Can Creditors Reach The Retirement Account Of A Divorced Spouse?

Let’s say that you divorce. Let say that retirement savings are unequal between you and your ex-spouse. As part of the settlement you receive a portion of your spouse’s 401(k) under a “QDRO” order.

COMMENT: A QDRO is a way to get around the rule prohibiting alienation or assignment of benefits under a qualified retirement plan. I generally think of QDROs as arising from divorce, but they could also go to a child or other dependent of the plan participant.

Your QDRO has (almost) the same restrictions as any other retirement savings. As far as you or I are concerned, it IS a retirement account.

You file for bankruptcy.

Can your creditors reach the QDRO?

Sometimes I scratch my head over bankruptcy decisions. The reason is that bankruptcy – while having tax consequences – is its own area of law. If the law part pulls a bit more weight than the tax part, then the tax consequence may be nonintuitive.

Let’s segue to an inherited IRA for a moment. Someone passes away and his/her IRA goes to you. What happens to it in your bankruptcy?

The Supreme Court addressed this in Clark, where the Court had to address the definition of “retirement funds” otherwise protected from creditors in bankruptcy.

The Court said there were three critical differences between a plain-old IRA and an inherited IRA:

(1)  The holder of an inherited IRA can never add to the account.

(2)  The holder of an inherited IRA must draw money virtually immediately. There is no waiting until one reaches or nears retirement.

(3)  The holder of an inherited IRA can drain the account at any time – and without a penalty.

The Court observed that:

Nothing about the inherited IRA’s legal characteristics would prevent (or even discourage) the individual from using the entire balance of the account on a vacation home or sports car immediately after bankruptcy proceedings are complete.”

The Court continued that – to qualify under bankruptcy – it is not sufficient that monies be inside an IRA. Those monies must also rise to the level of “retirement funds,” and – since the inheritor could empty the account at a moment’s notice - the Court was simply not seeing that with inherited IRAs.

I get it.

Let’s switch out the inherited IRA and substitute a QDRO. With a QDRO, the alternate payee steps into the shoes of the plan participant.

The Eighth Circuit steps in and applies the 3-factor test of Clark to the QDRO. Let’s walk through it:

(1)  The alternate payee cannot add to a QDRO.

(2)  The alternate payee does not have to start immediate withdrawals – unless of required age.

(3)  The alternate payee cannot – unless of required age - immediately empty the account and buy that vacation home or sports car.

By my account, the QDRO fails the first test but passes the next two. Since there are three tests and the QDRO passes two, I expect the QDRO to be “retirement funds” as bankruptcy law uses the term.

And I would be wrong.

The Eighth Circuit notes that tests 2 and 3 do not apply to a QDRO. The Court then concludes that the QDRO has only one test, and the QDRO fails that.

The Eighth Circuit explains that Clark:

… clearly suggests that the exemption is limited to individuals who create and contribute funds into the retirement account.”

It is not clear to me, but there you have it – at least if you live in the Eighth Circuit.

No bankruptcy protection for you.

Our case this time for the home gamers was In re Lerbakken.

Can Payroll Taxes Put You In Jail?

Can you go to jail for not remitting payroll taxes?

Let’s set this up:

• You have a temporary nursing staffing agency in Minnesota.
• You treat your nurses as independent contractors.
• You had a predecessor company which the IRS charged with willfully misclassifying workers and failing to remit payroll taxes.  You survived that occasion by settling with the IRS, but the settlement included language similar to the following:

 “... with respect to any other business similar to the ... entities that he might own, operate or control in the future, he would treat as employees for tax purposes all workers who performed functions or duties that were the same or similar as the function or duties performed by the nurses and nursing assistants who worked for the ... entities. In other words, defendant ... was obligated to withhold and pay over employment taxes for the nursing professionals who worked for any of his entities.”

• Minnesota has a law requiring nursing staffing agencies to certify that they are treating their nurses as employees and not as independent contractors. You have made this certification to Minnesota.

So, can you go to jail for not remitting the nurses’ payroll taxes?

A too-common problem is a cash-strapped business falling behind on depositing their payroll taxes. You can fall behind on many types of taxes and still be able to work something out. You fall behind with payroll taxes, however, and the IRS can be very harsh. The reason is that the IRS (and the states also) considers it stealing. You pay an employee $700 and withhold $200 for taxes. That $200 is not your money: it is the employee’s money that you now hold as agent for remittance to the IRS. The IRS reserves one of its most frightening penalties for this: it is called the trust fund recovery penalty. This penalty is 100% (you read that right), and it attaches to you as an individual. You cannot shed that penalty by leaving or bankrupting the business, because the penalty applies to you. It follows you like a bad haircut.

That penalty however is not what we have here. What we have here is Francis Leroy McLain (U.S. v McLain). The case was appealed to the Eight Circuit from the District Court of Minnesota.

The IRS looked at two entities owned by McLain, Kind Hearts and Kirpal Nurses, and came to the conclusion that the nurses were employees.

OBSERVATION: The IRS will almost always say that someone is an employee, whether they are or not. They want the payroll taxes, of course.

McLain owed about $340,000 in payroll taxes. He had been down this path before, and the IRS had not forgotten. They dusted off Section 7202, a very special tax gem for someone who pushes the sled too far:

Any person required ... to collect, account for, and pay over any tax imposes by this title who willfully fails to collect or truthfully account for and pay over such tax shall, in addition to the other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $10,000, or imprisoned not more than 5 years, or both, together with the cost of prosecution.”

McLain left the shores of the responsible person penalty far behind. He sailed into the deep waters of going to jail. He is now dealing with CID, the criminal side of the IRS.

NOTE: A word to the wise: you never want to deal with CID. These guys have badges. They have guns. And they will put you in jail. I know. I had a client who had gone to jail courtesy of CID, and I know a tax practitioner in northern Kentucky who will be going.

As a tax guy, I am hoping that McLain has some serious technical arguments to make in his defense. I am expecting a ferocious goal-line stand. Here comes his first play:

(1)   McLain referred to the two agencies, King Hearts and Kirpal Nurses, as “Kirpal.” He argued that Kirpal was the employer, and, as the employer, only Kirpal had a duty to account and pay over taxes on its employees.

COMMENT: McLain starts off by irritating me. There was a case on this issue before I even came out of school. The case is Slodov v United States. It was a Supreme Court case and included the following language:

“Sections 6672 and 7202 were designed to assure compliance by the employer with its obligation to withhold and pay the sums withheld, by subjecting the employer’s officials responsible for the employer’s decisions regarding withholding and payment to civil and criminal penalties ...”

            McLain was an officer. What part of this did he not get?

            SCORE: IRS (1) McLain (0)

(2)   McLain argues that he had a good faith belief that the nurses were not employees. The lawyers refer to this as “mens rea,” and he argued that his state of mind did not rise to “willful.” Without willfulness, McLain cannot come under Section 7202.

COMMENT: I like this argument. Unfortunately, he had a prior run-in with the IRS on this very same point, which greatly diluted the argument’s persuasiveness.

            SCORE: IRS (2) McLain (0)

(3)   McLain argues that the IRS has to pursue a civil penalty before it can pursue a criminal penalty, and the civil penalty requires a written notice. He received no written notice, so the IRS cannot proceed with criminal prosecution.

COMMENT: I noticed that the Court reminded McLain’s attorney that he “has an independent obligation, regardless of what his client may demand, to refrain from filing frivolous motions.”

            SCORE: IRS (3) McLain (0)

(4)   McLain moved to dismiss the charges because (1) he is a “natural human being” and the United States does not have authority over him.

COMMENT: McLain’s attorney blanched here, and McLain fired him. McLain represented himself from this point on.

A tax protest argument? Seriously?

SCORE: IRS (4) McLain (0)

McLain lost soundly.

This type of action by the IRS is rare. I can assure that – in almost all cases – the IRS does not want to put anyone in jail. They want your money, and being in jail impedes you getting the IRS any money. And all parties in the system – the IRS, the courts and judges, responsible practitioners – are tired of the tax protest siren song.

I am sympathetic to arguments that our tax system left the world of rational thought years ago, but that does not mean the income tax is illegal. It can be irrational, immoral, confiscatory, divisive and destimulative without being illegal.

McLain has taken what could have been a civil penalty – albeit a stiff one – and morphed it into a multi-year stay at Club Fed. There likely is a fairly impressive fine also. He did however enter the tax literature, primarily for being a blockhead.