How 401(k) Bankruptcy Exemption Can Be Lost


The Bankruptcy Code contains a number of exemptions that an individual who has filed for bankruptcy can use to exclude property from the individual’s bankruptcy estate and shelter the property from the individual’s creditors. One of those exemptions is for funds held in a retirement plan that is qualified under Internal Revenue Code Section 401.[1]

A recent case decided by the United States District Court for the District of Connecticut, Jie Xiao v. Ronald I. Chorches, Trustee[2] discusses some of the issues that can arise when an individual who is the principal owner of a small business, in this case Xiao, files for bankruptcy and seeks the protection of the retirement funds exemption for amounts held for the owner’s benefit in the business’ qualified retirement plan.

Bankruptcy Code Section 522(b)(4)

Section 522(b)(4)(A) of the Bankruptcy Code provides that funds held for the benefit of a person in a retirement plan will be presumed to be exempt from a debtor’s bankruptcy estate if the plan has received a favorable Internal Revenue Service determination letter upon which the plan can rely.[3]

As a result of modifications in IRS administrative policies, retirement plans that are intended to qualify under Code Section 401 rarely have an individual determination from the IRS. Instead, particularly in the case of small businesses, qualified plans are typically maintained pursuant to a prototype or a similar plan document sponsored by a financial institution that receives approval from the IRS in the form of an opinion letter.

The LXEng LLC pension plan, which held the retirement benefits of Xiao, used a prototype plan document that was the subject of an IRS opinion letter.

The judge in Xiao noted that there is disagreement among the courts as to whether an opinion letter for a prototype plan rises to the level of a Section 522(b)(4)(A) favorable IRS determination letter. The court went on to say that it did not have to weigh in on the disagreement. In the court’s view, the adoption of amendments to the LXEng pension plan made reliance on the opinion letter invalid.

This conclusion — based upon the facts supplied by the court — suggests an apparent misunderstanding on the part of the court of the IRS rules regarding reliance upon prototype opinion letters.

The court accurately stated that a change to a prototype plan document negates reliance upon the plan’s opinion letter. This occurs when a company using a prototype modifies the document, except for specified minor modifications, to add a provision that is not part of the prototype.[4]

Although the amendments to the LXEng pension plan may have raised qualification problems by, for example, inappropriately benefiting Xiao, there is no indication in the opinion that the amendments were outside of the provisions of the prototype.

Not having been able to convince the court that he was eligible for the Section 522(b)(4)(A) presumption, Xiao next looked to Section 522(b)(4)(B) of the Bankruptcy Code[5], which states that if the Section 522(b)(4)(A) presumption is unavailable, retirement plan funds are exempt if the debtor demonstrates that:

  • neither a court nor the IRS has made a prior determination that the plan holding the funds is not in compliance with the requirements of Section 401 of the Internal Revenue Code; and
  • the plan is in substantial compliance with those requirements, and if not in substantial compliance with those requirements, the debtor is “not materially responsible for that failure.”

In Xiao, the court found that, although there had been no prior IRS or court determination that the LXEng pension plan was not in compliance, the plan had been operated solely for the benefit of Xiao and his spouse, without providing benefits to the company’s other employees, in violation of IRS rules that prohibit such discrimination.

The court gave short shrift to Xiao’s argument that he could not have been materially responsible for the LXEng pension plan’s failure to comply because he relied upon advisors to manage the plan.

The court concluded — correctly — that, as CEO of the company maintaining the plan and co-trustee of the plan, Xiao had final authority over the plan, and absent compelling evidence to the contrary, had responsibility for the plan’s lack of compliance.

Absent a decision by the IRS or a court disqualifying the retirement plan of a large employer, the benefits of a participant in a large employer’s retirement plan are likely to fall within the Section 522(b)(4) exemption.

Even if a bankruptcy court were to determine that the large employer’s plan has a qualification failure, the benefits of a plan participant who is in bankruptcy will nevertheless be exempt from the bankruptcy estate, since in very few instances would the participant have been materially responsible for the failure.

On the other hand, as exemplified by the Xiao case, the same will often not be true where the owner of a small business files for bankruptcy.

The Impact of the IRS Correction Program on the Bankruptcy Exemption

For a number of years, the IRS has had in place the Employee Plans Compliance Resolution System, or EPCRS, which enables a company to correct the failure of its retirement plan to meet IRS requirements. In simple terms, under EPCRS, the company files a request for voluntary correction with the IRS in which the failure is disclosed, and if the IRS agrees with the company’s proposed method of correcting the failure, the company is permitted to retroactively correct the failure.

A noteworthy issue in the Xiao case was how the IRS’ correction program impacts the substantial compliance element of Section 522(b)(4)(B). The court noted that there were at least two bankruptcy court opinions that recognize the retroactive effect of post-bankruptcy petition corrections under EPCRS. The court questioned the validity of those opinions, stating that they are “arguably in tension with the basic rule that exemptions are determined as of the petition date.”

In any event, the court said that Xiao could not rely upon those cases, whether or not they were correctly decided, because Xiao had failed to take any steps to correct the failures in the LXEng pension plan. The court held that “the mere possibility of future corrective action simply does not preclude an otherwise proper finding that a plan was not substantially compliant ... as of the petition date.”

The benefit to be gained from a voluntary correction under EPCRS — the ability to avoid the potentially harsh tax penalties that the IRS could assert if a qualification failure is discovered on audit — has long been known. The Xiao case highlights a potentially significant additional reason for a small business to promptly correct plan qualification failures under EPCRS.

A small business that has a 401(k) or other qualified retirement plan is faced with many of the same compliance complexities as a large company with a qualified retirement plan, but often without the expertise or resources to properly address those complexities.

The owner of a small business beset by financial difficulties would likely not be focused on making sure that the business’ retirement plan satisfies the IRS requirements for qualification.

Putting aside whether Xiao was more than merely unobservant, the case presents an important reminder of the circumstances under which a small business owner’s retirement benefits can slip outside the bankruptcy exemption generally applicable to such benefits.

“How 401(k) Bankruptcy Exemption Can Be Lost,” by Daniel L. Morgan was published in Law360 on October 21, 2019. Reprinted with permission.

[1] Internal Revenue Code Section 401.

[2] Jie Xiao v. Chorches, No. 3:18-cv-1477-MPS, 2019 U.S. Dist. LEXIS 167739 (D. Conn. Sep. 30, 2019).

[3] Bankruptcy Code Section 522(b)(4).

[4] See IRS Revenue Procedure 2017-41, Sections 7 and 8.03.

[5] Bankruptcy Code Section 522(b)(4)(B).