What Is a Preferential Debt Payment?

“A debtor cannot favor one creditor over another,” is a common phrase used in bankruptcy. It means that a bankruptcy filer isn’t allowed to pick and choose which creditors to pay. Doing so could result in one creditor getting more than its entitled to receive at the expense of another. The result would be a preferential debt payment.

Unless you’re well-versed in bankruptcy law, it isn’t easy to predict how much each creditor should get paid. The priority rules outline the payment order of particular categories of debt. For instance, court-ordered child support payments and taxes have a higher payment priority than credit card debt. Each of the former obligations would be fully repaid before the latter would receive anything.

Here's how the process works.

After the debtor files the official bankruptcy paperwork, the court orders all debt collection activity to stop (an order known as the “automatic stay”). Funds available to pay creditors, if any, are held by the bankruptcy trustee—the court-appointed official tasked with overseeing the matter—in the bankruptcy estate.

The trustee will review the Your Statement of Financial Affairs for Individuals Filing for Bankruptcy form. On it, the filer must report certain payments—considered preferential debt payments—made before the bankruptcy filing. The disclosures include those made to:

  • creditors three months before filing for bankruptcy, and
  • family, friends, and business associates (insiders) one year before filing for bankruptcy.

The trustee will reclaim (take back) any preferential debt payments and hold the money in the bankruptcy estate. After accounting for all funds belonging to the estate, the trustee will disperse payments to creditors according to the priority rules.

(For detailed information, read Pre-Bankruptcy Payments to Creditors: Can the Trustee Get the Money Back?)

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