Planning to file bankruptcy? Don’t repay your debts

When some people are in a sticky financial situation, they may turn to friends, family and other loved ones for financial assistance in getting them through the rough times. When this occurs, people are generally inclined to make paying back those that helped them a priority. Although this is understandable, if bankruptcy is needed later on, paying back certain choice creditors before filing it is high on the list of bankruptcy don’ts.

Although this may seem counterintuitive, there is a sound reason for this. Under the bankruptcy laws, persons who file bankruptcy must treat all their creditors equally just before or during the bankruptcy process. As a result, filers may not pay back their parents before they pay their electric bill, for example. Filers that violate this rule can find themselves (and potentially those that they paid back) in trouble, as it may be regarded as a preferential transfer. Under the bankruptcy laws, this is defined as:

• A payment made to a creditor for an outstanding debt;

• Made within 3 months before filing bankruptcy (with an important exception);

• Made while the filer was insolvent (which is presumed during the 90 days before the bankruptcy was filed); and

• That allowed the creditor paid to receive more money that it would have had the filer filed Chapter 7 bankruptcy

In the majority of cases, most unsecured creditors in Chapter 7 bankruptcy receive nothing from the filer. Because of this, any significant payments made during 3 months before bankruptcy runs a fair chance of being regarded as preferential.

As mentioned above, there is an important exception to the three-month rule. If the creditor paid is an “insider,” the period in which any repayments will be scrutinized is one year. Since the law considers family, friends and business associates as “insiders,” any repayments made to this class of persons during a year before bankruptcy is likely to be regarded as preferential.

However, every transfer made during the 3-month (or one year) period is not preferential. The law exempts some transactions from being considered preferential. These transactions include most aggregate transfers of less than $600 as well as payments for child support and alimony.

What happens if a transaction is preferential?

When the filer files bankruptcy, the bankruptcy trustee examines all financial transactions made during the 3-month (or one year period if applicable) period before bankruptcy. If it is found that preferential transfers were made, the trustee can sue the creditor and force repayment of the amount paid to them. After recovering any preferential transfers, the trustee divides the proceeds among all creditors according to the rules of distribution set by law.

Because of the potential consequences, those that are planning to file bankruptcy should refrain from repaying chosen debts before filing. Instead, filers should wait until after bankruptcy is completed to repay these debts (although there is no obligation to do so, as the debt itself may have been discharged in bankruptcy). Since bankruptcy is rife with traps for the uninitiated, an experienced bankruptcy attorney should be consulted as early as possible to ensure that the process goes smoothly.