Filing Bankruptcy When You Owe a Friend or Family Member

Filing for bankruptcy is rarely an easy decision. The factors are different for everyone, but one common consideration is what will happen to debt owed to friends and family members. Many people looking for ways to protect those personal relationships want to pay off those close to them before filing bankruptcy, or simply leave the debt out of the filing. 

Unfortunately, these self-crafted workarounds often make things worse, for debtors and for friends and family members they hoped to protect. 

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How Common is Debt to Friends and Family? 

60% of respondents to a BankRate survey conducted last year said they’d loaned cash to friends or relatives, expecting to be repaid. The arrangement went wrong in many cases. About 35% said they’d suffered ill effects, such as damaged relationships, lost money, or a decline in credit scores. It’s enough of a problem that many news outlets and personal finance resources offer advice about how to manage loans to friends and family. Many, including Los Angeles Times personal finance columnist Liz Weston, advise not to lend more than you can afford to lose. But, many people don’t follow that rule, or feel they can’t stick to it when a loved one is in a critical crunch.

With so much at stake, it’s no surprise so many people want to carve out debt to friends and family from their bankruptcy cases. But, the “solutions” people ask about most often generally won’t work.

The Wrong Ways to Address Friend and Family Debt

Leaving Debts to Friends and Family out of the Bankruptcy Filing

You are required to list all outstanding debts in your bankruptcy schedules, and those documents are submitted under penalty of perjury. So, simply leaving out the money you owe your mom or your college roommate is a mistake. If you value the personal relationship, make sure you talk with the person you borrowed from before you file, or as soon as you’ve filed. Every creditor listed will receive a notice from the bankruptcy court, and that’s probably not the way you want a personal connection to learn that they’ve been included in your bankruptcy.

Quickly Paying the Debt Before You File Bankruptcy

When you file for bankruptcy, your case is assigned to a trustee. Part of the trustee’s job is to make sure the case moves forward in a way that is fair to your creditors. That includes looking back at transactions over the 90 days, or one year in the case of insiders, leading up to your bankruptcy filing to see whether anyone got a disproportionate payment. 

Imagine, for instance, that your Los Angeles Chapter 7 bankruptcy is a “no asset” case. That means there aren’t any assets to distribute to creditors, and your unsecured creditors will get nothing. But then, the trustee discovers that a month before you filed, you paid back a $2,000 loan to your next door neighbor. In other words, one unsecured creditor got $2,000, while the rest got nothing.

Under the U.S. Bankruptcy Code, the trustee may avoid that transaction. ”Avoid” sounds relatively harmless, but what that means in practical terms is that the trustee can bring your neighbor into the proceeding and take that money back. Obviously, this can create significant stress and conflict, particularly if the person you paid pre-bankruptcy already spent the money and doesn’t have it to surrender to the trustee.

This type of transaction is avoidable only if the debtor was insolvent at the time the payment was made. But, it’s important to understand what “insolvent” means in legal terms. A person earning a good income and paying his bills on time generally doesn’t think of himself as insolvent. But, what the trustee will look at is whether that person’s debts were greater than his assets at the time. 

The Lookback Period is Longer for “Insiders”

While the trustee generally looks at transactions in the 90 days prior to your bankruptcy filing, certain creditors are considered “insiders” and subject to special rules. The lookback period is one year rather than 90 days. So, generally, repaying that loan to your neighbor six months before filing bankruptcy wouldn’t raise any issues. But, substitute your brother for your neighbor and the trustee may be able to avoid that payment and try to reclaim the $2,000 from your brother.

People who are considered insiders in bankruptcy–and so are subject to a one-year lookback period–include: 

  • Parents
  • Children
  • Brothers and Sisters
  • Grandparents and Great Grandparents
  • Grandchildren and Great Grandchildren
  • Nieces and Nephews
  • Aunts and Uncles

Not all insiders are family members. The one-year lookback also applies to:

  • A general partner of the debtor, or a relative of a general partner of the debtor
  • A partnership in which the debtor is a general partner
  • A corporation, if the debtor serves as an officer or director or otherwise controls the corporation

Protecting Friends and Family (and Yourself) in Bankruptcy

Generally, debts to friends and family must be listed in your bankruptcy schedules, and unless you have a very long time to plan ahead, it would be risky at best to try to pay off those debts before filing. 

The good news is that discharge of a debt to a personal friend or relative doesn’t prevent you from paying them. It simply puts the decision entirely in your hands. With very limited exceptions, money you receive after you file your Chapter 7 bankruptcy petition is yours to keep and spend as you choose. Your friend or family member won’t be able to sue you to collect the debt, but if you can afford to do so after bankruptcy, you are free to make payment–either in a lump sum or over time. 

Managing debt to friends and family is just one of the areas in which people considering bankruptcy often make serious mistakes before speaking with a bankruptcy attorney, or by concealing information from their attorneys. The best way to protect yourself and others involved is to speak with an experienced Los Angeles bankruptcy attorney before you make any decisions, and to disclose everything to your attorney.

The attorneys at Borowitz & Clark have been helping people in the Los Angeles area resolve debts for decades, and know how much more smoothly the process can go if you have reliable information in advance. To schedule a free, no-obligation consultation, call us at 877-439-9717 or fill out the contact form on this page.

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