What Is a Preferential Debt Payment?

Usually, when a person experiences financial problems they turn to family and friends for assistance. It only makes sense. But, what happens if their assistance is not enough to completely bail the person out and they have to file for bankruptcy protection?

Many debtors (a person who files for bankruptcy) have certain debts they would rather pay back before others, such as loans from family and friends. If you are going to file for bankruptcy protection, it is only natural to want to protect those individuals that you know you will be seeing on special occasions and at work. However, this thinking could get you into trouble. I always warn my clients to fight the urge to pay back their family members and friends prior to filing for bankruptcy protection as the payment could be considered a preferential debt payment. Once you file for bankruptcy, your bankruptcy trustee has the ability to go back in time to undo preferential payments and recover that money in order to distribute it to your creditors.

What Is a Preferential Debt Payment?

Preferential debt payment is a payment or transfer made for the benefit of certain creditors shortly before filing for bankruptcy. For example, if your mother loaned you money and you pay her back prior to filing for bankruptcy, this would be a preferential debt payment. Another example would be if you paid off your $5,000 Visa Card at the Credit Union because you didn't want to hurt the credit union.

If you make payments over $600 to a creditor in the 90-day period prior to filing for bankruptcy and that payment gives your creditor more than it would have through your bankruptcy, it could be a preferential debt payment. Any payments you make to insiders (such as family, friends or business partners) are also considered a preferential debt payment. Payments to insiders are considered preferential if made within one year of bankruptcy. So, it is important to think back and see if you repaid any loans to friends and family in that time frame.

If the court determines that you made a preferential debt payment prior to filing bankruptcy, your bankruptcy trustee can get this money back for the bankruptcy estate. One of the goals of bankruptcy is the fair treatment of all creditors. If you pay back a creditor before filing for bankruptcy, other creditors may not receive as much as they would be entitled to in your bankruptcy. As a result, the clawback provision of the bankruptcy code allows the trustee to recover preferential debt payments. The trustee will then distribute the funds to your creditors. This ensures that your creditors get repaid as much as possible, regardless of whether you file for Chapter 7 or Chapter 13.

Are Preferential Debts Illegal?

Preferential debt payments are not illegal unless you made them with the intent to defraud your creditors or hide money from the trustee. If you intentionally try to hide assets, you risk losing the ability to discharge your debts. When you file for bankruptcy, you'll have to fill out paperwork that will ask if you've made preferential payments to any insiders in the last 12 months. This is when you'll disclose that information. If you did make a preferential payment, the recipient of the money may have to return the money that you paid them.