Most people think the bankruptcy process is just about wiping out debt.  Indeed, discharging debt is the key mission of bankruptcy.

However, there is another important goal of the bankruptcy process: ensuring fair treatment of creditors. To achieve equality of treatment the bankruptcy law empowers its Trustees to avoid payments that unfairly prefer one creditor over another.

When a debtor has paid back money borrowed from family members within one year of filing they must disclose those payments on the bankruptcy schedules. These payments are considered to be “insider preference payments.”

Law of Insider Preference Payments.

Section 547 of the Bankruptcy Code sets forth the rules on avoiding preference payments.

The trustee may . . .  avoid any transfer of an interest of the debtor in property

    1. to or for the benefit of a creditor;
    2. for or on account of an antecedent debt owed by the debtor before such transfer was made;
    3. made while the debtor was insolvent;
    4. made—(A) on or within 90 days before the date of the filing of the petition; or (B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider.

Who is an insider?

Bankruptcy Code Section 101(31) defines the term “insider” and it includes any relative of the debtor.  So who is a relative?  “The term “relative” means individual related by affinity (i.e., by marriage) or consanguinity (i.e., a blood relative) within the third degree as determined by the common law, or individual in a step or adoptive relationship within such third degree.”

The typical insider preference payment.

Most insider/family preference payments are fairly straightforward.  A debtor paying back his or her parents $200 per month for 12 months has a $2,400 preference to report on the bankruptcy schedules.  The bankruptcy Trustee will then demand the parents return the money to be distributed to all creditors pro-rata.  That is fairly simple.

Revolving door preference payments.

What gets complicated are cases where the same $100 is borrowed and paid over the course of a year.  If a debtor borrows $100 from a parent and pays it back and then borrows and pays it again each month throughout the year, how much is the preference? Is the preference $100 or $1,200?

In the case where a debtor has something of a Revolving Line of Credit arrangement with a parent, the courts look to see whether the parent’s relative position has improved or worsened during the year.

For example, assume a parent was owed $1,200 at the beginning of the year but, due to new borrowing and payments, at the end of the year the parent was owed $2,000. In that case the parent’s position got worse and there is no avoidable preference.  However, if the parent was owed $1,200 at the beginning of the year and by the end of the year was owed only $500, then the parent has a voidable preference of $700.

Listing family debts on the creditor list.

A very common mistake made by bankruptcy attorneys occurs when they list a preference payment on the Statement of Financial Affairs but fail to list the parent on the  creditor list.  If the parent is still owed money they should be listed on both sections.

Solutions to the Insider Preference Payment Problem

The most obvious solution to insider payments is to wait one year before filing the Chapter 7 case.  If a significant preference payment occurred and the case must be filed now, consider filing a Chapter 13 payment plan.  The bankruptcy trustee in chapter 13 has no power to claw back insider preferences (although it may be a factor in how much is repaid to creditors).  A third option is to reverse the preference and have the parent pay back the money to the debtor assuming there are enough exemptions to protect the money. This last option is somewhat questionable and the court may not approve of such a tactic.


Image courtesy of Flickr and Kevin Dooley.