Preferential Transfer: Paying Back Family in CA Bankruptcy

Paying Debts to Family Members Before Filing for Bankruptcy

Preferential Transfer CA Bankruptcy Attorney Last updated July 26, 2017.

Maybe you couldn’t make your credit card payment, so you borrowed some money from your sister. Maybe you couldn’t afford the down payment on a house, so your parents loaned you the cash. Now your debts have piled up and you’re planning on filing for bankruptcy. Can you pay your family back?

We discuss what your family members have to do with your bankruptcy, potential tax consequences in repaying them, how to avoid having a bankruptcy trustee reclaim your bankruptcy estate, how long the preferential transfer time period lasts, and how to get help with your bankruptcy today.

Your Family Members are Considered Creditors in Bankruptcy

In order to handle a debt through the bankruptcy process, you must list all of your debts and creditors. The court uses this list to give notice to all of your creditors that you’re filing for bankruptcy and that you’re now protected by the automatic stay — which halts foreclosures, lawsuits, repossessions, and other collection methods. You can include personal loans from friends and family members on this list, but that doesn’t guarantee that they’ll get their money back with no strings attached.

Under Chapter 7 bankruptcy, your nonexempt property is sold and the proceeds go to creditors. Whatever debt remains after this process is discharged. In most cases, debtors have no nonexempt property and creditors get nothing. The debts are officially wiped out with minimal or no repayment.

Under Chapter 13 bankruptcy, you’ll make scheduled plan payments; these payments will be allocated to creditors equally but in a priority established by the U.S. Bankruptcy Code. Your family may get some money back over the course of the plan, depending on your income and the size of your debt to them and to your other creditors. At the end of the plan, the remaining debts are discharged. In either case, unless your plan pays back 100% to all creditors, your family almost definitely won’t get full repayment — most debtors pay pennies on the dollar for their debts before discharge.

Can I repay my family after bankruptcy?

You may choose to repay your friends and family anyway after bankruptcy, but there are potential tax consequences. Because you’re no longer repaying a loan (since the loan was discharged in bankruptcy), the payment to your family is considered a gift. You can gift up to $14,000 annually without incurring any taxes, plus up to $5.34 million in addition to your annual max over the course of your life. If you’re over that line, you’ll have to pay a significant tax.

Remember that you will have to provide documentation for each debt listed on your bankruptcy schedules. If you don’t have documentation, the trustee and the court may remove that creditor from your schedule. That means you can’t invent a $50,000 loan from your parents and direct some of your funds to them instead of other creditors through the bankruptcy process. Doing so is illegal and may result in fines and a denial of your discharge.

See also: How Long Will a Debt Stay on My Credit Report?

What if I pay my family back before I file for bankruptcy?

This option probably seems attractive to family members worried about repayment. They may be concerned that you won’t want to or be able to pay them after bankruptcy and they won’t have any claim if they were listed as a creditor and you received a discharge. Can you simply pay them before you file?

You can, but that doesn’t mean they’ll get to keep the money. Bankruptcy is designed to help consumers get out from under crippling loads of debt while still treating creditors as fairly as possible. That means all creditors must be treated equally through your bankruptcy process.

To that end, the bankruptcy trustee will investigate your financial activity during the “preferential transfer period.” For payments to non-family creditors, that period starts 90 days before you file for bankruptcy. The bankruptcy trustee can “claw back,” or reclaim for your bankruptcy estate, any payment over $600 made to a creditor during the preferential transfer period. This rule aims to prevent you from paying off one creditor while discharging your debts to others through bankruptcy.

Friends, family members, and business associates are considered “insiders” for bankruptcy purposes. For payments to insiders, the preferential transfer period starts one year before you file for bankruptcy. In other words, if you paid back a loan to your parents 7 months ago and you file for bankruptcy tomorrow, the trustee can take that money back from them and include it in your bankruptcy estate.

Repaying a regular creditor or an insider during the preferential transfer period is not illegal. You won’t be in any legal trouble, but they won’t get to keep the money. Failing to disclose a payment of more than $600 made during the preferential transfer period, however, is illegal and could cause the court to deny your discharge. Transferring property with the intent of hiding it from creditors is also illegal; the bankruptcy trustee and your creditors will look at your financial history to see if you’ve transferred assets as gifts in order to keep them out of your bankruptcy estate.

Exceptions to the Preferential Transfer Period

A transfer made before you file for bankruptcy is avoidable (meaning it can be clawed back by the trustee) if you were insolvent at the time you made the payment. You are insolvent if your debts exceed your assets. So, if you repaid that loan to your parents 7 months ago, but your assets were greater than your debts at the time, the trustee can’t take the money back. The court presumes that you are insolvent during the 90 days before you file for bankruptcy; proving that you were solvent during that time is very difficult.

Even for payments made more than 90 days before you file for bankruptcy, it’s difficult to prove that you were solvent.

For more information: Transferring Assets Before Bankruptcy in California

How can I pay my family back?

If you don’t want to list them as creditors in your bankruptcy case (or if they don’t want to be listed), you can wait until the preferential transfer period has expired. If you file for bankruptcy more than a year after you make the payment to your family, the trustee can’t claw the money back. If you can’t wait that long (many debtors can’t), you may choose to file under Chapter 7 and pay your family with money you earn after you file for bankruptcy. Under Chapter 7, money you earn after you file is not a part of your bankruptcy estate and you can do whatever you want with it. Under Chapter 13, the money you earn after filing does become part of your bankruptcy estate and you won’t be able to make payments to family members outside your payment plan.

The bottom line is, people turn to their families first in times of hardship, financial and otherwise. We want to repay them first when we have the means. Regardless, bankruptcy law treats your family just like every other creditor. If you’re taking a loan from or making a loan to a family member, make sure that loan is documented so you have the option to list it on a bankruptcy schedule. Remember the preferential transfer period and plan accordingly.

If you’re struggling with debts to family members and other creditors, reach out to one of our experienced bankruptcy attorneys for a free consultation to discuss your circumstances and your options.