Sometimes when you’ve paid a creditor shortly before filing for bankruptcy, the bankruptcy trustee will be entitled to get this money back. The idea is that bankruptcy should treat all creditors fairly, so if the money you paid should belong in your bankruptcy estate, the trustee has the power to “reverse” the transfer of money or property and then distribute it among your creditors.
These types of payments, called “avoidable preferences” are not illegal or improper if you did not intend to defraud your creditors. (Some other types of pre-bankruptcy transfers are prohibited and will get you into trouble.) But if you don’t want the bankruptcy trustee to come knocking on your creditor’s door (which might be the case, for example, if the payment was to your Aunt Mabel), then it pays to learn about these rules before you file for Chapter 7 bankruptcy.
Types of Avoidable Preferences in Chapter 7 Bankruptcy
Whether a payment (often called a “transfer of property” in bankruptcy law) can be voided by the bankruptcy trustee depends on who the creditor is, how much you paid the creditor, and when you made the payments. Transfers include monetary payments as well as transfers of property such as cars, real estate, or the like.
For the most part, the rules are divided into two categories: Payments made to insiders and payments made to creditors who are not insiders. There is also a separate rule for business debtors.
Payments to Insiders
An “insider” is a relative, friend, or business associate. The bankruptcy trustee can undo any transfers of property worth more than $600 to insider creditors if the transfer was made within one year of your bankruptcy filing. Keep in mind that the insider must be a creditor. So giving your old car to your adult son won’t trigger the rules, but giving your old car to your aunt in payment of a debt to her, would. (However, if your gift was made in order to defraud your creditors, you could land in hot water.)
Payments to Regular Creditors
If a creditor is not an insider, the trustee cannot undo the transaction unless you paid the creditor more than $600 within 90 days before your bankruptcy filing.
In many districts, the bankruptcy trustee will not try to get back a preference payment unless it involves an amount substantially more than $600. A local bankruptcy attorney may know what the standard procedure is in your local bankruptcy court.
Payments of Business Debts
If you are a business debtor (which means the majority of your debts arise from your business), the trustee will only look at payments or transfers of property that are more than $5,850.
Consequences of Violating the Preference Rules
If you do make a payment to a creditor that falls within the rules defining an avoidable preference, the trustee is authorized to take back the money or property. There is no penalty to you.
Exceptions to the Preference Rules
If, at the time you made the payment, you were not insolvent, then the payment is not considered to be an avoidable preference. You are insolvent if your assets are greater than your liabilities. So, for example, if you repaid a $5,000 loan to your father eight months before you filed for bankruptcy, but at the time your debts were not larger than your assets, your father can keep the money.
Proving you were not insolvent for purposes of non-insider creditors is tricky. This is because bankruptcy law presumes you are insolvent during the 90-day period before you file for bankruptcy.
If You Don’t Want the Bankruptcy Trustee to Reverse Your Preference Payments
If you’ve made a payment or transferred property to a creditor that would qualify as an avoidable preference, and you don’t want the trustee to come after the creditor, you can simply wait to file for bankruptcy until you are outside of the applicable time periods.
If it would be a hardship to delay your bankruptcy filing (which is the case for many debtors), you can always pay the creditor after you file your petition using income you earn after the filing date or exempt property.