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 or family member 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.
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.
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:
Here is how the rules get applied to regular creditors, insider creditors, and business debt creditors.
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 assuming that you made an unknowing mistake and weren't attempting to commit bankruptcy fraud.
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.)
If you weren't insolvent when you made the payment, then the amount won't be considered to be an avoidable preference. You're not insolvent if your assets are more significant 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 overall debts, you'll be considered solvent and your father can keep the money.
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.
(For an overview of things to avoid doing before bankruptcy, read Hiding Assets in Bankruptcy.)
Updated June 24, 2020