If you’re thinking about filing for bankruptcy, you may be tempted to pay off a debt just before you do. For example, you may want to give your best friend the $3,000 she loaned you a couple months ago so you could buy a new car. But think twice before you write that check. A bankruptcy court would most likely frown upon the payment, calling it a “preferential transfer.” In fact, the bankruptcy trustee assigned to your case may reverse any payment you make just before you file for bankruptcy, on the grounds that it favors one creditor over others.
What Is a Preferential Transfer?
In a bankruptcy proceeding, a preferential transfer is a payment or transfer of property someone makes to a creditor shortly before filing for bankruptcy. Whether a transfer is preferential depends on when you made the transfer, how much it was, and who you paid.
Transfers within 90 days of bankruptcy. If you transfer money or property worth more than $600 within 90 days of filing for bankruptcy, the court will probably call that a preferential transfer. This is more likely to be true if:
- you had more debts than assets when you made the transfer (you were “insolvent”), and
- your transfer meant that the creditor got more than it would have if it waited until after the bankruptcy.
Payments or transfers to friends, family, or business partners. Following the rules above, the court is also likely to find that payments you make to “insiders” are preferential transfers. But, in the case of insiders, your transfer is preferential if you make it within one year of filing for bankruptcy.
These rules are set out in 11 U.S. Code, Section 547(b).
Can Someone Else Pay Your Debt Before You File for Bankruptcy?
So what happens if a relative offers to pay a debt for you before you file for bankruptcy? Can the trustee reverse that payment, too? Some courts say yes, depending on how the payment was made.
In a recent case before the Tenth Circuit Bankruptcy Court, a debtor’s mother paid more than $21,000 to clear her son’s debt to a law firm. A couple of weeks later, the son filed for bankruptcy. Because the payment was explicitly a loan from the mother to her son, and because the son acknowledged that his mother paid the debt on his behalf, the bankruptcy trustee was allowed to reverse the payment as a preferential payment to the law firm.
This is a “gotcha” for unsuspecting debtors. If a relative is offering to pay off a debt, and you’re thinking of filing for bankruptcy, make sure that:
- The money or property is a gift to you, not a loan.
- You don’t control the money or property at any time. In other words, have your relative pay the money directly to the creditor. Don’t—for example—deposit the money in your own bank account first.
To learn more about bankruptcy rules before you file your case, see Legal Consumer’s bankruptcy learning center.