Preferential Debt Payments in Bankruptcy

Most debtors would rather pay particular debts before others, such as a pet's medical insurance policy or a loan from a family member or friend. However, repaying a preferred creditor before filing for bankruptcy can be considered a preferential debt payment, which comes with consequences. The bankruptcy trustee appointed to administer your case can "avoid" or undo a preferential payment transaction, recover the funds, and use the money to pay other creditors. Read on to learn more about preferential debt payments in bankruptcy.

If you're planning on filing for bankruptcy, consider learning about the differences between Chapter 7 and 13 and how to avoid potential bankruptcy problems by planning for bankruptcy.

Preferential Debt Payments in Bankruptcy

The purpose of bankruptcy is to give you a fresh start. However, another goal of bankruptcy is to treat all creditors fairly. Because it's common for a debtor to pick and choose whom to pay when money is tight, preferential debt payments can result, leaving some creditors with less than they would be entitled to otherwise.

Also, debts don't all receive the same treatment in bankruptcy. For instance, under priority payment rules, support obligations and recent taxes must be paid before lower priority debts like credit card balances, medical bills, and personal loans.

The Debt Payment Preference Rules

When you complete your bankruptcy paperwork, you'll disclose debt payments made to creditors on the bankruptcy form called Your Statement of Financial Affairs for Individuals Filing for Bankruptcy. If your disclosures indicate that you unfairly paid a particular creditor before filing your case, the clawback provision of the Bankruptcy Code allows the trustee to recover the funds and distribute the money appropriately.

On the bankruptcy form, two categories of preferential payments exist.

Payments Within 90 Days of Bankruptcy

If your debts are primarily consumer debts—not debts related to running a business—the trustee can reclaim money paid to a creditor as a preferential payment if the following are present:

• the payments were made to one creditor
• totaling over $600 in the 90 days before filing
• while the debtor was insolvent (debts exceeded assets), and
• the total exceeded the amount the creditor would otherwise have received in bankruptcy.

The maximum payment amount increases to $7,575 if you owe mostly business debts.

Payments to Insiders Within One Year of Bankruptcy

Even more stringent preferential debt payment rules apply to creditors that debtors commonly favor, called "insiders." Insiders include family, friends, and business partners. The trustee can recover preferential payments made within one year of bankruptcy instead of just 90 days.

The Trustee and the "Clawback" Procedure

The trustee will likely start by attempting to resolve the problem informally. If that isn't possible, the bankruptcy judge will decide the preferential payment dispute as a central or "core" proceeding in bankruptcy. If it's determined the debtor made a preferential debt payment before filing the case, the trustee can avoid the payment and get the money back for the benefit of creditors—an action referred to as a "clawback" bankruptcy procedure.

Preferential payments aren't illegal unless you made them to defraud your creditors or hide money from the trustee. However, the payment recipient will still have to return the money. Sometimes, the debtor repays the funds to avoid subjecting the creditor to litigation—especially when friends or family are involved.

Avoiding Preferential Payments

The best strategy is to avoid violating the preferential payment rules altogether. Of course, you might have already made a preferential payment. In that case, there likely won't be much you can do about it—just be aware that the trustee will use the clawback procedure to reverse the payment. And keep in mind that even if you lose the benefit of the payment, it's likely that it will still be worthwhile to file your bankruptcy case.

Some people believe that delaying filing for bankruptcy is the answer, but it might not work out quite how you expect. Whenever you intentionally hide assets or defraud your creditors, you risk losing the benefit of your bankruptcy discharge and face criminal prosecution.

Learn about other red flags trustees will look for in bankruptcy paperwork.