Doing what you believe is the right thing can backfire, if you pay a special creditor before you file bankruptcy.
Bankruptcy law focuses for most purposes on what you own and who you owe at the moment your bankruptcy case is filed. But there are some limited yet potentially dangerous ways that the law can look into the past. “Preference” payments are one example.
Here’s what the law says. If during the one year before you file a bankruptcy case, you pay one creditor more than you are paying at that time to your other creditors, then after you file bankruptcy that favored creditor could be required to pay back the money you’d paid, not back to you but rather to your bankruptcy trustee, for distribution to all of your creditors.
For example, if you received an income tax refund and used $1,500 of it to pay off a debt to your brother, and then six months later you filed a bankruptcy case, your brother could be required to pay that $1,500 to the trustee. The trustee would then divvy up the $1,500 among your creditors as prescribed by law. Your brother would likely get just a tiny portion of that money, based on his pro rata share of all your debts.
This $1,500 payment you made to your brother is called a “preference.” The law considers that you paid that creditor in “preference” to your other creditors. So the bankruptcy trustee may be able to undo, or “avoid” that payment.
The Harshness of Preferences
The result is that your good intentions backfire. You want to be considerate to a special creditor—a family member or good friend, your long-time doctor or dentist, or some other favored creditor–by reducing or paying off your debt. You may want to keep that person out of your bankruptcy case. You might want this creditor not to know about you filing bankruptcy. Or you might just want to do what’s right, fulfilling a moral or some other special obligation you feel to this special creditor.
But the result could be very different. Your favored creditor gets involved in your bankruptcy case, in a way much more intrusive and embarrassing than would want. He or she has to give up the money you paid, usually quite a few months later and totally unexpectedly. The person likely spent the money long before and so may have a challenge coming with it. The trustee could sue him or her to force payment. And then after all that, you may again feel obligated to make good on that debt. So you might end up paying that debt to your favored creditor a second time, after your bankruptcy is over. What a mess.
The Good News Is This Is Preventable
This mess can be prevented altogether if you get legal advice before you make the preferential payment to your favored creditor. Or even if you’ve already made the payment when you see your attorney, there are often ways to solve this problem and avoid your favored creditor from being forced to return the money. There are many twists and turns in this law.
You have to be very careful because the law about preferences is very complicated. Section 547 of the Bankruptcy Code on preferences is anything but straightforward. It’s about 1,300 words long, containing 56 sub-sections and sub-sub-sections. Look at it and you’ll see it’s maddeningly complicated.
To simplify things for our purposes here, if you are considering filing a bankruptcy case anytime soon, don’t pay a debt to a relative, friend, or any other special creditor without talking first to an experienced bankruptcy attorney. And if you figure this does not apply to you because you don’t even consider the person you are paying to be a creditor—because it’s a “personal debt,” was never put into writing, or nobody knows about it—then you especially should talk to an attorney about it first.
And if you’ve already made such a payment before you see an attorney, be sure to talk about this right away, early at the first meeting, because there are often solutions, and sometimes easy ones. And sometimes a preference payment could affect your game plan, and maybe the timing of your bankruptcy filing.
Practically speaking, preference payments mostly create problems when they are revealed only AFTER your bankruptcy is filed. Be upfront with your attorney so that the issue can be resolved in a way that is best for you. Then most likely preferences will not be a problem for you.