Beware of paying back debts before you file bankruptcy

If your financial situation looks hopeless, you may be considering bankruptcy as a way out. However, before you file bankruptcy, you may be tempted to pay off a debt. This may especially be the case if you owed money to a friend or family member (or any preferred creditor). Although you may think that taking care of one last debt is the right thing to do before your bankruptcy begins, you could actually cause future problems for yourself and the creditor you paid, as your payment may be regarded as a preferential transfer.

You must treat your creditors equally

Preferential transfers occur when bankruptcy filers significantly favor one creditor over another during a certain period leading up to bankruptcy. Under the bankruptcy laws, it is required that you treat all your creditors the same before and during bankruptcy. Because of this rule, it is prohibited that you repay a friend before a car loan, for example. The law defines a preferential transfer as:

• A payment you made to a creditor because of a debt;

• That you made within 90 days before filing bankruptcy. However, if the debt was made to a friend, family member, business associate or other "insider" under the law, this period is one year;

• Made while you were insolvent (the law assumes this 90 days before you file bankruptcy; and

• That caused the creditor you paid to receive more money than they would have received if you had filed Chapter 7 bankruptcy

As a point of reference, most unsecured creditors (which includes credit cards and most personal debts) receive little or nothing during Chapter 7. As a result, most significant payments you make on debts within a year of filing bankruptcy may be considered preferential. This is because the creditors that you are most likely to repay (i.e. friends, family and business associates) are "insiders" under the law. Since "insiders" have more knowledge of your financial situation than ordinary creditors do, the law prohibits you from paying them back for a longer period before bankruptcy.

Preferential transfers can cause trouble

After you file bankruptcy, the trustee examines all transactions you made during the one-year lookback period. If any payments made during this period were preferential, the trustee can force the creditor to repay the amount of the transfer by bringing a lawsuit against them in court (which often can come as a complete surprise to the creditor). Once the preferential transfers have been recovered, the trustee distributes the funds to all creditors pursuant to the law.

Of course, not every transaction made during the lookback period is preferential. For example, transactions to creditors in an aggregate amount of less than $600 are generally exempt from being considered preferential. Additionally, payments you make for child support, alimony and most domestic support expenses are similarly exempt.

Although you may think you are doing the right thing by paying back a debt before your bankruptcy, in reality, you may cause the creditor the trouble of being involved in a lawsuit at a later date. If you sincerely want to repay someone for their financial generosity towards you, it is generally a better idea to wait until after bankruptcy is completed (although you will be under no legal obligation to repay the debt by then). Since the bankruptcy process has several pitfalls for those inexperienced with it, it is vital to have the assistance of an experienced bankruptcy attorney along the way to ensure a smooth transition through the process.