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Avoiding “Preference” Shock—Except When You Don’t Want To

Nov. 22, 2011

The part of bankruptcy law which seems to go most against common sense involves “preferences”—payments that you make to creditors (even if you don’t see them as creditors) within a certain amount of time before your bankruptcy case is filed. In most cases, if you understand and avoid preferences you will much more likely have a smooth bankruptcy case.

The idea behind the term “preference” is that it is a payment to a creditor in preference to your other creditors. You’re playing favorites with one of your creditors. If you do make such a payment, after you file your bankruptcy case the trustee may have the right—depending on the facts—to require that creditor to “return” the amount of that payment, not back to you but rather to the trustee. Then the trustee can distribute that money to all your creditors evenly.If you paid this person because you felt a strong moral obligation to do so—such as to a relative or close friend—then it may be a financial hardship to that person (and intensely embarrassing to you) when the trustee forces that person to “return” the money you paid. In fact, you may well feel like you must make up for that lost money by paying that person again. NOT a good situation.

We’ll tell you the basic rules about preferences in a moment, but first suggest that you’ll understand the term better if you start by disassociating the term from its usual meaning. A payment may be “preferential” even if you are not playing favorites at all. Indeed, the preference payment is often paid unintentionally, such as through a garnishment. The purpose behind the trustee’s right to undo a preferential payment is to discourage creditors from being overly aggressive against a person who looks like they may be a candidate for filing bankruptcy. If creditors know that money they grab may have to be returned, they will tend to be less aggressive about pursuing someone who is hurting financially. At least that’s the theory.

So here’s the basic rule. A preference is a payment (usually money, but it can be any asset) made on a prior debt to a creditor (anybody to whom you legally owe money) during the period of 90 days or less before the filing of a bankruptcy. However, that period is stretched out to a full year before filing for payments made to “insiders”—basically relatives and business associates.

There are a lot of exceptions. An important one is if the payment was made not on a prior obligation but rather to buy something new—say if you bought a used car for $1,500 right before filing bankruptcy, the payment of that amount would not be a preference. Also, if the payment to any particular creditor is less than $600 in a consumer case, or less than $5,000 in a business case, the trustee cannot pursue the preference.If you come in to see us about filing bankruptcy, we will definitely ask you about payments made to creditors in the past year. But we suggest that instead of waiting for us to ask, tell us at the beginning of our initial meeting if within the prior year (or longer if you have any doubt how long it’s been) you paid money (or made payment by transferring assets instead of money) to anyone—especially to relatives or business partners or other associates. We may decide to delay filing a bankruptcy to avoid a payment being a preferential one, but sometimes we may want to hurry the filing to enable the payment to be preferential. In the latter case, in the right circumstances money that you thought was long gone could be retrieved from a creditor and potentially used by the trustee to pay a debt that benefits you, such as paying a child support arrearage or income tax debt that would otherwise not be written off in your bankruptcy.
As you can see, preferences are an unusual aspect of bankruptcy. If we address them appropriately, we can either avoid some bad surprises or occasionally give you a good surprise.