There is a flourishing industry of financial advisors devoted to "asset protection" for the well-to-do who focus on legal structures that will limit the ability of creditors to reach their clients' assets. And even financially healthy and completely solvent companies are routinely forced to confront issues arising from the insolvency or bankruptcy of individual employees when those companies or the plan administrators of their qualified plans are served with garnishments or levies directed against the qualified retirement plan assets of those insolvent or bankrupt employees.
A recurrent question that arises in both of these settings is whether assets held in a qualified plan (i.e. a 401(k), pension plan or other qualified retirement plan) are beyond the reach of creditors. A recent case illustrates that although these assets are beyond the reach of creditors generally, the IRS really is different in this regard. It is an object lesson in the limitations on the ability to avoid payment of unpaid taxes.
Generally speaking, qualified plans are one of the best available vehicles for asset protection planning. By statute they are a form of "spendthrift trust" and are beyond the reach of creditors of the plan participant. Moreover, again by statute, such plans are "exempt" assets and are not subject to claims of creditors in bankruptcy. Note, however, that the government is not so limited in its remedies. Under Treas. Reg. § 1.401(a)-13(b)(2), plan assets are not exempt from levy under a Federal tax lien or under a judgment for payment of an unpaid tax assessment.
Still, on the face of it, qualified plans would appear to be absolutely one of the best possible asset protection vehicles available. And in many ways they are. But a recent case illustrates a potential Achilles heel of vulnerability when it comes to unpaid income taxes, even when the tax liability itself can be discharged in bankruptcy.
In Wadleigh v. Commissioner, an individual taxpayer filed his 2001 individual income tax return but did not pay the tax shown due on the return. The IRS subsequently properly notified the taxpayer of the deficiency and then filed what proved to be a defective notice of federal tax lien for the deficiency. Three years later, the taxpayer declared bankruptcy. In the bankruptcy proceeding, pursuant to Section 541(c) of the Bankruptcy Code and applicable court decisions, the taxpayer elected to exclude his qualified plan from the assets included in the bankruptcy estate. The bankruptcy court ultimately entered a discharge order in favor of the taxpayer, including a discharge of the taxpayer's liability for the delinquent 2001 taxes.
Despite the bankruptcy court's discharge of the 2001 tax liability, after the bankruptcy concluded, the IRS subsequently sought to levy upon the taxpayer's qualified retirement plan account to satisfy the amount of the unpaid taxes. The IRS argued that it was permitted to do so because the lien that arose when the taxpayer filed his return for 2001 showing a tax liability was not discharged in the bankruptcy proceeding even though the underlying tax liability was discharged in the bankruptcy. So the IRS argued it was permitted to pursue the assets in the qualified plan to satisfy the tax lien which arose when the taxpayer filed a return in 2001 showing a tax due because those plan assets had been excluded from the bankruptcy proceeding.
In ruling in favor of the IRS, the Tax Court found that the bankruptcy court's discharge of indebtedness for the underlying taxes did not protect the taxpayer's pension plan from being levied upon by the IRS. In drawing a distinction dear to lawyers, the court held the IRS could legally levy upon the taxpayer's assets excluded from the bankruptcy proceedings because that lien attached to assets prior to the bankruptcy which were excluded from the bankruptcy, and therefore the lien was still enforceable against those pre-petition assets. In legalese, the levy was not in personam but rather was in rem.
Although this case turns upon metaphysical legal hair-splitting of a high order, the take-aways are relatively obvious. As is so often the case when it comes to bankruptcy or insolvency planning, the best advice is to pay the government first. Normal creditors can have their claims wiped out in bankruptcy. But the government is different.
So for planning purposes, a taxpayer in similar straights should first attempt to pay the delinquent taxes or, alternatively, reach an offer-in-compromise with respect to the delinquent taxes before (or in connection with) the bankruptcy in order to limit the ability of the IRS to reach the taxpayer's qualified retirement plan assets. If the taxpayer deals with the claim for the unpaid taxes, then qualified plans really may be the best asset protection vehicle out there.
Similarly, companies who are called upon to confront these issues when their employees run into financial difficulties and the employees' retirement accounts are levied upon need to remember that although most garnishments and levies by creditors against plan assets are ineffective, levies by the government really are different.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.