Warning: qualified plans may not be protected in bankruptcy despite Patterson v. Shumate.

• Author: Martin, Ronald T.
• Position: ERISA benefit plans

In Patterson v. Shumate, 504 U.S. 753 (1992), reh'g denied, 505 U.S. 1239 (1992), the U. S. Supreme Court decided that funds maintained in certain "ERISA qualified" retirement plans are not "property of the estate" under $541 of the Bankruptcy Code and, therefore, are not available to creditors holding claims against the debtor, beneficial owner of the ERISA plan. Bankruptcy courts construing Shumate have had to come to terms with the Supreme Court's reliance on ERISA qualification as a requirement for plan exclusion from the property of the estate.

This article surveys the cases that have relied on Shumate to determine the substance of an ERISA qualification requirement, and draws attention to the consequences, for estate planners and their clients, of lower courts' applying the Shumate analysis to ERISA plans. The first section of the article reviews the two lines of authority proceeding from Shumate; first, the cases concluding that ERISA-qualified means "tax qualified," and second, the cases that focus, instead, on the anti-alienation provisions of ERISA to vindicate the Supreme Court's rationale. The article then turns to a crucial scope issue: Which retirement plans are not within the scope of the ERISA plans protected by Shumate and so are ineligible for whatever protection the decision does provide? That inquiry supports observations concerning another bankruptcy option available to those trying to insulate a retirement account from the claims of creditors: the debtor's right to exempt sufficient property to support the debtor's "fresh start." Treatment of the exemption issues requires consideration of the fit between ERISA and the Bankruptcy Code's deference to state exemption law. The article analyzes ERISA preemption issues before concluding with suggestions for practitioners trying to steer a course through the Bankruptcy Code, Shumate, ERISA, and state exemption law.

The Rule of Patterson v. Shumate

Section 541(c)(2) of the Bankruptcy Code excludes from the bankruptcy estate a beneficial interest of the debtor in a trust, where the trust contains a restriction on the transfer of the beneficial interest which is "enforceable under applicable nonbankruptcy law." Prior to the Supreme Court's decision in Patterson v. Shumate, there was a conflict among the circuits as to whether the term "applicable nonbankruptcy law," as used in Bankruptcy Code [sections] 541(c)(2), was limited to state spendthrift trust law, or whether [sections] 541(c)(2) also applied to pension plans which contained an anti-alienation provision pursuant to [sections] 206(d)(1) of ERISA.[1] Title I, Part 2, [sections] 206(d)(1) of ERISA contains the requirement that "[e]ach pension plan shall provide that benefits provided under the plan may not be assigned or alienated." A requirement for tax qualification of a pension or profit-sharing trust under I.R.C. [sections] 401(a) is that the benefits may not be assigned or alienated.[2]

The Supreme Court in Shumate phrased the question as follows:

We must decide in this case whether an anti-alienation provision contained in an ERISA-qualified pension plan constitutes a restriction on transfer enforceable under "applicable nonbankruptcy law," and whether, accordingly, a debtor may exclude his interest in such a plan from the property of the bankruptcy estate.[3]

In answering the question in the affirmative, the court held that a debtor could exclude from his bankruptcy estate his interest in an"ERISA-qualified" plan pursuant to [sections] 541(c)(2) of the Bankruptcy Code.

The current conflict in bankruptcy court decisions results from the Supreme Court's use of the undefined term "ERISA-qualified." One line of cases, represented by the seminal case of in re Hall 151 B.R. 412 (Bankr. W.D. Mich. 1993), holds that a plan is excluded from the bankruptcy estate under [sections] 541(c)(2) only when it is "ERISA-qualified," which the cases define as a plan

1) Subject to ERISA;

2) Containing the anti-alienation provision required by ERISA [sections] 206(d)(1); and

3) Tax qualified under I.R.C. [sections] 401(a).[4]

The only Florida bankruptcy court to address this issue, In re Harris, 188 B.R. 444 (Bankr. M.D. Fla. 1995), follows the Hall view.

The significance of the Shumate decision is that the Court interpreted the statutes at issue in accordance with the plain and literal meaning of the language utilized by Congress in enacting the statutes:[5] "In our view, the plain language of the Bankruptcy Code and ERISA is our determinant.[6] (Emphasis supplied.)

In interpreting [sections] 541(c)(2) of the Bankruptcy Code to mean what it says, the Court held that the term "applicable nonbankruptcy law" is not limited to state law: "Plainly read, the provision encompasses any relevant nonbankruptcy law, including federal law such as ERISA.[7]

In response to the trustee's argument that Bankruptcy Code [sections] 522(d)(10)(E)[8] would be superfluous if [sections] 541(c)(2) is held to encompass "ERISA-qualified' plans, the Court explained that [sections] 522(d)(10)(E) was much broader in scope than [sections] 541(c)(2), in that the former section may protect governmental plans, church plans, individual retirement accounts, and other pension plans not subject to ERISA. Additionally, the court concluded that its holding would further ERISA's goal of protecting pension benefits, i.e., "of ensuring that `if a worker has been promised a defined pension benefit upon retirement--and if he has fulfilled whatever conditions are required to obtain a vested benefit--he actually will receive it."[9]

The Court also determined that the anti-alienation provision of the plan in question was enforceable under ERISA, since "[al plan participant, beneficiary, or fiduciary, or the Secretary of Labor may file a civil action to `enjoin any act or practice' which violates ERISA or the terms of the plan. 29 U.S.C. [subsections] 1132(a)(3) and (5)."[10] Because the plan in Shumate contained a restriction on transfer enforceable under nonbankruptcy law, the debtor was entitled to exclude his interest in the plan from his bankruptcy estate.

The plan involved in Shumate happened to be tax-qualified under I.R.C. [sections] 401(a). Consequently, the Shumate Court stated that the plan complied with the anti-alienation requirement of I.R.C. [sections] 401(a)(13) as well as with the restriction on transfer required by ERISA [sections] 206(d)(1). Similarly, after illustrating that an ERISA-mandated restriction on transfer is enforceable under ERISA, the court, in a footnote,[11] stated that the Internal Revenue Service has espoused the view that the transfer of a beneficiary's interest in a 401(a) plan to a bankruptcy trustee would disqualify the plan from taking advantage of its preferential tax treatment.[12]

Hall was the first case to address the issue of whether Shumate requires a plan to be tax-qualified in order to be excluded from the bankruptcy estate under Bankruptcy Code [sections] 541(c)(2). However, the rule set forth in Hall is dictum, since Hall involved a plan that was not subject to ERISA. Similarly, Houck, 181 B.R. 187 (Bankr. E.D. Pa. 1995), and Orkin, 170 B.R. 751 (Bankr. D. Mass. 1994), which both adopt the Hall view, involved non-ERISA plans.

The other line of cases follows In re Hanes, 162 B.R. 733 (Bankr. E.D. Va. 1994), and holds that a plan is "qualified under ERISA," and, therefore, excluded under [sections] 541(c)(2), "if it is (1) governed by ERISA and (2) includes a non-alienation provision that is (3) enforceable under ERISA."[13]

The Hall court's analysis is twofold. First, the court cited a portion of the Shumate decision in which the Supreme Court quoted the restriction on transfer requirement of ERISA [sections] 206(1)(d) as well as the anti-alienation requirement of I.R.C. [sections] 401(a)(13). The Hall court opined that the Supreme Court would not have cited I.R.C. [sections] 401(a)(13) if "ERISA-qualified is determined without regard to tax law.[14]

Second, the Hall court felt compelled to rule as it did because of the language used by the Sixth Circuit[15] in the pre-Shumate decision of Forbes v. Lucas (In re Lucas), 924 F.2d 597 (6th Cir. 1991). Forbes involved a plan that was subject to ERISA and qualified under I.R.C. [sections] 401(a). In ruling that the plan contained a restriction on alienation enforceable under nonbankruptcy law, the Sixth Circuit reasoned that its conclusion "(1) harmonizes the Bankruptcy Code, ERISA and the Internal Revenue Code; (2) prevents a pension plan from being subject to disqualification and loss of tax exempt status when the trustee seeks turnover of the plan; and (3) guarantees uniform treatment of benefits."[16]

The Hanes decision rejected Hall, reasoning that "[i]t is the presence of a non-alienation provision that is important under Section 541(c)(2), and ERISA requires such provisions and enforces them."[17] The Hanes court also expressed the concern that obtaining tax qualification under I.R.C. [sections] 401(a) is tantamount to scaling a "legal mountain," and that even where tax qualification is initially obtained, creditors could reach plan benefits if the employer fails to amend the plan to comply with changes in the tax law.

An encouraging word on the issue of tax-qualification comes from the Fifth Circuit in Youngblood v. Federal Deposit Insurance Corporation, 29 F.3d 225 (5th Cir. 1994), which holds that the bankruptcy court is bound by an IRS determination that a qualified plan should not lose its tax-qualified status despite various improprieties in the administration of the plan. In Youngblood, the pension plan was terminated and the debtor rolled over the assets to an IRA. The debtor subsequently filed a Ch. 7 bankruptcy petition, and one of the creditors challenged the debtor's claim that the IRA was exempt property under Texas law, which provided that "amounts qualifying as nontaxable rollover contributions ... are treated as exempt...