Protecting Private Wealth: Recent Bankruptcy Cases Involving Tuition Payments and Profit Sharing Plans

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Explore:  Consumer Bankruptcy IRA

Two recent decisions may affect the assets of individuals available to satisfy creditors' claims in bankruptcy. In the first decision, the Bankruptcy Court for the Eastern District of New York determined that married, joint debtors received value in exchange for tuition payments and rejected the bankruptcy trustee's arguments that the tuition payments were fraudulent transfers. In the second decision, the United States Court of Appeals for the First Circuit determined that assets in a debtor's profit sharing plan, funding an individual retirement account, are property of the estate, available to satisfy the claims of creditors, if the debtor has failed to maintain the profit sharing plan in substantial compliance with applicable tax laws.

Certain Tuition Payments Held Not To Be Fraudulent Transfers

A bankruptcy trustee has the power to avoid and recover certain transfers made by a debtor prior to the commencement of the bankruptcy case. An avoidable transfer includes a transfer made by an insolvent debtor within two years of the petition date, if no "reasonably equivalent value" is received in exchange for the transfer.[1] In such circumstances, the transfer is deemed to be constructively fraudulent, and the trustee does not need to prove intent to defraud. A gift or a gratuitous transfer by an insolvent debtor is a prime example of a constructively fraudulent transfer.

The bankruptcy trustee in In re Akanmu, 502 B.R. 124 (Bankr. E.D.N.Y. 2013) brought an action against two high schools, Xaverian High School and Our Lady of Mt. Carmel-St. Benedicta School, to avoid and recover tuition payments made by joint debtors, arguing that the tuition payments were constructively fraudulent transfers. The trustee argued that the debtor received no direct benefit from the private education obtained in return for those tuition payments. Chief Judge Carla E. Craig found that the debtors were legally obligated under New York state law to provide their minor children with an education. It was of no consequence that the parents chose to educate their children in parochial school rather than public school. The court acknowledged the line of cases analyzing whether tuition payments for students over eighteen years old constitute constructively fraudulent transfers, because parents are not legally obligated to provide an education to children at that age. In those cases, the courts found the parents received no benefit or value in exchange for tuition payments. Because the tuition payments in In re Akanmu were made for the education of minor children, they were not susceptible to an analysis as constructively fraudulent transfers.

Individual Retirement Accounts Funded by Profit Sharing Plans can be Reached by Creditors

Generally, any and all legal and equitable interests of a debtor are subject to distribution to creditors, except for certain exempt property. What constitutes property of the estate is broadly construed. In In re Daniels, 736 F.3d 70 (1st Cir. 2013), the debtor sought to exempt from a bankruptcy estate certain retirement funds held in a fund or account that is tax-exempt under section 401 of the Internal Revenue Code.

The First Circuit found that the debtor could not exempt a profit sharing plan that repeatedly violated the Internal Revenue Code. The profit sharing plan prohibited any transaction in which a plan fiduciary "deals with" plan assets "in his own interests or for his own account," or receives consideration connected to a transaction involving plan assets. The court determined that there were "prohibited transactions"[2] between the plan, on one hand, and the debtor's son, daughter-in-law, and other family members, on the other, including, but not limited to: (1) the rental of property owned by the profit sharing plan over a ten-year period to the debtor's son and daughter-in-law; (2) a "lease and sale" agreement between the debtor's son and the profit sharing plan; (3) a "gift of equity" associated with the same transaction; (4) a loan to the debtor's son from the profit sharing plan; and (5) the sale of property and loan to the plan administrator's daughter. Although the IRS had previously audited the debtor's tax returns and did not disqualify the profit sharing plan or assess additional taxes, the First Circuit rejected the debtor's argument that the IRS's favorable determination following the audit created a presumption that the debtor's interest in the profit sharing plan was exempt from his bankruptcy estate.

The First Circuit also upheld the bankruptcy court's ruling that the debtor's individual retirement accounts were not exempt because the debtor intentionally concealed or failed to fully disclose those assets in a number of court filings. The debtor had formed the individual retirement accounts less than seven months before filing a bankruptcy petition in the wake of affirmance of a large judgment against him. The funds transferred to the individual retirement accounts represented nearly 50 percent of the debtor's total assets. The First Circuit concluded that even though the individual retirement accounts may have been exempt from the bankruptcy estate, the debtor should have disclosed their existence. The First Circuit upheld the lower courts' rulings that the individual retirement accounts were property the bankruptcy estate to be distributed to the debtor's creditors.

Topics:  Consumer Bankruptcy, IRA

Published In: Bankruptcy Updates, Education Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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