Payments Made to Creditors Before Bankruptcy: Can the Trustee Get the Money Back?

Many bankruptcy filers want to pay a particular creditor before filing for bankruptcy. For instance, you might want to preserve a relationship with a veterinarian or repay a friend or family member for an emergency loan. But before you do, you should know the rules because, in some cases, the bankruptcy trustee appointed to administer your case will have the right to get this money back—especially if you paid it shortly before filing.

In this article, you'll learn:

• how preferential payment rules promote creditor fairness, and
• why a trustee might undo a payment made before bankruptcy.

Also, we explain when a payment might be fraudulent instead of preferential and when you should consider consulting with a bankruptcy lawyer.

Treating Creditors Fairly Before Bankruptcy

One of the goals of bankruptcy is to avoid favoring one creditor with a windfall while giving others less than they're entitled to receive under the bankruptcy priority payment rules. So the bankruptcy trustee can "reverse" certain transfers and distribute the funds among your creditors.

These "avoidable preferences" payments aren't illegal or improper if you didn't intend to defraud your creditors. In contrast, other prebankruptcy transfers are prohibited and will get you into trouble—more below.

But if you don't want the trustee knocking on your creditor's door, you'll want to learn the rules before filing for Chapter 7 bankruptcy.

What Is an "Avoidable Preference" Payment in Bankruptcy?

When the bankruptcy trustee reviews your bankruptcy paperwork, one of the things scrutinized will be asset transfers. A transfer can include giving or paying money to another person or business or transferring property like a car or real estate to someone else.

Whether the trustee will void or reverse a payment made to another will depend on:

• the creditor's relationship to you
• how much you paid the creditor, and
• when you made the payment.

Here is how the rules apply to regular, insider, and business debt creditors.

• Insider payments. An insider is a relative, friend, or business associate. The bankruptcy trustee could undo any transfers of property to insider creditors if the debtor transferred the funds within one year of the bankruptcy filing. You'll include domestic support obligations, such as alimony and child support. 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 vehicle to your aunt in payment of a debt to her, would. However, if you gave the gift to defraud your creditors, you could land in hot water, so it's best to avoid all transfers.
• Regular creditor payments. If a creditor is not an insider, the trustee can't undo the transaction unless you paid the creditor more than $600 within 90 days before your bankruptcy filing; however, actual practices can vary depending on the court and trustee.
• Business debt payments. If you are a business debtor (the majority of your debts arise from your business as opposed to consumer debt), the trustee will only look at payments made to a creditor totaling $6,825 during the 90 days before filing.

If a creditor payment 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 assuming that you made an unknowing mistake and weren't attempting to commit bankruptcy fraud.

You'll list each type of payment on the official Statement of Financial Affairs for Individuals Filing for Bankruptcy form. Learn more about the information you'll provide and how to fill out bankruptcy forms.

What's the Difference Between a Preference Payment and a Fraudulent Transfer?

Fraudulent transfers aren't made to pay a debt, but rather to avoid paying a creditor, and, unlike preference payments, friends and family are usually the recipients of a fraudulent transfer. The trustee has the power to reverse fraudulent transfers that occurred during the two years before the bankruptcy filing.

Learn more about things to avoid doing before bankruptcy, such as hiding assets in bankruptcy.

Discuss Potential Preference Payments With a Lawyer

Depending on your court's jurisdiction, a payment falling within the avoidable preference rules might not be subject to the trustee's clawback provisions. For instance, your bankruptcy court might allow you to prove that you weren't bankrupt when you made the payment, and as a result, the payment isn't subject to the preference payment rules.

However, here's the catch. It costs money to put up a defense, even when it's a potential winner, and most bankruptcy files don't have extra cash for litigations. Also, you'll want to consider a few other things from a practical standpoint.

• The trustee recovers money from the creditor, not you, so it's genuinely the creditor's fight. The creditor won't have recourse against you if you can wipe out the debt in bankruptcy, so getting involved won't likely be in the filer's interest.
• Because paying an attorney to represent you could easily cost more than the amount the trustee will recover, some filers handle this situation by simply paying the trustee the amount in question, or

Ultimately, you'll want to do a cost/benefit analysis involving the amount at stake, the viability of the defense, and the cost of putting forth that defense. A local bankruptcy lawyer will be in the best position to review your options and develop a feasible and cost-effective strategy.

Need More Bankruptcy Help?

Did you know Nolo has been making the law easy for over fifty years? It's true—and we want to make sure you find what you need. Below you'll find more articles explaining how bankruptcy works. And don't forget that our bankruptcy homepage is the best place to start if you have other questions!

We wholeheartedly encourage research and learning, but online articles can't address all bankruptcy issues or the facts of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.