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Anyone in financial distress who has substantial assets in one or more IRAs and who anticipates a possible bankruptcy filing should be vigilant about not using IRA funds in ways that could constitute a prohibited transaction. Even if bankruptcy does not occur, the income tax consequences of having the IRA lose its tax exemption can be severe.
In 1993, Ernest Willis opened a self-directed IRA. Later that year, Willis authorized a $700,000 wire transfer from the IRA to an account jointly owned with his wife. The $700,000 was subsequently used to purchase an investment. In early 1994, Willis repaid the $700,000 to the IRA with funds borrowed from friends and family.
In 1997, a joint brokerage account held by Willis and his wife suffered a loss. To cover the loss, Willis engaged in a series of "check-swapping" transactions between the joint brokerage account and the IRA. He repeatedly engaged in simultaneous transfers of funds from the IRA to the brokerage account and vice versa and attempted to avoid tax on the IRA withdrawals by returning funds to the IRA within 60 days.
Willis also had two other IRAs, both of which were funded, in full and in part, with funds from the first IRA.
Willis filed for bankruptcy relief in 2007. He claimed exemptions for the full value of the three IRAs, totaling about $1.5 million. The bankruptcy court determined that, since Willis was responsible for managing the investments in the IRA, he was a fiduciary and thus a disqualified person. The various actions he took with the IRA constituted prohibited transactions. Therefore, the IRA's tax-exempt status and bankruptcy estate exemption were both disqualified as of Jan. 1, 1993. The court also found that the other two IRAs were not exempt because their funds were derived from the first IRA.
Willis appealed the bankruptcy court's decision. First a federal district court and now the Court of Appeals for the 11th Circuit have agreed with the bankruptcy court. (Willis v. Menotte, CA 11 April 21, 2011, 107 AFTR 2d 2011-752)
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