Payments to Friends and Relatives

If you think you might need to file a bankruptcy in the near future you might be tempted to make payments on some of your obligations before filing.  Sometimes people want to pay off some debts before filing so they do not have to list those creditors in the bankruptcy case.

Most people only think about their personal property being seized when they file a bankruptcy.  They are worried a bankruptcy trustee will seize their property and sell it for the benefit of their creditors.  This is an important issue but not the only one to worry about.

If You’ve Paid Friends or Relatives Recently, Your Bankruptcy Could Affect Them

If you borrow money from a relative or friend and you pay them back before filing the bankruptcy the bankruptcy trustee can recover the money from them for up to one year after you make the payment.  You may be making things worse by making the payments because the trustee has the power to sue them to recover the money.

Payments on debts to friends or relatives are known as insider transactions.  We call them insiders because you have a special relationship with them.  We naturally want to take care of our friends and relatives more than we do a credit card company but the bankruptcy code prohibits treating them differently.  Under the bankruptcy code your friends and relatives are in the same boat as your other creditors except that the court can look back at your transactions with them for up to a year.

Proper Planning Can Prevent This From Becoming a Big Problem

It is very important to understand that there are ways to plan around this kind of problem.  First you need to disclose these payments to your attorney.  Then you need to figure out if the payments were made just on the old debt or if they include some new value received.

A great example is where you borrow money during the year from your mother and then at tax time you pay her back each year.  She then slowly loans out money to you again during the year and you plan to pay her back next tax season.

If that were the case and you paid her $4,000 on March 1 and then filed a bankruptcy on October 15.  Your mother started loaning you $400 per month on April 1 for the next 6 months for a total of $2,400 loaned prior to the filing of the bankruptcy case.  You would subtract the new money she loaned you from the amount you paid her on March 1 to determine how much of the money could be recovered by the bankruptcy trustee as an insider transaction.  $4,000 minus $2400 equals $1,600.  The amount that could be recovered by the trustee is $1,600.

Another example is where you live with the relative that loans you the money.  This comes up sometimes when you move in with a relative while trying to get back on your feet.  They let you live in their house for free and sometimes loan you money at the same time.  As you get back on your feet you want to pay them back.  Most people would choose to pay back the debt first and then pay rent.

Bankruptcy, Debts, and Ongoing Obligations

If you are thinking about bankruptcy you should pay rent first rather than the loan.  The rent is a fee for an ongoing benefit – having a roof over your head.  If you pay reasonable rent that is an expense and is not a preferential payment to an insider.  It is allowable and cannot be reversed.

While you cannot go back and retroactively re categorize payments that occurred you can change the nature of the payments going forward. You might be able to argue that in some cases the payment of rent and a loan are intertwined so much that the benefit of paying the loan was that you got to stay living with them, but it is better not to rely on this kind of an argument if possible.  

It is important if this happens and you need to start paying rent as opposed to paying off a loan that you sit down with your relative or friend and discuss the issue.  You are not trying to commit a fraud on the court but simply to make sure that you are paying them in an appropriate fashion where you are receiving a benefit for the payments.

You might also be able to show the trustee that your relative or friend is judgement proof or near judgement proof.  In some cases the person you made the payments to might be on a fixed income like social security.  Those funds cannot be garnished and if the relative has no other assets that are not exempt the trustee will not be able to recover anything.

Insider Payments and Bankruptcy

If you file a bankruptcy with a potential insider payment to a friend or relative you may have some choices about how to handle it with your trustee.  Always make sure you disclose everything to the trustee.  If you fail to disclose something and it comes out later it might appear as though you were withholding information or lying to the court.  You never want to be in that position.  You always want to disclose and provide truthful information so you can negotiate from that position.

If you file a chapter 7 case you might be able to pay the trustee yourself after the case is filed so they will not go after your friend or relative for the money.  In some cases the trustee might give you 6 months to pay back the money you have paid to the relative or they might be willing to wait and collect the funds out of your next tax refund or let you cash out a retirement plan (or borrow money from retirement) to pay it back.

In a chapter 13 bankruptcy you can pay the trustee back the money through your plan.  This often involves paying it back over 3 or more years.  This can buy you a lot of time and protect your relative.  The trustee will normally ask that your relative or friend sign off on this arrangement so they understand that if you don’t pay they could be sued in the future.

You could in some cases wait to pay relatives back borrowed money until after your bankruptcy is filed (chapter 7) or completed (chapter 13).  Filing a bankruptcy removes your legal obligation to pay creditors but if you still want to pay them after the case you can.  Nothing prevents you from putting off those payments and making them later.

When In Doubt, Consult a Bankruptcy Professional

If you are concerned about some of your transactions please feel free to reach out to us to go over things.  There might be several things you can do to help reduce the problems that arise when you pay relatives.