When a person declares bankruptcy, all of their property becomes part of the estate -- the total assets that are used to pay existing creditors. Here is the exact definition contained in the bankruptcy code:
(a) The commencement of a case under section 301, 302, or 303 of this title creates an estate. Such estate is comprised of all the following property, wherever located and by whomever held:
(1) Except as provided in subsections (b) and (c)(2) of this section, all legal or equitable interests of the debtor in property as of the commencement of the case.
(2) All interests of the debtor and the debtor’s spouse in community property as of the commencement of the case that is --
(A) under the sole, equal, or joint management and control of the debtor; or
(B) liable for an allowable claim against the debtor, or for both an allowable claim against the debtor and an allowable claim against the debtor’s spouse, to the extent that such interest is so liable.
This is very similar to the definition the gross estate in the estate tax code or gross income in §61 -- it's an exceedingly broad definition, designed to include every piece of property owned by the debtor.
The code, however, does allow several specific exemptions. Under the federal statute, the debtor may choose federal or state law exemptions. Under federal statute, retirement plans are excluded
§522(b)(1) Notwithstanding section 541 of this title, an individual debtor may exempt from property of the estate the property listed in either paragraph (2) or, in the alternative, paragraph (3) of this subsection.
(C) retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986.
Most states allow this exemption as well.
According to §401(a)(4), a deferred compensation plan cannot discriminate in favor of highly compensated employees (HCEs), which is a person who either owned 5% of the business at any time during the year or made more than $80,000 (inflation-adjusted) during the preceding year.
The regulations provide two safe-harbor tests for defined contribution plans (which comprise the vast bulk of 401ks). The first is a "unified allocation formula," which requires all plan contributions to be allocated in one of three ways:
While the rules do allow a C-Suite executive to benefit from the plan based on their status within the company, it doesn't allow them to benefit more than their status would allow.
The second method uses a "uniform points method" which are determined by summing "the employee's points for age, service, and units of plan year compensation for the plan year."
The main point that advisers should take from these rules is that the regulations contain very rigid, mechanical rules that prevent the top of the employee ranks from rigging the retirement plan to their benefit at the expense of the rank-and-file.
In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program. He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution. He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog. He is also an investment adviser with Thompson Creek Wealth Advisors.
In order for a deferred compensation trust to the “qualified,” it must comply with all of §401's specific requirements. Complete compliance creates tax-deferred status. §501 states (emphasis mine), “An organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503.”
One of 401s most important requirements is that funds can only be used for the benefit of the employees. §401(a)(2) states in relevant part,
“(2) if under the trust instrument it is impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of his employees or their beneficiaries…”
To borrow language from contract law, this section contains a condition precedent, which is, “... an event which must take place before a party to a contract must perform or do their part.” The following hypothetical illustrates: Company A owes a significant amount of money and also has a large, well-funded retirement plan. 401(a)(2) prevents the company from raiding the retirement fund until every possible obligation of the trust is paid.
The Treasury Regulations add additional color:
(2) As used in section 401(a)(2), the phrase “if under the trust instrument it is impossible” means that the trust instrument must definitely and affirmatively make it impossible for the nonexempt diversion or use to occur, whether by operation or natural termination of the trust, by power of revocation or amendment, by the happening of a contingency, by collateral arrangement, or by any other means. Although it is not essential that the employer relinquish all power to modify or terminate the rights of certain employees covered by the trust, it must be impossible for the trust funds to be used or diverted for purposes other than for the exclusive benefit of his employees or their beneficiaries.
The phrasing is unambiguous, providing no legal “wiggle-room.”
In my introductory post on the topic, I specifically noted this code section uses trust language, placing a fiduciary duty and obligation on the sponsoring company. This section furthers that observation.
29 U.S.C. Chapter 18 contains ERISA -- the Employee Retirement Income Security Act, which was passed in 1974. Its purpose is to protect employee benefit plans from employer malfeasance, such as using employee plans to fund corporate operations or pay corporate debts.
Like the deferred compensation section of the tax code, ERISA itself its own legal specialty. A complete discussion would be the subject of an entire course in law school. For our purposes, the following points are salient:
1.) The statute gives federal courts jurisdiction over a large number of causes of action related to ERISA: ("Except for actions under subsection (a)(1)(B) of this section, the district courts of the United States shall have exclusive jurisdiction of civil actions under this subchapter brought by the Secretary or by a participant, beneficiary, fiduciary, or any person referred to in section 1021(f)(1) of this title. State courts of competent jurisdiction and district courts of the United States shall have concurrent jurisdiction of actions under paragraphs (1)(B) and (7) of subsection (a) of this section.). This greatly increases the weight of potential litigation.
2.) The statute creates a complex compliance burden. Here is a list of the sections contained in 29 U.S.C. Part I: Reporting and Disclosure:
This is yet another reason why an entire industry exists to service deferred compensation plans.
Certain sections of the tax code (such as §1031 like-kind exchanges and §482 transfer pricing) have become their own mini-specialty. §401-§420 (deferred compensation) is another such area of the code. In the following posts, I’ll go over the “high points” of these code provisions, starting with today’s general introduction to the topic.
The opening sentence of §401 contains a large amount of important information:
A trust created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall constitute a qualified trust under this section—
Here are that sentence’s key provisions:
 In Re Rothko, 43 N.Y. 2d 305 (I have reversed the order of the quotes for the sake of clarity).
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