IRA Exempt--Debtor’s Grant of Lien in Client Relationship Agreement Not A Prohibited Transaction - Articles

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Posted by: Lynn Pointer on Dec 9, 2013

by Maurice K. Guinn

Four days after oral argument, the Sixth Circuit entered its Opinion disagreeing with the Bankruptcy Court and District Court decisions denying an exemption claim in an IRA.  (In re James L. Daley, Jr., Case No. 12-6130).  The facts were stipulated by the trustee and the debtor.  On August 25, 2010, the debtor filed his Voluntary Petition under Chapter 7.  He valued his interest in a Merrill Lynch IRA at $61,646.00 and claimed an exemption under T.C.A. § 26-2-105(b).  The Merrill Lynch IRA was established from a rollover from another IRA.  When the debtor opened the Merrill Lynch IRA, he completed a section of the Client Relation Agreement including Terms and Conditions, one of which is entitled “Liens” providing:  “All of your securities and other property in any account--margin or cash--in which you have an interest, or which at any time are in your possession or under your control, shall be subject to a lien for the discharge of any and all indebtedness or any other obligations you may have to Merrill Lynch.”  Accordingly, the debtor pledged his IRA as security for any future debts to Merrill Lynch.  The IRA is the only account the debtor had with Merrill Lynch.  The debtor never borrowed any funds from the Merrill Lynch IRA, which is self-directed, nor did he ever request an advancement of a margin loan against his funds.

The IRS had issued a determination letter the Merrill Lynch IRA “satisfies the requirements of Code Section 408[.]”  In view of the IRS determination letter, the debtor was entitled to a presumption the IRA is exempt.  Citing 26 U.S.C. § 4975(c), the trustee argued the debtor had entered into prohibited transactions.  The Bankruptcy Court did not agree with the trustee’s argument that the debtor’s failure to mark the “Decline Margin Lending” box in the section of the Merrill Lynch Client Relationship Agreement constituted entry into a prohibited transaction.  However, the Bankruptcy Court determined the grant of a lien at the IRA’s inception did constitute an extension of credit or guaranty, which is a prohibited transaction under 26 U.S.C. § 4975(c)(1)(B).  The Bankruptcy Court opinion recites:  “As incongruous as it appears, based upon the language of the Client Relationship Agreement signed by the Debtor, the mere opening of the Merrill Lynch IRA caused the Debtor to participate in a prohibited transaction under § 4975. . . .  Through no fault of his own and notwithstanding the fact that between his creation and the filing date the Debtor conducted no borrowing transactions against the Merrill Lynch IRA, the Debtor indirectly engaged in a prohibited transaction under 26 U.S.C. § 4975 simply by signing the Client Relationship Agreements granting Merrill Lynch a lien on all of his accounts.”

After the District Court affirmed the Bankruptcy Court’s decision, the debtor appealed to the United States Court of Appeals for the Sixth Circuit.  The Court of Appeals noted the debtor never became indebted to Merrill Lynch nor did he withdraw any money from his IRA or use it as collateral for a loan of any sort.  The Court noted the debtor had never authorized Merrill Lynch to advance funds or securities and that his only account with Merrill Lynch was the IRA.  Simply because the debtor signed a boiler plate lien provision as a requirement of opening an account the IRS had approved did not rise to the level of a prohibited transaction.  The debtor made no transactions with his IRA and opened no other accounts, so there is no possibility that the lien granted under the boiler plate would amount to anything.  Because the debtor had not used his retirement account to extend himself credit or borrow any funds from Merrill Lynch, the debtor had not entered into a prohibited transaction.  His exemption claim in the IRA was allowed.


Maurice K. Guinn is attorney with the firm of Gentry, Tipton & McLemore, P.C. in Knoxville and serves as a member of the TBA Bankruptcy Section Executive Council.