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Posted by: Rob Cohen
In times of difficulty, we naturally turn to family and friends for help. The same holds when those difficulties are financial. Family and friends know you and understand your troubles; they’ll be willing to lend you a hand even when banks won’t. They trust you regardless of your credit score. If you borrow from people close to you, can you pay them back before you file bankruptcy?
Preference Payments to Insiders
When you file for bankruptcy protection, the court wants to round up all your creditors into one place and deal with them all at once. No one is supposed to be left out of the system. That includes your family and friends, if they’re your creditors. Basically, the laws are set up so that you can’t treat one creditor differently than the others. In order to ensure that all your creditors are treated fairly, the court requires you to list all your creditors and debts.
Your parents, siblings, other relatives, and close friends are “insiders” in bankruptcy law. 11 U.S.C. § 101(31). In other words, the court knows that you’re likely to choose to repay them over other creditors. So, they’ll look very carefully at any payments you make to friends and family before filing. Payments to insiders are called preference payments and they’re prohibited by bankruptcy law. If you repaid your friends and family within a year before filing bankruptcy, the court may “avoid,” or reverse, the payment. They can actually claw back money from your relatives.
In fact, preference payments need not be made to friends and family. If you repaid any creditor within 90 days of filing, the court will examine the payment to determine if it qualifies as a preference. Perhaps you were worried about keeping your car and chose to pay it off before filing without making payments to your other creditors. That may be deemed a preference and the money may be clawed back by the bankruptcy trustee.
What payments are safe?
The court isn’t going to claw back every payment you’ve made in the three months before you file. Regular payments, such as your mortgage and car payments, rent payments, and utility payments are allowed. The court is looking for extraordinary payments – ones that you didn’t have to make.
Insiders vs. Non-Insiders
So, the court will look closely at payments made to non-insiders within 90 days of filing. The look-back period for insiders is a full year. Part of the rationale for the longer look-back period for insiders is that they have an edge over other creditors. Given the option, most people will choose to repay a loan from their grandmothers before a loan from a big bank. The court doesn’t care where the loan came from or who the creditor is. In bankruptcy, they should all be treated the same way.
Transfers of Property
In addition to actual cash payments, the court will look at any transfers of property. They don’t want people to transfer property to friends or family in order to hide it from the bankruptcy process. In other words, you can’t give a valuable painting to your cousin before you file in order to avoid having to sell it to repay your creditors.
How to Protect Your Family’s Interest
One common issue with loans from friends and family is the lack of formality of the loan. The court is worried about official creditors. A loan from your parents without an official promissory note isn’t enough – the court will treat that as though your parents gave you a gift. If you want your friends and family to receive payment through the bankruptcy process, you need to have an official document recording the loan amount, the parties to the loan, and the repayment terms. Otherwise the court will leave them out of the bankruptcy process altogether and everything you pay will go to your official creditors.
Of course, the benefit of dealing with friends and family is the familiarity you have with them. If there is no promissory note, you can choose to repay them after the bankruptcy process. If there is a note, they will probably only receive partial payment through the bankruptcy process. Your legal obligation to repay the loan will be discharged at the end of the bankruptcy, but you can always choose to pay the full balance afterward.
If you file under Chapter 7, your bankruptcy process will take only a few months and you’ll be able to start repaying whatever loans you’ve taken from family and friends as soon as it’s over. You can also use income you earn after you file; income earned after filing is not part of the bankruptcy estate. If you file under Chapter 13, the situation is a little more complicated. If the loan from friends or family is documented by a promissory note, you’ll be able to pay it back through your payment plan. However, those payments will be proportional to the size of the debt. If that note represents just 10% of your total debt, only 10% of any given payment will go toward it. You won’t be able to dedicate any more payments to it until the end of your Chapter 13 plan, which will last 3-5 years.
Planning to File
When you’re considering filing bankruptcy, make sure your attorney knows about any payments made to family and friends prior to filing. You’ll also want to disclose any loans you’ve taken out from insiders with official promissory notes. Your attorney can help you determine if the payments will be clawed back or if the court will allow them. If your payments are likely to be considered preferential, you may be better off waiting until those payments are no longer within the look-back period. You should also discuss the loan with the person you borrowed from. You may want to warn them that the payment may be clawed back. The court can sue them for the return of the money, so it’s probably best for you to discuss the issue with them before that happens. You can also work out repayment arrangements for after the bankruptcy, if you choose.
Contact an experienced local bankruptcy attorney to discuss payments to and loans from family and friends before you file to discuss your options for repayment.
Rob Cohen, the Managing Partner of Cohen & Cohen P.C., is a bankruptcy attorney that practices in Colorado and Wyoming. He serves as a Chapter 7 Bankruptcy Panel Trustee, and has to date administered over 8,000 Chapter 7 bankruptcy estates. Rob is a Certified Consumer Bankruptcy Specialist, and was nominated for Denver Business Journal’s 40 under 40 in both 2014 and 2016.