Paying debts before filing bankruptcy can create legal issues for the unwary

If you are in dire financial straits, you may have turned to friends or family for money. If, despite their help, your financial problems have not been resolved, you may be considering bankruptcy. Due to your personal relationship with them, you may have considered paying them back what you can. Although this is a noble sentiment, if you later file bankruptcy, this gesture could cause problems, as it may be regarded as a preferential transfer.

What is a preferential transfer?

A preferential transfer occurs when you significantly favor one creditor over another during a certain period before filing bankruptcy. Bankruptcy laws require you to treat your creditors equally, both before and during bankruptcy. So, for example, if you repay a family member before a credit card debt, and then file bankruptcy, you have "preferred" the family member and unwittingly caused them to become involved in your bankruptcy case. Specifically, under the law, a preferential transfer is defined as:

• A transfer made to a creditor because of a debt owed;

• One you made within 90 days before you filed bankruptcy (or one year before, if the transfer was to family, friends, business associates and other "insiders", defined as someone with intimate knowledge of your finances);

• Made while you were insolvent (the law considers you insolvent, that is, unable to service debt as it becomes due, 90 days before you filed bankruptcy); and

• Which caused the creditor to receive more than they would have received in a Chapter 7 bankruptcy (liquidation)

Since most unsecured creditors (which includes personal debts) receive little or nothing during Chapter 7, many if not all significant repayments of personal debts you make within a year of filing bankruptcy are considered preferential. This is mainly due to the fact that most friends and family members are considered "insiders" (i.e. they have more knowledge of your financial situation than ordinary creditors) under the law, so the law prohibits you paying them off for a longer period before bankruptcy.

What happens to preferential transfers?

When you file bankruptcy, the bankruptcy trustee will look at the transactions you made during the year before you filed bankruptcy. If any preferential transfers are found, the trustee can legally compel the creditor to repay the amount they received. The trustee will first send a letter demanding repayment, and if that fails, the trustee can bring legal action against the creditor to force repayment. All preferential payments recovered are distributed among all your creditors, according to the priorities set by the bankruptcy laws.

However, there are exceptions to the preferential transfer rules. For one, if the aggregate amount of the transaction to the creditor was less than $600, it is generally not considered to be preferential because the cost of taking action to pursue the preference exceeds what will be recovered. Additionally, all transfers for child support, alimony and other domestic support are exempt from being regarded as preferential. In addition, the trustee rarely seeks to recover a preference against a taxing authority as they are accorded priority status under the law and so would be the first to receive a distribution from the trustee.

An attorney can help

It is natural to want to repay the kindness of a friend or family member. However, assuming that you file bankruptcy, doing so can involve them in your case. As a result, it may be better to wait after your bankruptcy case is closed before you repay the debt.

The complicated nature of the bankruptcy process is one reason why it is important to consult with an experienced bankruptcy attorney before filing. An attorney can work on your behalf to ensure a smooth sailing through the process with a minimum of snags or negative outcomes.