A preference payment occurs when the amount paid before bankruptcy exceeds what the creditor would receive in the bankruptcy case. Because preferential payments deprive other creditors of what they're entitled to receive, the bankruptcy trustee administering the case can void the payment and "claw back" or recover the money or property from the person or business paid.
However, not every payment made before bankruptcy qualifies as a bankruptcy preference payment. Find out:
Although this topic might seem intimidating, keep in mind that clawback actions don't happen very often, and even when they do, they're fairly simple to navigate when you know what to expect. A bankruptcy lawyer can evaluate your case and help you formulate an effective bankruptcy strategy.
A preference payment occurs when a bankruptcy filer pays a creditor more than the creditor would be entitled to receive in the bankruptcy case. Preference payments unfairly funnel the bulk of a filer's money to a creditor of choice, leaving less money to pay other creditors in the bankruptcy case.
You'll report potential preference payments in your bankruptcy paperwork. One of the bankruptcy trustee's responsibilities is to review your bankruptcy paperwork for potential preference payment rule violations. If found, the trustee will instruct the creditor to return the preferred funds or property.
The bankruptcy preference period is 90 days before the bankruptcy filing for most creditor payments and one year for payments to a creditor who qualifies as an "insider." The following people and entities would be insiders:
Yes, you'll report potential preference payments made to creditors before bankruptcy. The creditor preference payments you'll be required to disclose will depend on whether you're a business or an individual bankruptcy filer.
An individual filer's debts are primarily "consumer" debts incurred for personal and household expenses. Most of a business filer's debts would have been incurred while pursuing a profit-generating enterprise—in other words, a business.
All bankruptcy filers report payments made to insider creditors. However, the 90-day reporting requirement differs for individual and business filers. Here are the specific rules:
The figures are valid as of August 2022.
The trustee isn't going to unwind payments for basic living expenses, such as normal and usual mortgage or car loan payments, or court-ordered support payments. That said, you won't want to pay rent, utility bills, support payments, or any other obligation months in advance.
Not only will the trustee likely recover any amount paid over and above what was currently due, but the trustee might suspect fraud if it appears you were trying to hide money from creditors.
The bankruptcy trustee will attempt to resolve the issue informally by asking the creditor to return the funds. If unsuccessful, the trustee (or another creditor) can bring an action in bankruptcy court asking the judge to require the creditor to return the funds.
As the bankruptcy debtor, you must cooperate with the trustee, although you won't be pursued for the money owed or be required to make an effort to recover it from the creditor.
You might not care if the trustee tries to recoup the money you paid to a regular creditor. But the situation can become uncomfortable if the trustee demands the return of money paid to a relative or someone close to you.
Here's what this might look like.
Suppose you borrow $1,500 from your brother to pay for a car repair. You later receive a tax refund and repay your brother the $1,500. Six months later, you file for bankruptcy. The bankruptcy trustee will want to get the $1,500 from your brother, add it to your bankruptcy estate, and distribute it to all of your unsecured creditors.
If you are facing this situation, you have several options:
You wouldn't be the focus of a clawback action, the creditor would, so it's unlikely you'd raise a defense, especially given the cost of litigation. Even if you were the focus, from a cost-cutting measure, the most viable defensive move would likely be negotiating with the trustee early.
Your bankruptcy lawyer will be in the best position to explain a defensive strategy. However, generally, you must be insolvent before the preference rules apply, and you're insolvent when your debts exceed your assets.
Here's the problem. Most people are insolvent long before filing for bankruptcy. It's common for people to spend considerable amounts of time exploring every way possible to avoid bankruptcy, and even when bankruptcy looks inevitable, spend six months or more contemplating whether filing for bankruptcy is the right course of action.
So unless the trustee is asking for the return of funds that don't qualify as a preferential transfer, or you had a very sudden and unexpected financial downturn, it's unlikely you'll have much of a defense. But every case is unique, so it would be prudent to speak with a knowledgeable bankruptcy lawyer.
When investigating funds to bring back into the case for creditors, the bankruptcy trustee will look at more than creditor payments. All transfers of money and property will be evaluated, and the look-back period will extend as far as ten years. Expect the trustee to look carefully at gifts of property and cash, and transactions in which it appears you sold an asset for less than its value.
You'll find all transfer disclosure periods in the Statement of Financial Affairs for Individuals Filing for Bankruptcy form. We provide a form link in the "More Bankruptcy Information" box.
Understanding bankruptcy rules and procedures before filing can help you avoid problems in your case or anticipate potential issues. In many cases, a bankruptcy lawyer can review your situation and predict stumbling blocks, including spotting possible preference payments and the potential outcome.
Once you know what to expect, you'll be in an excellent position to decide whether filing for bankruptcy is in your best interest.
Bankruptcy is essentially a qualification process. The laws provide instructions for completing a 50- to 60-page bankruptcy petition, and because the rules apply to every case, you can't skip a step. We want to help.
Below is the bankruptcy form for this topic and other resources we think you'll enjoy. For more easy-to-understand articles, go to TheBankruptcySite.
More Bankruptcy Information
Bankruptcy Forms and Document Checklist
Statement of Financial Affairs for Individuals Filing for Bankruptcy
Chapter 7 and 13 Bankruptcy Form List
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We wholeheartedly encourage research and learning, but online articles can't address all bankruptcy issues or the facts of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.