Why is paying off creditors before bankruptcy generally not a good idea?

It is generally not wise to repay debts just before filing bankruptcy.

Those considering bankruptcy often owe debts to many creditors. As a result, many are tempted to attempt to pay off one or more particular creditors before they file bankruptcy. This is especially common when the creditor is a family member. If you are in this situation, you may think that you are doing the creditor a favor. However, in reality, this type of transfer may be considered a preferential transfer and voided later.

What are preferential transfers?

Whether you choose to file for Chapter 7 or Chapter 13, the bankruptcy trustee will examine the transactions that you made before your filing date. The purpose of this is to assure that all creditors are treated equally and to prevent filers from defrauding their creditors.

Preferential transfers are one way that some filers, for a multitude of reasons, attempt to favor one creditor over another. Under the bankruptcy code, this type of transfer is defined as:

  • A payment made on account of a debt owed
  • Made within 90 days before filing bankruptcy
  • Made while the bankruptcy filer was insolvent (the court will assume that you were insolvent within 90 days before filing bankruptcy)
  • Allowing the creditor to receive more than it would have received in Chapter 7

Since most creditors receive little or nothing in Chapter 7 bankruptcy, virtually any significant repayment of debt made during the 90-day period can be considered a preferential transfer.

Consequences of preferential transfers

Under the law, a trustee is empowered to avoid all preferential transfers. This means that the trustee can force all creditors receiving such transfers to return the money. Any money recovered becomes part of the bankruptcy estate and is distributed according to law.

Fortunately, the law has carved out several exceptions for certain transfers made before bankruptcy is filed. Under the law, payments made on account of domestic support obligations such as child support or alimony are not considered preferential transfers . Additionally, aggregate payments of less than $600 to creditors are generally exempt from being considered as a preferential transfer. However, if most of your debts are business debts, you may pay up to $6,225 towards a business debt without fear of having the transaction avoided later.

If you are contemplating bankruptcy, you may have questions about how your creditors will be treated, especially if they are family members or business associates. An experienced bankruptcy attorney can fully advise you on how the process would affect your unique situation.

Keywords: preferential transfers, bankruptcy