Why should I avoid paying off debts before I file bankruptcy?

On behalf of Richard Pearson

Knowing about preferential transfers can help avoid a wasted effort before bankruptcy.

If you are struggling with debt you cannot afford to pay back, you probably owe money to many creditors. However, you may want to pay a certain creditor back before the others. For example, a friend or family member may have given you a loan during financial hard times, so you may feel morally obligated to pay them back with the last bit of cash you have before you file bankruptcy. You may think that this is the right thing to do, but in reality, this is an example of a classic thing not to do before bankruptcy, as it may later be regarded as a preferential transfer.

What are preferential transfers?

Whether you file for Chapter 7 or Chapter 13, the bankruptcy laws mandate that you treat your creditors equally. Accordingly, when you file bankruptcy, your financial transactions that you made during a certain period before the date you filed are scrutinized to make sure that you did not play favorites with your creditors.

Simply put, preferential transfers occur when a bankruptcy filer significantly favors one creditor over another. In many cases, the favored creditor is a family or friend. However, preferential transfers can involve creditors that you do not have a personal relationship with. Under the law, a preferential transfer is made when:

  • A transfer to a creditor is made because of a debt owed;
  • Within 90 days before the bankruptcy filing date (or one year if the creditor is an "insider" under the law);
  • While the bankruptcy filer was insolvent (insolvency is presumed 90 days before the filing date); and
  • Which caused the creditor to receive more than they would had the filer filed Chapter 7 bankruptcy

In Chapter 7 bankruptcy, the majority of unsecured creditors receive little or nothing, so many transfers made within 3 months of the bankruptcy filing date can be considered preferential. If the payment was made to an "insider," which includes family members and business associates (among others), the same can be said for any payment made in the past year.

What happens to preferential transfers? Are there any exceptions?

If it is determined that a preferential transfer was made, the bankruptcy trustee is empowered to void the transaction and seek repayment of the monies paid from the preferred creditor. Once the funds are recovered, they become part of the bankruptcy estate and are distributed to creditors according to law.

Although all transfers made just before bankruptcy can potentially be considered preferential, the bankruptcy laws make several exceptions. For example, payments made because of alimony, child support and other domestic support obligations are not considered preferential. Also, transfers to creditors in an aggregate amount not exceeding $600 are generally not considered preferential.

An attorney can help you

The laws against preferential transfers can negate any good deed you think you are doing by settling a debt before your bankruptcy. As a result, if you are drowning in debt you cannot afford, is it wise to seek the advice of an experienced bankruptcy attorney as soon as possible. The attorneys at Prescott Pearson & Tande, PA can help you avoid the pitfalls surrounding bankruptcy, ensuring that you return to a stronger financial position as soon as possible.