A Lesson in Property Exemptions from the Recent Supreme Court Decision about Inherited IRAs

Some debtors can, but others cannot, choose between the federal and state exemptions. That’s because of a major political compromise.

 

Our last blog post summarized the U.S. Supreme Court’s ruling handed down on June 12, 2014 in Clark v. Rameker.  In a unanimous opinion the Court held that a woman who filed a Chapter 7 case could not exempt—or shelter from her creditors—an Individual Retirement Account (IRA) that she had received years earlier as the beneficiary on her mother’s IRA.

This opinion by the “highest court in the land” is a great vehicle for understanding property exemptions in general.

What Are Property Exemptions?

The Court, in its opinion written by Justice Sonia Sotomayor, introduced property exemptions in a straightforward way:

When an individual debtor files a bankruptcy petition, her “legal or equitable interests… in property” become part of the bankruptcy estate. §541(a)(1). “To help the debtor obtain a fresh start,” however, the Bankruptcy Code allows debtors to exempt from the estate limited interests in certain kinds of property.

Explaining further:

As a general matter, [the Bankruptcy Code’s exemption] provisions effectuate a careful balance between the interests of creditors and debtors. On the one hand, we have noted that “every asset the Code permits a debtor to withdraw from the estate is an asset that is not available to… creditors.” [Citation omitted.] On the other hand, exemptions serve the important purpose of “protect[ing] the debtor’s essential needs.” [Citation omitted.]

Can Always Choose Between Federal Exemptions and State Exemptions?

The Bankruptcy Code provides a list of property exemptions, but each state’s laws do as well.

The opinion referred to these sets of exemptions in a footnote, saying: “Under [the federal Bankruptcy Code], debtors may elect to claim exemptions either under federal law…  or state law… .”

But do debtors really always have this choice? Actually, no.

The quoted sentence from the Court’s opinion goes to show that even a unanimous Supreme Court can be wrong!

In reality, “debtors may elect to claim exemptions either under federal law…  or state law” ONLY if they happen to live in a state which allows that choice. You may actually be stuck with using the state’s exemptions and not be allowed to use the federal exemptions. That’s because under the Bankruptcy Code, Congress gave each state the right to require its residents to use the state’s exemptions. And 30 or so states do so, NOT permitting their residents to use the federal exemptions. Contrary to what the Supreme Court said.

To be generous about what the Supreme Court may have been trying to say, in Wisconsin, where the Chapter 7 bankruptcy case at issue originated, debtors in bankruptcy can choose to use either that state’s set of exemptions or the federal ones in the Bankruptcy Code.

But How Can States Force Debtors to Use State Exemptions in Federal Bankruptcy Court?

How can states have this power if bankruptcy is clearly stated to be exclusively a matter of federal law under the U.S. Constitution? Article I, Section 8 lists the powers of Congress, including the power to “establish… uniform laws on the subject of bankruptcies throughout the United States.” How can those laws be “uniform” if each state can use its own exemptions for the bankruptcies filed within that state?

It’s because when Congress created a set of exemptions in the Bankruptcy Code, it didn’t force everybody to use them, but rather gave each state the right to require its residents to use its own set of exemptions instead.

But property exemptions are central to the balancing of the rights of debtors and creditors in bankruptcy. So why did the federal government cede this much power to the states?

Like so much else that is political, this was a compromise. Quite a grand compromise, with more than a century of conflict behind it.

The Grand Compromise

Most people don’t know that for most of our nation’s first 100 years, we did not have a bankruptcy law on the books. The general pattern was that whenever there was a major national financial calamity—and the 19^th century was marked by a series of severe economic “panics”— Congress would be spurred into passing a bankruptcy law, but after a few years it would be repealed or would expire, until the next “panic” inspired another new, temporary bankruptcy law.

These bankruptcy laws did not survive long in large part because of deep regional disagreements about how much protection debtors and their assets should have from their creditors. Property exemptions are at the heart of that debate.

And that debate played out in one of the deepest and most persistent areas of contention in American history, between states’ rights and federal governmental power. (Do you remember the Civil War?)

Yes, the nation’s founders emphatically made bankruptcy a national procedure—imagine the confusion if each state would be able to have an entirely different set of laws and procedures of bankruptcy!

But that doesn’t mean that the states didn’t have a lot of say about how the bankruptcy laws would actually work, and how much states’ laws would still apply.

That resulted in the delicate compromise about exemptions that is now in the Bankruptcy Code:

1. Congress established a set of exemptions for debtor’s to use when filing bankruptcy;

2. BUT debtors can choose to use their state’s own set of exemptions instead;

3. AND debtors may ONLY use their state’s exemptions if that state decides to require them to do so.