You can be setting your relatives up for a problem if you pay them back before you file bankruptcy.

The bankruptcy Trustee has the power to avoid preferences, see 11 U.S.C. § 547. With certain exceptions, the Trustee may avoid any transfer of property made by the debtor.

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(b) Except as provided in subsection(C) and (I) of this section, the trustee may avoid any transfer of an interest of the debtor in property –

(1) to or for the benefit of a creditor;

(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;

(3) made while the debtor was insolvent;

(4) made –

(A) on or within 90 days before the date of the filing of the petition; or

(B) between 90 days and 1 year before the date of the filing of the petition, if such creditor was an insider; and

(5) that enables such creditor to receive more than such creditor would receive if –

(A) the case was a case under chapter 7 of this title;

(B) the transfer had not been made; and

(C) such creditor received payment of such debt to the extent provided by this provision of this title.

Here we are talking about preferential payments to family members. A family member falls within the definition of “insider,” as set out in section (4)(B) above. An insider is defined as:

(31) The term “insider” includes –

(A) if the debtor is an individual –

(i) relative of the debtor or of a general partner of the debtor;

(ii) partnership in which the debtor is a general partner;

(iii) general partner of the debtor; or

(iv) corporation of which the debtor is a director, officer, or person in control,

Congress’ purpose in putting this section into the Bankruptcy Code is to effect equality among all of the creditors. You are a “preferred” creditor if you got more from the debtor than you would have received in a chapter 7 liquidation of the debtor’s assets. The section also prevents a competition amount the creditors to get possession of the debtor’s property and assets before the debtor’s bankruptcy case is filed.

Preference analysis can be involved, but simply stated with regard to a family member, if the family member is unsecured or only partially secured (this means there is no or little collateral securing the debt) and receives a payment on the debt within one year of the bankruptcy case filing, that payment is probably a preference, as it will be applied to that portion of the debt that is unsecured, and thus will allow the family member to recover more than he/she would have in a liquidation of the debtor’s assets.

Many people borrow from friends and family when times are tough and they are trying to survive an economic downturn. So often, before they file a bankruptcy case, they seek to repay the people who helped them out and loaned them money BEFORE they file a bankruptcy case. They do this because they do not want to discharge the debt they owe to the person or persons who helped them.

While this is a commendable goal, the choice to make these preferential payments is a poor one.

If you repay a relative a debt less than one year before you file your bankruptcy petition, the relative may be forced to return that money to the bankruptcy trustee. The preference period for a friend is only 90 days. Clearly, the timing of any repayment to a creditor becomes critical.

While it is often possible to put off a bankruptcy filing for 90 days if payments have been made to friends or other non-relatives, putting off a bankruptcy filing for a year, if payments have been made to family members is often not possible when faced with levy or garnishment or foreclosure.

In a Chapter 7 case, if there is a preferential payment to a relative, the Trustee will often give the debtor an opportunity to pay the Trustee the amount in question which serves a couple of purposes. First, it saves the relative from being approached by and potentially sued by the Trustee to recover the money or property preferentially paid. It saves the Trustee the time and effort to seek to recover the money or property from the preferred creditor. Finally, the debtor may be able to settle with the Trustee for an amount less than what was paid as a preference because it’s less work for the Trustee if the Trustee is paid by the debtor.

In a Chapter 13 case, the preferential payment amount becomes part of the “threshold” amount that the debtor will repay over the life of his bankruptcy case. In a Chapter 13 case the Trustee will look to the debtor to repay the preferential payment amount, rather than seek to recover the money or property from the preferred creditor. For this reason a Chapter 13 case is sometimes filed when the debtor could have qualified for and filed a Chapter 7 case.

I think that most of my clients who pay relatives or friends before filing their bankruptcy case believe that if they do not pay these people back before their bankruptcy case is filed, they cannot pay them back. They believe that they will not be able to pay the debt back after the bankruptcy case. That is not the case. The debtor can repay any of his creditors back voluntarily after his/her bankruptcy case is over. There is nothing out there to prevent a debtor from voluntarily repaying any creditor after the bankruptcy case has been concluded.

The discharge received in bankruptcy eliminates any legal obligation to repay pay a debt. But it does not prevent or restrict the debtor in any way if he/she wishes to voluntarily repay a debt.

I often tell potential bankruptcy clients with debts owing to friends or family members to put the blame on me. I tell them to tell their family members or friends that the darn bankruptcy attorney is making them include all of their debts in their bankruptcy case, but that when the case is over, they will repay the debt as promised – IF that is their intention.

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