Prior to filing for bankruptcy you should avoid paying relatives and friends any money owed to them. Paying them any money owed prior to filing for bankruptcy can be treated as a “preference”.
WHAT’S A “PREFERENCE”?
It’s a payment you made to a creditor within a certain amount of time before you file bankruptcy. The payment is considered to be “preferential”—that you somehow favored that creditor—based on its timing and on some other conditions.
Whether your payment is a preference or not matters because the creditor to whom you made a “preferential” payment before you file bankruptcy can be forced to return the money you paid. And that money would not be paid back to you but rather spread out among all your creditors. The payment is said to be “avoided”—in effect reversed by the bankruptcy trustee requiring the creditor to pay him or her the money for distribution among the creditors.
If you really wanted that one creditor to be paid, having that creditor lose the money you had paid earlier can be very frustrating to both the creditor and you. The creditor, instead of being glad about getting paid before you filed bankruptcy, will likely be quite unhappy about being required to surrender the payment amount. And you, instead of having the satisfaction of having paid that creditor, may well be dissatisfied about it later losing what you had paid.
HOW DO “PREFERENCES” APPLY TO RELATIVES?
A “preferential” payment can involve any creditor, but becomes especially problematic when you made that payment (or payments) to a relative or friend to whom you owe a debt. You may have felt a deep moral obligation to pay that relative or friend in return for the personal favor extended to you when he or she lent you the money. You may have also wanted to pay off the person so that he or she would not become involved in your bankruptcy case. You may have even really wanted the person not to hear that you were filing bankruptcy, and so you paid back the debt beforehand.
But if that payment you made is later considered to be “preferential” in your bankruptcy case, your good intentions would backfire. Your favored creditor would get pulled into your case, in a way likely more embarrassing than would have been otherwise. He or she would have to give up the money you paid, usually many months later, probably well after having spent it. And afterwards, you may still feel a family or moral obligation to make good on that debt. So you might end up paying that debt to your favored creditor a second time. This is certainly a situation you want to avoid. The good news is that usually it can be avoided.
BUT FIRST, WHAT ALLOWS THE BANKRUPTCY SYSTEM TO DO THIS?
Although bankruptcy law for most purposes focuses on your financial situation at the time your bankruptcy case is filed, in some important ways the law can look into the past. “Preferences” are one example.
The justification for the system being able to “avoid” a payment you made beforehand is that it serves one of the most important principles of bankruptcy law: equal treatment of legally equal creditors. Under the law, if at the time you file bankruptcy you have an unprotected asset, it gets sold and the proceeds distributed among your creditors in a way the law stipulates, generally with pro rata payments to creditors of the same type. The rationale behind preferences is that people filing bankruptcy defeat that principle of treating creditors equally WITHIN bankruptcy if they favor a creditor during the time BEFORE filing bankruptcy. Preference law, at least in theory, is intended to discourage people from favoring any particular creditors when they are on the brink of filing bankruptcy.
SO WHAT DOES THE LAW OF “PREFERENCES” SAY?
If during the one year before you file a bankruptcy, you pay an “insider” creditor a payment that is a larger proportion of its debt than you are paying at that time to your other creditors, then after you file bankruptcy your bankruptcy trustee can “avoid” that payment, requiring the creditor to pay to the trustee the money that you had paid earlier to that creditor.
The look-back period is only 90 days for most creditors. The one-year period applies only to “insiders”—which includes close relatives and business associates. So the reach back is much longer on payments made to relatives and other “insiders” than payments made to conventional creditors.
WHO ARE “INSIDERS”?
Bankruptcy law gives a precise definition of “relatives” for preference purposes, but that definition is less important because “insiders” can include friends and relatives who don’t meet that precise definition. Candidly the definition of “insider” is vague; it can include anybody who you’d be inclined to favor over other creditors.
DOES MY INTENT TO FAVOR A RELATIVE MATTER?
For a payment to be a preference you don’t have to be trying intentionally favor that creditor.
The primary requirement—over and beyond the timing of the payment—is that you be “insolvent” at the time the preferential payment was made. “Insolvent” means that your total debts exceed your total assets. There are rare exceptions but most people filing consumer and small business bankruptcies are insolvent by this definition for years before their filing. So this condition about being insolvent at the time of the payment(s) is usually met without a problem.
HOW CAN I AVOID A “PREFERENCE”?
To state the obvious, if filing bankruptcy is even possibly on your horizon, do not pay anything on any debts to anybody who could be possibly considered an “insider”—relatives, friends, or people you are in business with you in any capacity. That would prevent any preferences when you do file your bankruptcy case.
If you have already paid a relative or friend money then there are several steps you can take to avoid a preference action. You can read about them in What Can You Do If you Paid a Relative Money Before Filing for Bankruptcy?