat. § 222.21 was saved from preemption by § 1144(d). More recently, the Sixth Circuit joined the fray and aligned with the Ninth Circuit in the unpublished opinion of Lampkins v. Golden, issued January 17, 2002, Docket No. 00-1443. The Sixth Circuit found a SEP/IRA was a plan not protected by the antialienation provision of Part 2 of Title I, and that Michigan’s shield laws were preempted by Part 5 of Title I. The 11th Circuit’s analyses has been described as “tortured.”81 The Schlein holding does lead to potential disparate treatment of plans which are excluded from coverage of Part 2 but subject to the provisions of Part 5 in bankruptcy versus state courts. In fact, it has been suggested that the assets would be exempt in bankruptcy court and not exempt in state court proceedings82. Is it possible that the statute, having been “saved” from preemption for bankruptcy purposes by § 1144(d), is now a valid statute and, therefore, also saved in state court? If not, it would seem the debtor could simply invoke protection by filing a petition for bankruptcy. Nevertheless, unless and until the Supreme Court resolves the dispute among the circuits as to whether state shield laws are preempted by ERISA, Schlein should provide protection, at least in bankruptcy, to Florida debtors with tax qualified plans that are not covered by Part 2 of Title I, but remain subject to ERISA’s nasty preemption rule found in Part 5 of Title I. Yet, despite this conclusion, as outlined above, the bankruptcy courts continued to uniformly reject exemption under § 522(b) for plans that cover only owners or owners and their spouses. There seems no logical basis for this dichotomy. True, the bulk of these cases can be explained away by improper conduct or failure to adopt plan amendments, thereby causing the plans to become “disqualified”. In short, retirement assets of a Florida debtor in a plan that is tax qualified under § 401(a) of the Code should be exempt under Fla. Stat. § 222.21(2)(a) and Bankruptcy Code § 522(b), regardless of whether the plan is subject to Part 5 of Title I of ERISA, unless and until Schlein is overruled by the Supreme Court. This is an area that is ripe for legislative clarification. Finally, if Schlein is ultimately overruled by the Supreme Court, is it possible that a tax qualified plan that is excluded from coverage of Part 2 of Title I but subject to the preemption clause in Part 5 of Title I may be protected by the federal spendthrift provisions in Code § 401(a)(13). For example, assume a pension plan is tax qualified under Code § 401(a) and has an owner as its only participant. One of the requirements for tax qualification is that the plan must prohibit voluntary or involuntary transfer or alienation of plan assets.83 Arguably, this spendthrift provision of federal law, if enforceable, would constitute “applicable non-bankruptcy law” and form the basis of exclusion under Bankruptcy Code § 541(c)(2). At least one non-Florida court has squarely rejected this proposition.84 The problem is rooted in the fact that, unlike the similar spendthrift provision found in Part 2 of Title I of ERISA, the Code does not provide any civil action for enforcement to a participant, a beneficiary or plan fiduciary. The fact that failure to comply with the Code may lead to adverse tax consequences may not be sufficient to create an enforceable restriction. Furthermore, in Florida the claim for exclusion under Bankruptcy Code § 541(c)(2) based on the spendthrift provision found in the Code will run into a problem in post Shumate cases which hold that for its assets to be excluded under § 541(c)(2), the plan must be subject to Part 2 of Title I of ERISA (see discussion at Section IV.D.). Hopefully, Schlein will remain good law, the courts will correctly follow Schlein by holding tax-qualified plans are exempt under Fla. Stat. § 222.21(2)(a) regardless of whether they are subject to Parts 2 or 5 of Title I of ERISA and the issue of whether the spendthrift clause required by Code § 401(a)(13) creates an enforceable restriction on transfer will remain moot for Florida debtors.
V. Proposed Bankruptcy Reform
In the past three years, the House has on six separate occasions passed bankruptcy legislation that would provide significant overhaul of the Bankruptcy Code, only to have the measures fail in the sharply divided Senate. Last year’s latest House attempt failed due to an amendment that would bar anti-abortion protestors from using bankruptcy laws to avoid paying court fines.
On March 19, 2003, the House overwhelmingly (315-113) approved the Bankruptcy Abuse and Consumer Protection Act (H.R. 975), which mirrors the latest 2002 measure, without the controversial anti-abortion protestor provision. This proposed bankruptcy legislation would add exemptions to Bankruptcy Code §§ 522(b) and 522(d) for retirement assets in a fund or account that is exempt from taxation under Code §§ 401, 403, 408, 408A, 414, 457 or 501. The proposals would create a presumption of exemption for assets in a fund that (i) has received a favorable determination under Code § 7805 if that determination is in effect as of the commencement of the bankruptcy case, or (ii) has not received a favorable determination under Code § 7805 if the debtor demonstrates no prior determination to the contrary has been made by a court or the IRS and the plan is in substantial compliance with the “applicable requirements” of the Code, or if the plan fails to be in substantial compliance, that the debtor is not materially responsible for that failure.
A direct transfer or eligible rollover from one tax qualified plan to another will not cause a loss of exemption under the Bankruptcy Code.
A limitation on the amount qualifying for exemption is placed on IRAs, other than SEPs or SIMPLEs, in the amount of $1,000,000, without regard to amounts attributable to rollover contributions from tax qualified plans and earnings thereon. This limitation would be indexed for inflation. H.R. 975 would also add an exclusion under Bankruptcy Code § 541 for funds placed in an educational IRA or a qualified state tuition plan under Code § 529(b)(1)A at least 365 days before the filing of the case if the designated beneficiary is a child, stepchild, grandchild or step-grandchild of the debtor. A legally adopted child or a foster child can qualify under certain circumstances. If the funds in the account are pledged to secure a loan of the debtor, they will not qualify for the exclusion. There is a $5,000 cap on the exclusion for funds deposited between 720 days and 365 days before the filing date.
Although H.R. 975 does not address the issue of whether a plan must be tax qualified to be excluded under Bankruptcy Code § 541(c)(2), it does address the issue raised by the Youngblood case and the Florida cases that have refused to follow Youngblood for purposes of determining whether a plan will qualify for the new exemptions. Also, the exemptions are not dependent on a transfer restriction required by Part 2 of Title I of ERISA. Therefore, plans that only cover owners, governmental plans and non-electing church plans that are tax qualified under one of the quoted Code sections will qualify for exemption.
At the time this paper goes to press, the bill has been placed on the Senate Legislative calendar, and Senate Judiciary Committee Chairman Orrin Hatch, R-Utah, has promised to move quickly on the bankruptcy legislation. Furthermore, there is some question whether the bill can obtain the 60 necessary votes to proceed to a Senate vote. Interestingly, while this bill would definitely add measures designed to protect debtors’ retirement assets from seizure, consumer and civil rights groups and unions have opposed the measure because of a belief that the bill removes important protections for low-income workers, unemployed workers and workers facing large medical bills.
1. There is a definite distinction between planning to minimize the risk of loss of assets through attachment by a potential unforeseen future creditor, one that was either nonexistent or whose claim or the basis of claim was unasserted or unknown to the client at the time of planning, and planning to evade attachment by a creditor who was existing or whose claim was asserted or otherwise known to the client. The former situation presents one of many risks that should be considered and planned for during the estate planning process. The latter not only raises serious ethical concerns, but also raises potential civil claims against the planner for conspiracy.
2. See 29 U.S.C. § 1001(a)
3. 26 U.S.C. § 401(a)
4. 26 U.S.C. § 401(k)
5. 29 U.S.C. § 1002 (32)
6. 29 U.S.C. § 1002 (33)(A)
7. 29 U.S.C. § 1051(2)
8. 29 U.S.C. § 1002 (36)
9. P.L. 104-188, § 1421
10. 26 U.S.C. § 408(a)
11. 26 U.S.C. § 408(b)
12. 26 U.S.C. § 530
13. Rev. Proc. 87-50, 1987-2 C.B. 647 at § 4.03, as modified by Rev. Proc. 91-44, 1991-1 C.B.
13, Rev. Proc. 92-38, 1992-1 C.B. 859, Rev. Proc. 2002-10, 2002-4 I.R.B. 401, Announcement 2002-49, 2002-19 I.R.B. 919, and the annual IRS revenue procedures on ruling requests and users fees.
15. See 29 U.S.C. § 1001
16. 29 U.S.C. § 1003(a)
17. 29 U.S.C. § 1002(3)
18. 29 U.S.C. § 1002(1)
19. 29 U.S.C. § 1002(2)(A)
20. 29 U.S.C. § 1003(b)(2)
21. 29 U.S.C. § 1003(b)
22. 29 U.S.C. § 1144(a)
23. Labor Regs § 2510.3-3(b)
24. Labor Regs. § 2510.3-3(c)
25. Donna Litman, Bankruptcy Status of “ERISA Qualified Pension Plans”- An Epilogue To Patterson v. Shumate, Amer. Bankr. L. Rev. 23, 24, 30 (Winter 2001)
26. See, In Re Davis, 110 B.R. 573, 575 (Bankr. M.D. Fla. 1989); Waterbury v. Munn, 32 So. 2nd 603 (1947)
27. See Croom v. Ocala Plumbing & Electric Co., 57 So. 243, 244 (1911); In the Matter of Nichols, 42 B.R. 772 (Bankr. M.D. Fla. 1984), In re Lichstrahl, 750 F. 2d 1488 (11th Cir. 1985); In re Watson, 13 B.R. 391 (Bankr. M.D. Fla. 1981)
28. See 11 U.S.C. § 541(a)
29. See 11 U.S.C.§ 541(c)(2)
30. See 11 U.S.C. § 522
31. See 11 U.S.C. § 522(d)(10)(E)
32. 11 U.S.C. § 522(b)
33. See Fla. Stat. § 222.20
34. See Fla. Stat. § 222.201, adopted in 1987
35. See In Re Green, 178 B.R. 533 (Bankr. M.D. Fla. 1995)
36. See 29 U.S.C. § 1056
37. Labor Regs § 2510.3-3(b)
38. 29 U.S.C.§ 1056(d)(1)
39. See 29 U.S.C. § 1056(d)(2) and (3)
40. 29 U.S.C. § 1132(a)(3) and (5)
41. 11 U.S.C. § 541(c)(2)
42. See 29 U.S.C. § 1132(a)
43. See 26 U.S.C. § 401(a)(13)
44. 29 U.S.C. § 1132(a)
45. Litman, Supra
46. See 29 U.S.C. §§ 1056 and 1132(a)
47. Patterson v. Shumate, 504 U.S. 753 (1992)
48. See Lichstrahl, 750 F.2d at 1489
49. See 29 U.S.C. § 1132(a)
50. See 29 U.S.C. § 1003
51. See Labor Regs. § 2520. 104-23
52. Matter of Wittlin, 640 F. 2d 661 (5th Cir. 1981)
53. In re Nichols, 42 B.R. 772 (Bankr. M.D. Fla. 1984); In re Watson, 13 B.R.391 (Bankr. M.D. Fla. 1981); Lichstrahl, 250 F. 2d. at 1489
54. In re Rosenquist, 122 B.R. 775 (Bankr. M.D. Fla. 1990)
55. Shumate, 504 U.S. at 755
56. See In Re Hall, 151 B.R. 412, 419 (Bankr. W.D. Mich 1993 (first case to rule on the meaning of “ERISA-qualified”); In re Harris, 188 B.R. 144 (Bankr. M.D. Fla. 1995) (follows Hall); In re Lawrence, 235 B.R. 498 (Bankr. S.D. Fla. 1999); In re Fernandez, 236 B.R. 483 (Bankr. M.D. Fla. 1999)
57. See In Re Hanes, 162 B.R. 733 (Bankr. E.D. Va. 1994); SEC v. Johnston, 922 F. Supp. 1220 (E.D. Mich. 1996); In re Craig, 204 B.R. 756 (Bankr. B.N.P. 1997); In re Bennett, 185 B.R. 4 (Bankr. E.D. N.Y. 1995)
58. See, e.g., Harris, 188 B.R.at 444; In re Blais, 220 B.R. 485 (Bankr. S.D. Fla. 1997); In re Banderas, 236 B.R. 837 (Bankr. M.D. Fla. 1998); Lawrence, 235 B.R. at 498; Fernandez, 236 B.R.at 483
59. In the Matter of William Youngblood, 29 F. 3rd 225, 229 (5th Cir. 1994)
60. See Rev. Proc. 2002-47, 2002-29 I.R.B. 133 (2002)
61. Legislation requiring amendments to plan documents include the Tax Equity and Fiscal Responsibility Act of 1982, the Deficit Reduction Act of 1984, the Retirement Equity Act of 1984 and the Omnibus Budget Reconciliation Act of 1993.
62. Rev. Proc. 2002-47 at 133
63. 26 U.S.C. § 404(a)(5); Regs § 1.404(a)-12(b)(1); Regs § 1.402(b)-1)
64. 26 U.S.C. § 402(b)(1)
65. 26 U.S.C. § 401(b); Regs § 1.401(b)-1(b)
66. See, e.g., Regs § 1.415-6(b)(6), Regs 1.410(b)-2(a); Regs 1.401(a)(4)-1(a); Regs § 1.401(a)(26)-1(a); and Regs 1.401(a)(4)-11(g)
67. 2002-29 I.R.B. 133 (2002)
68. In re Harris, 188 B.R. at 449
69. Id at p. 449
70. See, e.g., Fernandez, 236 B.R. at 483; Blais, 220 B.R. at 485; Lawrence, 235 B.R. at 498; Banderas, 236 B.R. at 837
71. Lawrence, 235 B.R. at 498
72. See 29 U.S.C. §§ 1003, 1051
73. See, e.g., Harris, 188 B.R. at 444; Lawrence, 235 B.R. at 498; Blais, 220 B.R. at 485 and Fernandez, 236 B.R. at 483
74. In re Luttge, 204 B.R. 259, 262 (Bankr. S.D. Fla. 1997)
75. See 11 U.S.C. § 522(b); Harris, 188 B.R. at 451
76. Id. At 451
77. 29 U.S.C. § 1144(a)
78. 29 U.S.C. § 1144(d)
79. In re Dyke, 943 F. 2d 1435 (5th Cir. 1991); In re Vickers, 954 F. 2d 1426 (8th Cir.), cert. denied, 505 U.S. 1235 (1992).
80. Pitrat v. Garlikor, 947 F. 2d 419 (9th Cir. 1991) rev’d., 992 F. 2d 224 (9th Cir. 1993)
81. See Alan P. Woodruff, Are Interests In Florida Retirement Plans Really Safe From Creditors, Fla. Bar J. (July/August 1994)
83. 26 U.S.C. § 401(a)(13)
84. In re Witwer, 148 B.R. 930 (Bankr. L.A. Cal 1992)