Last updated May 31, 2017.
When you’re struggling with debt, it’s natural to turn to friends and family for help. They know you and they trust you, making it simpler and easier to seek financial aid from them than from a bank. If your financial difficulties continue and you decide to file for bankruptcy protection, what happens to the friends and family members from whom you borrowed?
Did you sign a promissory note?
The first question when considering money borrowed from family members is whether or not the debtor signed a promissory note. If you signed a promissory note, the money you received will be formally treated as a loan. A promissory note must include information identifying the borrower and the lender. It should specify the amount, the repayment terms, and what will happen if you don’t pay.
If there’s no note, that money may be treated as a gift. While you may feel bound to honor your word to Mom and Dad, the court wants a legal promissory note to mark a loan. Without the formal paperwork, it’s just a gift.
Loans in Bankruptcy: How They Work
If you have signed a promissory note, you’ll need to list the lender as a creditor on your bankruptcy schedules. They’re legally entitled to repayment the same way every other creditor is. They’ll also be treated just like any other creditor.
Most consumers file bankruptcy under either Chapter 7 or Chapter 13. Chapter 7 bankruptcy is a liquidation of your debts. You’ll use state and federal exemptions to protect most, if not all, of your property and the remainder will be sold to pay creditors. All creditors get a proportionate payment, so if Mom and Dad represent 5% of your debts, they’ll get 5% of the proceeds.
Under Chapter 13, the court will take your disposable income for payment of creditors for 3 to 5 years. Your disposable income is determined by taking your actual income and subtracting state and national standards for living expenses. You’ll pay your disposable income to the court and they’ll distribute it proportionally among your creditors.
At the end of both Chapter 7 and Chapter 13, the remainder of your unsecured debts will be discharged, or legally forgiven. You’ll no longer officially owe anything. You may, of course, choose to repay your friends and family on your own after the bankruptcy process.
See also: Can I Pay Back Family Before Bankruptcy?
Gifts in Bankruptcy: How They Work
If there’s no promissory note to mark your loan from friends or family, that money is considered a gift. You’ll have to disclose the gift on your bankruptcy schedules. If you’re the one who gave the gift, you’ll also have to disclose that on your bankruptcy schedules if it’s over a certain dollar amount, depending on the state in which you file.
Cash Gift in Chapter 7
What happens to a gift in bankruptcy depends on the timing. If you received the gift before you filed, the court will take it into account when determining what you can pay. If you received the gift after you filed for Chapter 7, the gift won’t be included in your bankruptcy proceeding.
Cash Gift in Chapter 13
If you received the gift during the Chapter 13 process, the answer is uncertain. If the gift happens before you file, you may be expected to pay more to your creditors. If you receive the gift between the date that you filed your case and the date that your repayment plan is confirmed by the court (that can take several months), the trustee in charge of your case may argue that you now have more disposable income and can pay more. If you receive the gift after confirmation of your payment plan, you’re more likely to be able to keep the gift without increasing your payments.
Note that if you’ve given any significant gifts before filing for bankruptcy, the trustee may be able to claw that money back. The court wants to avoid fraudulent transfers — ways of getting money out of the bankruptcy estate in order to keep it safe from creditors. That doesn’t have to be your intention in giving the gift; just giving cash to someone for a holiday or special occasion is enough to trigger a clawback. You may also trigger a clawback if you repay a loan from a friend or family member (with or without a promissory note) before you file for bankruptcy. That’s called a “preferential payment,” meaning that you chose to repay one creditor over another.
The court wants to ensure that all creditors are treated equally in the bankruptcy process, so that payment to Mom and Dad is going to get pulled back.
Bottom Line: Legal Documentation is Best
Your family and friends are there to help you in times of need and you’re there to help them. Unfortunately, the legal system doesn’t care about familial or friendship bonds. The bankruptcy courts want to see formal legal documentation of your financial situation. So, whether you’re borrowing from or lending to someone close to you, consider creating a proper promissory note.
You can download templates online for free and it can save you a lot of trouble in the bankruptcy court. It’s also a good idea to have a formal note for the sake of your relationship with the other party. You can discuss the terms in advance and have a real plan in place for repayment. You won’t be left wondering if Cousin Eddie ever really meant to pay you back that $1,000 or if he’s just taking advantage of you.
If you’re struggling with debt and considering bankruptcy, speak to a local bankruptcy attorney. Bring all your financial documents and be sure to discuss any financial arrangements with friends or family members, whether or not they’re formally recorded in a promissory note. Your attorney can help you determine what will happen to those financial arrangements in the bankruptcy process and can work with you to decide on the best way to deal with your debts.