By Garrett Sutton, Esq.
Are you misusing your IRA? Do you believe the claims of Internet charlatans who state you can use your IRA money for all sorts of investments?
We have warned clients for years about improper IRA investments. My newest book, Finance Your Own Business, (which goes on sale October 27th) has a whole chapter on the risks of using retirement funds. We have warned that the IRS and the courts would catch up with these shenanigans.
Here is the next case in the coming crackdown In Re Kellerman involves a couple who used their self-directed IRA to benefit themselves in a related transaction. (A statement of the entire case prepared by a research attorney follows this summary.)
Main Lesson from the Courts
A major take away of the case is this:
Your IRA is protected in bankruptcy. But if you revise your IRA, if you engage in a prohibited transaction, you lose your protection in bankruptcy. A creditor can reach your IRA monies. WARNING: Don’t bend the rules with your IRA!
This is what happened to the Kellermans. Money that would have been safe from creditors’ claims in a traditional IRA was lost by bending the rules. What follows is a more technical statement of the case.
IN RE KELLERMAN
(Debtor Caused IRA To Engage in Prohibited Transaction)
In In re Kellerman, 531 B.R. 219 (E.D.Arkansas May 26, 2015), the creditor and the Chapter 7 trustee both objected to an exemption claimed by the debtors in an individual retirement account (IRA). The United States Bankruptcy Court for the Eastern District of Arkansas, Little Rock Division, held that the debtor caused the IRA to engage in prohibited transactions, of the kind resulting in loss of the IRA’s tax exempt status and debtors’ ability to exempt their interest therein.
In In re: Barry K., 2015 WL 5330862 (D.Ark. September 14, 2015), the United States District Court for the Eastern District of Arkansas, Western Division, recently affirmed the Bankruptcy Court’s prior May 26, 2015, decision.
BRIEF STATEMENT OF FACTS
Prior to filing for bankruptcy protection, Barry Kellerman (“Mr. Kellerman”) created an IRA, which had a reported value as of October 27, 2008, of $252,112.67. The administrator of the IRA was Entrust Mid South, LLC (“Entrust”). The IRA was self-directed by Mr. Kellerman, who made all of the decisions pertinent to the issues raised in the objections. At the commencement of their bankruptcy case, the Kellermans valued the IRA at $180,000 and claimed it as exempt under 11 U.S.C. § 522(d)(12).
The creditor, Arvest Bank (“Arvest”) and the trustee objected to the debtors’ claimed exemption in the IRA because, they contended, it was no longer exempt from taxation under the Internal Revenue Code at the commencement of the case and thus was not eligible under 11 U.S.C. § 522(d)(12). They argued that the IRA lost its exempt status in 2007 when Mr. Kellerman directed the IRA to engage in prohibited transactions involving disqualified persons as defined by the Internal Revenue Code.
The transactions at issue involved the acquisition and development by the IRA and Panther Mountain Land Development, LLC (“Panther Mountain”), of approximately four acres of real property. Mr. Kellerman and his wife each owned a 50% interest in Panther Mountain. The address for Panther Mountain was the same as Barry Kellerman Construction, Inc. Mr. Kellerman was also a co-debtor on a number of debts with Panther Mountain.
In order to acquire and develop the four-acre tract, the IRA and Panther Mountain executed a partnership agreement on August 8, 2007. Mr. Kellerman executed the partnership agreement on behalf of Panther Mountain. Jerry O. Pearson, Jr. executed the partnership agreement on behalf of the IRA. Mr. Kellerman was the only person designated to sign partnership checks. The partnership took the name Entrust Mid South LLC FBO Barry Kellerman IRA # 0605002-01 and Panther Mountain Land Development, LLC (“Entrust Partnership”).
The partnership agreement provided that the IRA would contribute capital by delivering the real property as a noncash contribution valued at $122,830.56. The IRA also was supposed to contribute a cash contribution of $40,523.93 by November 30, 2007. Panther Mountain’s obligation was a cash contribution of $163,354.49 (an amount equal to the IRA’s cash and noncash contributions) at an unspecified construction completion date.
In a Buy Direction Letter dated August 8, 2007, Mr. Kellerman directed Entrust to buy the four-acre tract through Standard Abstract & Title Co. for a purchase price of $122,830.56. One day later, Mr. Kellerman directed the IRA to liquidate assets in the amount of $123,000. The purchase of the four-acre tract closed on August 8, 2007.
An effect of the purchase was to provide sewer access to nearby tracts of approximately 80 and 120 acres owned by Panther Mountain. While the four-acre tract could be independently developed, controlling it therefore substantially assisted in the development of the other Panther Mountain properties. The IRA funded the entire purchase price. The Warranty Deed from Maumelle Development, LLC, dated August 8, 2007, did not convey the property to the Entrust Partnership; rather, the deed conveyed the tract to the IRA and Panther Mountain with each owning an undivided one-half interest. The one-half interest is the sole remaining asset in the IRA.
The IRA’s October 27, 2008, Account Statement reflects the purchase of the real estate as a purchase of an asset of the IRA without reference to its divided interest. On December 5, 2007, the IRA, as a “Business Expense,” paid $40,523.93 to develop the property. Mr. Kellerman described this expenditure as design and engineering expenses. The IRA paid an additional “Business Expense” of $411.82 on October 15, 2008. On his individual bankruptcy schedules, Mr. Kellerman showed distributions from the IRA of $12,349.99 in 2009 and $124,100.74 in 2008, but none in 2007.
Shortly after the Kellermans commenced their bankruptcy proceeding on June 30, 2009, Panther Mountain filed its own Chapter 11 bankruptcy on September 20, 2009. On its schedules, Panther Mountain lists both the Kellermans and the IRA as unsecured creditors. Two debts are reflected as owed to the IRA: (1) $163,000.00 with the claim described as “50% Interest in new entity”; and (2) $7,891.96 with the claim described as “Loans from B Kellerman IRA to PMLD, LLC.”
As the bankruptcy court stated, Mr. Kellerman’s testimony regarding the $7,891.96 debt was unclear. Mr. Kellerman alternatively characterized that debt as money that he and his wife paid personally for Panther Mountain or money that did, in fact, come from the IRA. It is scheduled as a debt to the IRA and not a debt to the Kellermans. 531 B.R. at 220-22.
The bankruptcy court found that the IRA engaged in prohibited transactions that caused it to lose its tax exempt status. First, the bankruptcy court found that Panther Mountain used the IRA as a lending source for the purchase price and development of the four-acre tract of land in violation of 26 U.S.C. § 4975(c)(1)(B). 531 B.R. at 224-25. Secondly, the bankruptcy court found that Mr. 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 in violation of 26 U.S.C. § 4975(c)(1)(D) and (E). 531 B.R. at 225-27.
Alternatively, the bankruptcy court found that Mr. Kellerman dealt with the income as assets of the IRA as a fiduciary for his own interest in violation of 26 U.S.C. § 4975(c)(1)(E). 531 B.RE. at 227-28. Accordingly, the bankruptcy court concluded the debtors could not claim any interest in the IRA as exempt under 11 U.S.C. § 522(d)(12) of the United States Bankruptcy Code. 531 B.R. at 228.
Although it sometimes is permissible to use IRA money to purchase real estate, the proper rules must be followed. In this case, the Kellermans engaged in a “prohibited transaction” and did not follow the rules. As a result, the Kellermans lost their bankruptcy IRA exemption.