Can I Repay Debts Owed to Relatives Before Filing for Bankruptcy?

For many people considering bankruptcy, there is a natural inclination to try to do right by those who have lent you money in tough times and repay them prior to the bankruptcy.  This is particularly true if the person who loaned you money was a friend or relative.  But repaying debts before a bankruptcy can have serious consequences.  Its important to know the rules of the road.

My experience is that people who want to repay a friend or relative prior to bankruptcy do so for two reasons.

First, in the bankruptcy petition, there is a section where a bankruptcy filer is required to list all of their debts.  This information must be disclosed fully and completely, as the forms are submitted under penalty of perjury.   I find that people often prefer to payoff some debts prior to bankruptcy so they don’t have to list them.  But this can be a misconception.  While a paid off debt may not have to be listed in Schedules D, E, or F of the petition (the debt disclosures), a payment to a friend or family member would have to be disclosed in a separate section of the petition, known as the “Statement of Financial Affairs” (known informally as “SOFA”).  Question 8 on SOFA requires discloser of any payments or transfer “on account of a debt that benefitted an insider.  A friend or family member is generally considered an insider.

The second reason that people are sometimes inclined to pay a friend or family member is that they’d rather see their assets go to someone they know, rather than the bankruptcy court.  To understand this more deeply, in bankruptcy cases (and particularly chapter 7), the trade-off for getting rid of your debt is that you are limited in the assets you can keep.  The bankruptcy system provides certain allowances that a filer can keep during the bankruptcy process, called “exempt property.”  But if the filer’s assets exceed the allowed assets, they may have to give up the extra assets.  I think the perception of some people who consider bankruptcy is that they’d rather see the assets they’d have to give up go to a friend or relative than to the bankruptcy court.   As discussed below, while this thought process may be well-intentioned, such action could create serious problems in a case.

Part of the intent of the bankruptcy process is to insure that creditors get equal treatment (per classification of the debt).  In other words, if your creditors are going to take a haircut, the Bankruptcy Code wants to see them take the same haircut.  The Bankruptcy Code does not want to see one creditor receiving a disproportionate payment just before the bankruptcy while the remainder of the creditors receive little or nothing during the bankruptcy process.

A larger payment prior to a bankruptcy filing is termed a “preference”, and is addressed under the Code by Section 11 U.S. Code § 547.

So what could the penalties be for a preference payment?

First, its important to understand that one of the requirements to receive a bankruptcy discharge is that the bankruptcy has been filed in “good faith.”  Bankruptcy is a powerful tool that empowers consumers to eliminate thousands of dollars in debt.  But to get the benefit of that tool, the bankruptcy code wants to see filers play fair.  What does it mean to play fair?  Well in an extreme example, you might imagine that hiding $1 million in an off shore account without disclosing it probably wouldn’t be fair.  But even on a smaller level, if a bankruptcy filer has $10,000 that they give to a family member just before filing for bankruptcy,  that conduct might not be as extreme, but could fall into the same category of bad faith conduct.  So in summary, a preference payment (or pre-bankruptcy payment to a friend or family member) could compromise a filer’s eligibility for a discharge depending on circumstances.

Second, a preference payment may be recoverable after the bankruptcy is filed.  The trustee assigned to the case may be able to file a lawsuit again the person(s) you paid and retrieve the funds.  Or in the case of a chapter 13 bankruptcy, the preference payment may affect your payment plan.

So hopefully if you have read this, you know that paying a friend or family member prior to filing for bankruptcy can be a big deal.  It requires disclosure, it may result in the recipient being sued, and it can compromise your whole bankruptcy.  If you are trying to figure out the rules of the road in your situation, contact a profession.  We provide a complimentary 30 minute consultation with an experienced attorney.