Most debtors have certain obligations they would rather pay back before others, such as a pet’s medical insurance policy or a loan from a family member or friend. But paying back 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 has the power to avoid (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 considering filing for bankruptcy, you might want to start by learning about the differences between Chapter 7 and 13, and how to avoid potential bankruptcy problems by planning for bankruptcy.
The purpose of bankruptcy is to give you a fresh start. But rules also exist to protect creditors because when a debtor doesn’t have enough money to pay everything, it’s common to pick and choose whom to pay. The result can be a preferential debt payment. Preferential debt payment rules exist to unwind such transactions to ensure that creditors receive the amount they’re entitled to receive under bankruptcy law.
Two categories of preferential payments exist. General creditors can’t receive more than they would receive through bankruptcy. Even more stringent preferential debt payment rules apply to creditors that debtors commonly favor, called “insiders.” Here’s how it works.
A preferential payment to a creditor occurs if all of the following are present:
Keep in mind that bankruptcy law presumes you are insolvent during the 90 days before bankruptcy. As a result, the trustee doesn’t have to prove insolvency in most cases. Also, the trustee can prove insolvency—and fraud—if the payment was made more than 90 days before the bankruptcy filing. So delaying a bankruptcy filing won’t solve a potential fraud problem.
Any payments made to insiders (such as your family, friends, or business partners) are also subject to the above rules. But the lookback period is even greater. Payments to insiders are preferential if made within one year of bankruptcy instead of just 90 days.
You’ll be required to report such transactions in your bankruptcy paperwork on the bankruptcy form called Your Statement of Financial Affairs for Individuals Filing for Bankruptcy.
Resolving preferential payment issues is a central or “core” proceeding in bankruptcy within the jurisdiction of the bankruptcy judge. If the court determines that 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. Keep in mind that preferential payments are not illegal unless you made them with the intent to defraud your creditors or hide money from the trustee. But the recipient of the payment will still have to return the money.
One of the goals of bankruptcy is to treat all creditors fairly. If you pay back a preferred creditor before filing your case, other creditors may not be receiving as much as they would be entitled to in your bankruptcy. As a result, the clawback provision of the Bankruptcy Code allows the trustee to recover preferential payments and distribute the money among all of your creditors.
Also, not all debt is treated the same way in bankruptcy. Under priority payment rules, some debts, such as support obligations and recent taxes, must be paid before others.
The best course of action is to avoid violating the preferential payment rules altogether. Of course, if you already have made a preferential payment, 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 the way you expect. Whenever you intentionally try to 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.