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:
Also, we explain when a payment might be fraudulent instead of preferential and when you should consider consulting with a bankruptcy lawyer.
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.
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:
Here is how the rules apply to regular, insider, and business debt creditors.
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.
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.
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.
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.
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!
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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.