What are preferential payments in bankruptcy? (Updated 2020)

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In a Nutshell

This article will explore what constitutes a preferential payment and why it matters to you if you’re thinking about filing a Chapter 7 bankruptcy.

Written by Attorney Amelia Niemi.  
Updated September 23, 2020


Preferential payments, or preferences, are payments made to creditors before a bankruptcy case is filed that allow the creditor to receive more than they would have been able to recover in the bankruptcy case. Such preferential payments can be recovered by the bankruptcy trustee so the funds can be distributed to all unsecured creditors in shares. This article will explore what constitutes a preferential payment and why it matters to you if you’re thinking about filing a Chapter 7 bankruptcy

What are the elements of a preferential payment generally

Preferential payments are part of the bankruptcy estate. The bankruptcy trustee can take these payments and divide them fairly among other creditors. There are two elements that must be present before the bankruptcy trustee can recover a payment under the preferences rule.

First, the creditor – the person who made the loan – received money from the borrower. This money could be paid voluntarily, or it could be taken through a wage garnishment or a bank levy. Second, the money must be meant to repay part of a debt that existed before the date of the payment. This is known as an antecedent debt.

The bankruptcy trustee doesn’t have an unlimited timeframe to work from. The preference period is only the 12 months before filing bankruptcy for payments made to friends and family, known as “insiders.” It’s even shorter for other unsecured creditors, like past-due utility payments or an unsecured credit card. The preference period for antecedent debt paid to non-insiders is only 90 days before the bankruptcy petition was filed. The trustee also can’t go after every debt paid in the last 90 days or 12 months. The Bankruptcy Code does not allow trustees to collect money in consumer cases if the filer paid less than $600 during the preference period. If the trustee takes money back, they will divide the money between the other people or companies you owe money to. How much money one creditor gets is based on how much they are owed.

Creditor defenses 

When the bankruptcy trustee makes a claim for preference payments, the money isn’t automatically taken. Creditors do have some defenses they can raise to try to keep the money. These defenses protect companies who do business with people they know don’t have money and might file for bankruptcy soon. One defense is the “ordinary course of business” defense.

Here, money paid during the preference period can’t be taken back if: 

  • the debt was “incurred in the ordinary course of business or financial affairs of the debtor and the transferee,” (person or company that was paid) and 

  • the money was paid in the same way it always was, or if it was paid to the transferee according to ordinary business terms.

For example, if a person takes their car in for normal servicing, receives and pays an invoice from their car mechanic, and then files bankruptcy a month later, the bankruptcy trustee can’t take the money back from the mechanic. This transaction was made and paid in a normal way between the debtor and the car mechanic.

Creditors can also raise the “contemporaneous exchange” defense. Under this defense, when the filer buys a new product or merchandise, such as a new refrigerator or a new table, and pays for it at the same time. 

With either defense, the trustee can’t take back this money once the person makes their bankruptcy filing even if all elements of a preferential payment are met. Usually, only regular creditors, or non-insiders, are able to take advantage of these creditor’s defenses when it comes to a preferential transfer. These defenses rarely apply to situations where insiders, your friends and family, give you unsecured loans.

Regular creditors vs. insider creditors

Bankruptcy law treats regular creditors different from insider creditors. Insider creditors are members of your family, friends, coworkers, neighbors, or any person or company you have a close relationship with, who you owe money to. The look-back period for insiders is 12 months. Regular creditors, or non-insiders, are people or companies that aren’t part of this close circle. For regular creditors, the preferences occur in the 90-day period before filing bankruptcy.  When you fill out the bankruptcy paperwork, you will list your payment history. The papers ask for all the debts above $600 you paid during the preferences period. After filing your papers with the bankruptcy court, it’s the trustee’s job to collect this money.

Even though mortgage payments are usually more than $600, the trustee can’t claw back this money. Your mortgage is a secured loan. If you don’t make the mortgage payment, your house or other real estate will be taken away. The bankruptcy trustee does not look at secured loans when they look at your papers for preference payment claims. 

The Bankruptcy Code looks at preference payments to insiders differently from regular creditors. The Code wants to give a fair shake to all creditors. People filing bankruptcy can’t pay back all their debt to families, leaving other creditors out to dry. The Bankruptcy Code also wants to discourage people from making a transfer of property between family members to hide money or real estate from the court.

That said, trustees recognize the importance of human relationships. They often allow debtors to pay back the preference, so that the debtor’s family won’t have to be involved. Beware, though, this isn’t always the case. The trustee can try to get that money back from the insider directly if the amount of the repayment was more than $600. 

How to protect a family member or friend from a preference avoidance action

If you want to make sure that your friends and family can keep all the money you pay them through your bankruptcy case, you need to pay attention to timing. If you’ve already paid money back to your friend or family member, the only way to protect them is to wait until more than 12 months have passed from the date of payment. For example, if you repaid your sister on July 1, you’ll need to wait until at least July 2 the next year. Otherwise, the trustee could take back the money you gave your sister in a preference action.

On the other hand, if you haven’t yet repaid your family member or friend, but want to before filing your Chapter 7 case, WAIT! You’ll have the chance to make payments on this debt later, even though your debt will technically be discharged by the bankruptcy court. Paying back your friends and family now won’t do much good – you’ll either have to delay your filing longer, putting off your ability to get debt relief sooner, or that money might be taken away in the future by the trustee once you file.

Why timing matters even for regular creditors

Even if you don’t owe money to your friends and family, it’s still important to consider timing when it comes to debt payments to regular creditors, such as student loan payments, spousal support (alimony), or medical bills. These debts are divided into secured and unsecured loans. Secured loans are attached to property. Car loans are secured by the car. Mortgages are secured by your home. If you don’t make these payments, you can lose your car or home. Unsecured debt includes medical bills, student loans, spousal and child support

Debts are also divided into dischargeable and non-dischargeable debts. Dischargeable debts include medical bills, credit cards, and personal or payday loans. Non-dischargeable debts include taxes, spousal and child support and federal student loans. These payments won’t go away after finishing your Chapter 7 case. Instead, you’ll still need to pay them in full.

In some cases, if you made a payment within the past 90 days to a non-dischargeable debt, you might be better off if the trustee doesn’t take it back. After your bankruptcy case finishes, you will still owe all your back taxes. So, it’s better for you if the trustee leaves that money in place. 

Federal student loans, preference payments, and Chapter 7 bankruptcy can get a little tricky, so it’s really important to consider the timing of when you make payments. If the timing isn’t right, you may end up losing more money to your non-dischargeable debts than you would by waiting until the preference avoidance period is over. It can be tricky to figure out when the best time to file for bankruptcy is. If you work with a bankruptcy attorney, they’ll work with you to find the best time to file.

Example 1 - Preferential payments to regular creditors

Joe owes a lot of money on his unsecured credit card. On December 31, he received an end-year-bonus of $2,000 from his job and put all this money towards the credit card bill. Two weeks later, in the middle of January, Joe filed his Chapter 7 petition. The trustee can recover payment from the creditor because Joe paid the credit card company more than $600 in the 90 days before filing. As long as the debt is dischargeable under bankruptcy law, Joe won’t really be impacted by the trustee’s work to recover the preference claim.

Let’s take a look at a case with insiders.

Example 2 - Preferential payments to insiders

Jane owes her friend, Bill, $1,000. On May 1, she used her tax refund to repay her entire debt to Bill. On November 1 of the same year, Jane filed for Chapter 7 bankruptcy. Her bankruptcy petition listed the $1,000 she paid to Bill. The bankruptcy trustee can take the money back from Bill because the money Jane paid back is over the $600 limit and was within a year of filing bankruptcy. However, the trustee may give Jane the opportunity to pay the money first. If Jane doesn’t do this and ignores the trustee, the trustee can sue Bill to get the money back.

Conclusion

Don’t forget that with Chapter 7 bankruptcy, timing matters. This is especially true if you’re expecting a tax return or stimulus check. Wait to pay back your family and friends until after your other debts are discharged. Bankruptcy can offer life-changing debt relief to people in the United States. If you’re considering Chapter 7 bankruptcy but can’t afford a bankruptcy lawyer, see if you’re eligible for Upsolve’s free Web App.



Written By:

Attorney Amelia Niemi

LinkedIn

Amelia Niemi is an attorney licensed in Illinois. She received her J.D. from DePaul University College of Law. At DePaul, she was a staff writer for the DePaul Journal of Art, Technology & Intellectual Property Law. Her legal practice includes multi-million-dollar international b... read more about Attorney Amelia Niemi

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