Debtors' IRA Loses Its Exempt Status in Bankruptcy

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By Diane Davis

Sept. 16 — Debtors can't claim an individual retirement account (IRA) as exempt in their bankruptcy case because the IRA had entered into transactions prior to the bankruptcy that were prohibited by the Internal Revenue Code, a district court in Arkansas held.

Judge Leon Holmes of the U.S. District Court for the Eastern District of Arkansas agreed with the bankruptcy court's ruling that the debtors' IRA is not exempt property.

Debtors Barry K. and Dana M. Kellerman created an IRA with a reported value of $252,112. The IRA was self-directed by Barry Kellerman.

Exemption of Retirement Funds

When the debtors filed for bankruptcy protection, the Kellermans valued the IRA at $180,000, and claimed it as exempt under Bankruptcy Code Section 522(d)(12), which allows debtors to exempt “[r]etirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section … 408 … of the Internal Revenue Code of 1986,” the court said.

Section 408(a) of the Internal Revenue Codedefines an IRA as “a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries,” the court said. The retirement account is exempt from taxation unless “during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year,” the court said, citing I.R.C. § 408(e)(2).

No Longer Exempt?

Appellees Arvest Bank and Trustee Randy Rice objected to the debtors' claimed exemption in the IRA because it was no longer exempt from taxation under the Internal Revenue Code at the beginning of the case and, thus, was not eligible under Section 522(d)(12).

According to Arvest Bank and the trustee, the IRA lost its exempt status in 2007 when Barry Kellerman directed the IRA to engage in prohibited transactions involving disqualified persons.

The transactions at issue involved the acquisition and development by the IRA and Panther Mountain Land Development, LLC of approximately four acres of property. The debtors own a 50 percent interest in Panther Mountain.

The IRA paid $40,523 as a business expense to develop the property. On his individual bankruptcy schedules, Barry Kellerman showed distributions from the IRA of $12,349 in 2009, $124,100 in 2008, but none in 2007.

Shortly after the debtors filed their bankruptcy, Panther Mountain filed its own Chapter 11 bankruptcy case and listed the Kellermans and the IRA as unsecured creditors.

Engaged in Prohibited Transactions

The bankruptcy court found that the IRA engaged in prohibited transactions that caused it to lose its tax exempt status. According to the bankruptcy court, Panther Mountain used the IRA as a lending source for the purchase price and development of the land in violation of the Internal Revenue Code.

The bankruptcy court also found that Barry Kellerman transferred or used the IRA's assets “for the benefit of disqualified persons and as a fiduciary dealt with the IRA's assets for his own interest.” The debtors couldn't claim any interest in the IRA as exempt under Section 522(d)(12), the bankruptcy court said.

Loan to Partnership?

The debtors appealed to the district court, arguing that the purchase price for the land didn't constitute a loan. According to the debtors, the value of the property was $720,000, and even subtracting development costs, that was more than double the purchase price so “the IRA's payment for the property did not and could possibly have [sic] constituted a loan to Panther Mountain.” The cash contribution was merely the IRA's contribution to the partnership and not a loan to the partnership, the debtors said.

The district court rejected the debtors' argument, concluding that even though the value of the property exceeded the amount paid by the IRA doesn't contradict the evidence that this is a loan. The court also noted that it didn't matter that the Internal Revenue Service had not made a determination that the IRA was tax exempt. The IRS's decision is not binding on the court, the court said.

Even if the transaction weren't a loan, the IRA would still have lost its tax exempt status because the Kellermans and Panther Mountain benefitted directly from the transactions in violation of I.R.C. § 4975(c)(1)(D) and (E), the court said.

The court determined that the IRA lost its exempt status prior to the time the debtors filed for bankruptcy. Thus, the debtors can't include the IRA as an exempt asset under Section 522(d)(12), the court said.

Danny R. Crabtree, Little Rock, Ark., represented debtors Barry K. Kellerman and Dana M. Kellerman; Hamilton Moses Mitchell of Rice Law Office represented Trustee Randy Rice; and Stephen L. Gershner of Davidson Law Firm, Ltd., represented Arvest Bank. 

To contact the reporter on this story: Diane Davis in Washington at

To contact the editor responsible for this story: Jay Horowitz at

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