It’s common to want to pay a particular creditor before filing for bankruptcy. For instance, you might want to preserve your relationship with your veterinarian or repay a friend for an emergency loan. The problem is that in some cases, the bankruptcy trustee appointed to administer your case will be entitled to get this money back—especially if you paid it shortly before filing.

Treating Creditors Fairly in 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 if the money you paid out belongs in your bankruptcy estate, the bankruptcy trustee can “reverse” the transfer and distribute it among your creditors.

These types of payments, called “avoidable preferences,” aren’t illegal or improper if you didn’t intend to defraud your creditors. (Some other types of pre-bankruptcy transfers are prohibited and will get you into trouble—more below.) But if you don’t want the trustee to come knocking on your creditor’s door, then you’ll want to learn the rules before filing for Chapter 7 bankruptcy.

Types of Avoidable Preference Payments

When the bankruptcy trustee reviews your bankruptcy paperwork, one of the things scrutinized will be asset transfers. A transfer can include a monetary payment or a transfer of property, such as a car or real estate.

Whether the trustee will void a monetary payment 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 get applied to regular creditors, insider creditors, 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 car to your aunt in payment of a debt to her, would. (However, if your gift was made 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 $6,425 during the 90 days before filing.

If you 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.

You’ll list each of these types of payments on the official Statement of Financial Affairs for Individuals Filing for Bankruptcy form. (Learn more about the information you’ll provide in How to Fill Out Bankruptcy Forms.)

Exceptions to the Preference Rules

If you weren’t insolvent when you made the payment, then the payment won’t be considered to be an avoidable preference. You’re not 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, and at that time the total dollar amount of your assets exceeded your total debts, you’ll be considered solvent and your father can keep the money.

Preference Payments Versus Fraudulent Transfers

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-year period before the bankruptcy filing.

(For an overview of things you’ll want to avoid doing before bankruptcy, read What is Bankruptcy Fraud?)

Updated July 18, 2018

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