In In re Kellerman, Case No. 4:09-bk-13935 (Bankr. Ct. E.D. Ark. (May 25, 2015)), the U.S. Bankruptcy Court sustained objections to debtors’ exemption of an individual retirement account. The Bankruptcy Court held that Barry and Dana Kellerman used the income and assets of an IRA for their benefit, violating Internal Revenue Code Section 4975(c)(1)(D). The court found that Barry alternatively dealt with the IRA income or assets as a fiduciary for his own interest, violating IRC Section 4975(c)(1)(E). As a result, the IRA lost its tax-exempt status because of prohibited transactions engaged in by disqualified persons, and the Kellermans were unable to claim any tax-exempt interest in the IRA under Section 522(d)(12) of the U.S. Bankruptcy Code.
Barry created a self-directed IRA that, as of Oct. 27, 2008, was worth $252,112.67. Entrust Mid South, LLC (Entrust) was the administrator of the IRA. At the time Barry and Dana commenced a bankruptcy proceeding, the IRA was worth about $180,000. The Kellermans claimed the entire fund as exempt under Section 522(d)(12) of the Bankruptcy Code. Arvest Bank (Arvest), a creditor of the Kellermans, along with the trustee of the Kellermans’ estate, filed objections to the claimed exemption, arguing that the IRA lost its exempt status in 2007 because Barry directed the IRA to engage in prohibited transactions involving disqualified persons. The Kellermans conceded that the transactions involved disqualified persons; however, they argued that the transactions weren’t prohibited transactions as defined in IRC Section 4975(c).
Barry and Dana each owned a 50 percent interest in Panther Mountain Land Development, LLC (Panther Mountain). The IRA and Panther Mountain formed a partnership on Aug. 8, 2007, with the purpose of acquiring and developing four acres of property. Barry executed the partnership agreement on behalf of Panther Mountain; Jerry O. Pearson, Jr. executed the agreement on behalf of the IRA. The partnership agreement, which operated under the name “Entrust Mid South LLC FBO Barry Kellerman IRA #0605002–01 and Panther Mountain Land Development, LLC” (Entrust Partnership), didn’t disclose Panther Mountain’s ownership. The IRA and Panther Mountain each owned 50 percent of the partnership.
Under the partnership agreement, the IRA was to deliver real property as a noncash
contribution valued at $122,830.56 and make a cash contribution of $40,523.93 by Nov. 30, 2007. On an unspecified date, Panther Mountain was to contribute $163,354.49, which equaled the IRA’s cash and non-cash contribution values. Panther Mountain never made any cash contribution.
On Aug. 9, 2007 Barry liquidated $123,000 worth of assets from the IRA through a “sell direction letter.” In the letter, Barry explicitly noted that Entrust wouldn’t review the merits of the investment, and he’d hold Entrust harmless regarding any investment decisions. By a separate “buy direction letter” with similar language, Barry directed Entrust to buy the four acres of land for $122,830.56. Barry bought the land because it benefitted Panther Mountain in developing its other properties.
In a warranty deed, the property wasn’t conveyed to Entrust Partnership. Rather, the seller conveyed an undivided one-half interest to the IRA and an undivided one-half interest to Panther Mountain. The sole remaining asset in the IRA after the purchase was the undivided one-half interest.
On Dec. 5, 2007, the IRA paid $40,523.93 to develop the property and recorded it as a business expense comprised of engineering and design expenses. In October 2008, the IRA paid another business expense of $411.82.
The Bankruptcy Filings
On June 3, 2009, the Kellermans filed for Chapter 11 bankruptcy. In September 2009, Panther Mountain filed for Chapter 11 bankruptcy, listing both the Kellermans and the IRA as unsecured creditors. Panther Mountain claimed that it owed the IRA $163,000 (as a 50 percent interest in a new entity) and $7,891.96 (as loans from “B Kellerman IRA to PMLD, LLC”).
The trustee and Arvest objected to the Kellermans’ attempt to exempt the IRA under Section 522(d)(12) of the Bankruptcy Code. That section exempts IRAs “to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986.”
The Bankruptcy Court began its analysis by noting that a debtor’s claim of exemption is presumptively valid, and an objecting party bears the burden of proving that a debtor’s exemption isn’t properly claimed. If the objecting party meets its burden, the burden of production shifts to the debtor to show that the exemption is proper.
To ascertain whether the Kellerman’s claimed exemption was proper, the court turned to IRC Section 408 regarding whether the IRA was tax-exempt. Under Section 408(e)(2)(A), (B), an IRA is tax-exempt so long as its owner or beneficiary doesn’t engage in a prohibited transaction. If an owner or beneficiary engages in a prohibited transaction, the IRA is no longer tax-exempt. Under IRC Section 4975(e)(2), a prohibited transaction, by necessity, involves a disqualified person.
Section 4975(e)(2) provides a list of disqualified persons. Included in that list is a “fiduciary,” defined as “any person who exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets,” or “any person who has any discretionary authority or discretionary responsibility in the administration of such plan.” (IRC Section 4975(e)(3)(A), (C)). Along with a fiduciary, a fiduciary’s family member is also a disqualified person.
Because Barry was the beneficiary of the IRA and exercised discretionary authority and control over the IRA as its owner, Barry was a fiduciary and thus a “disqualified person.” As Barry’s wife, Dana was a “disqualified person.” Panther Mountain was a disqualified person because Barry owned a 50 percent membership interest in it. Finally, Entrust Partnership was a disqualified person due to Barry’s ownership interests in it as well.
Section 4975(c)(1) provides six scenarios that constitute prohibited transactions. The court noted that prohibiting certain transactions is to prevent taxpayers with IRAs from using them for their own account that could place the IRA assets and income at risk of loss before retirement. To determine whether Barry and Dana engaged in prohibited transactions, the Bankruptcy Court turned to RES-GA Gold, LLC v. Cherwenka (In re Cherwenka), 508 B.R. 228 (Bankr. N.D. Ga. 2014), Office of Pension and Welfare Benefit Programs, Opinion No. 2000–10A, 2000 WL 1094031 (Dept. of Labor July 27, 2000), and Rollins v. Comm’r, T.C.M. 2004–260 (Nov. 15, 2004). Those cases examined transactions in which taxpayers allegedly derived benefits from certain actions outside of their IRAs.
In this instance, Barry engaged the IRA in transactions including the purchase of real property with IRA funds and subsequent conveyance of the property to the IRA and Panther Mountain, as well as a cash contribution of $40,523.93 to Entrust Partnership. “Collectively, individually, and with some redundancy, both the non-cash contribution and the cash contribution constitute ‘prohibited transactions’ with disqualified persons…which renders the IRA non-exempt,” stated the court.
The court specifically relied on Section 4975(c)(1)(B), which forbids the lending of money or other extension of credit between a plan and a disqualified person. The court rejected Barry and Dana’s argument that there was no loan but rather an investment in real estate through Entrust Partnership. It found that Panther Mountain used the IRA as a lending source for the purchase price and development of the four-acre land without any obligation to do anything other than contribute an equal amount on an unspecified, ambiguous date.
Moreover, the court found that Barry used the IRA for the other disqualified persons and for his own interest. “The real purpose for these transactions was to directly benefit Panther Mountain and the Kellermans in developing both the four acres and the contiguous properties owned by Panther Mountain,” noted the court. In essence, the court found that Barry and Dana used the IRA to indirectly secure financing for the
Panther Mountain development, without having to deal with independent lenders.
Thus, stated the court, the Kellermans violated Section 4975(c)(1)(D) by using the IRA income and assets for their benefit, as disqualified persons. The court alternatively found that Barry dealt with the IRA income or assets as a fiduciary for his own interest, violating Section 4975(c)(1)(E). Based on the prohibited transactions engaged in by disqualified persons, the IRA lost its tax-exempt status as of Jan. 1, 2007. Accordingly, the Kellermans couldn’t claim any tax-exempt interest in the IRA under Section 522(d)(12) of Bankruptcy Code.