One of the questions I frequently encounter when meeting with people considering Chapter 7 bankruptcy is: Can I pay back my parents, other family members, or close friends before I file bankruptcy?

The answer is not necessarily. In fact, this is a fairly common issue in bankruptcy, and it can create problems for both the person filing bankruptcy and the family member who received the money.

I understand why people do this. When someone is experiencing financial difficulties, it is often Mom and Dad, a brother or sister, or another close family member who steps in to help. They might lend you $2,000, $5,000, or even $10,000 to help you get through a difficult financial period.

Then, perhaps you go back to work, receive an income tax refund of a few thousand dollars, or otherwise get back on your feet financially. What is one of the first things you want to do? Pay back the people who helped you when you needed it.

Instead of paying down your credit cards with Citibank, Capital One, or Discover, you pay back Mom and Dad.

That is understandable. It is also natural. You feel an obligation to the people who helped you, and you want to make things right.

Unfortunately, bankruptcy law looks at this situation differently.

In Bankruptcy, Mom and Dad Are Creditors Just Like Citibank and Capital One

When you file bankruptcy, the law generally treats your parents, siblings, and other family members who loaned you money as creditors, just like your credit card companies, medical providers, and other lenders.

The Chapter 7 Trustee has a responsibility to administer the bankruptcy estate for the benefit of creditors and to make sure creditors are treated fairly under the Bankruptcy Code.

The problem arises when you repay one creditor shortly before filing bankruptcy while leaving your other creditors unpaid.

For example, suppose you owe:

• Mom and Dad $5,000.
• Citibank $12,000.
• Capital One $8,000.
• Discover $6,000.
• Medical providers $4,000.

You receive a $5,000 income tax refund and use the entire amount to repay your parents.

You then file Chapter 7 bankruptcy a few months later.

From your perspective, you simply repaid a family loan. From the bankruptcy trustee’s perspective, however, you paid one creditor in full while leaving all of your other creditors unpaid.

This is exactly the type of transaction that the bankruptcy preference laws are designed to address.

What Is a Preferential Transfer?

Under Section 547 of the Bankruptcy Code, a Chapter 7 Trustee has the authority to avoid certain payments made to creditors before bankruptcy. These are commonly referred to as preferential transfers or simply preferences.

The purpose of the preference law is to prevent a debtor from favoring one creditor over another shortly before filing bankruptcy.

There is an important distinction when the payment is made to a family member.

Generally, a trustee can look back 90 days before bankruptcy for payments made to ordinary creditors. However, when the payment is made to an insider, the trustee can look back an entire year before the bankruptcy filing.

Parents, children, siblings, and spouses generally qualify as insiders under the Bankruptcy Code.

Certain other relationships may also qualify, depending on the circumstances.

There is also a monetary threshold. Under Section 547(c)(9), certain transfers involving consumer debts are protected from avoidance if the aggregate value is less than the statutory threshold. The applicable threshold must be considered when evaluating the payments.

The important point is that repaying a family member within the year before filing bankruptcy can create a preference problem even if you had every intention of simply paying back a legitimate loan.

Does the Trustee Have to Prove Fraud?

No.

This is an important point because people sometimes become alarmed when they hear that a bankruptcy trustee can pursue a preferential transfer or a fraudulent conveyance.

A preference is not necessarily fraudulent.

You do not have to intend to cheat your creditors. You do not have to intend to hide money. You do not even have to know that making the payment could create a bankruptcy problem.

The preference provisions are designed to address the effect of the payment, not necessarily your intentions.

A fraudulent transfer is a separate legal concept under Section 548 of the Bankruptcy Code and can involve transfers made with actual fraudulent intent or transfers for less than reasonably equivalent value under specified financial circumstances.

For purposes of this article, we are primarily discussing preferential payments made to family members who loaned you money.

How Does the Bankruptcy Trustee Find Out That You Paid Back Your Parents?

This is a question I get quite often. People sometimes assume that because they paid their parents back privately, the bankruptcy trustee will never know about it.

That is not a safe assumption.

There are several ways a Chapter 7 Trustee may discover payments made to family members.

1. The bankruptcy petition specifically asks about transfers to insiders.

When you file bankruptcy, you are required to disclose certain payments and transfers made to insiders during the year before filing. This includes payments to relatives and other people who may qualify as insiders.

This is not an optional disclosure. You must answer the question truthfully, even if you believe the payment was completely legitimate.

2. The trustee may review your income tax returns.

For example, I have had trustees ask clients questions along these lines:

“I see that you received a fairly substantial income tax refund last year. What did you do with that money?”

If you received a $5,000 tax refund and used it to repay your parents, that is something the trustee may want to investigate.

3. The trustee may review your bank statements.

Bank statements can reveal payments that might otherwise go unnoticed. A trustee reviewing your financial records may see a check written to a parent, an electronic transfer to a sibling, or a withdrawal of several thousand dollars in cash.

The trustee may then ask you to explain what happened to the money.

4. The trustee may simply ask you about family loans at your 341 hearing.

Trustees sometimes ask whether you borrowed money from family members, whether you have repaid any of those loans, and whether you still owe money to relatives or friends.

The important thing is to be truthful. Do not assume that a payment is too small or too insignificant to disclose.

What Happens If You Already Paid Back Your Parents?

First, don’t panic.

I have represented many people who have found themselves in this situation. It is not unusual, and it does not automatically mean that you cannot file Chapter 7 bankruptcy.

There are several ways to address a potential preference, depending on the amount involved, when the payment was made, the circumstances surrounding the payment, and the trustee’s position.

Here are some possibilities.

1. The Trustee May Decide That the Amount Is Too Small to Pursue

Sometimes the amount paid to a family member is relatively small.

For example, perhaps you paid your mother $700 or $1,000 over the course of several months. Although the payment may raise a preference issue, the trustee must consider whether pursuing recovery makes economic sense.

A trustee may decide that it is not worthwhile to open and administer a bankruptcy estate just to pursue a relatively small payment.

However, you should never assume that the trustee will simply ignore the payment. It must still be disclosed, and the trustee must evaluate the circumstances.

2. You May Be Able to Negotiate a Settlement With the Trustee

Another possibility is that the debtor, meaning the person filing bankruptcy, may be willing to negotiate a settlement with the trustee.

For example, suppose you repaid your parents $5,000 within the year before filing bankruptcy.

The trustee may have the ability to pursue recovery of that money from your parents.

Rather than having the trustee file a lawsuit against your parents, you may be able to negotiate a settlement directly with the trustee.

In some circumstances, the debtor may be willing to contribute an agreed-upon amount to the bankruptcy estate in exchange for resolving the potential preference claim.

This can be a practical solution because it may avoid the expense, inconvenience, and stress of having your parents sued in bankruptcy court.

Of course, any settlement must be approved or handled as required by the applicable bankruptcy procedures, and the trustee is not obligated to accept your proposed settlement.

3. Your Parents May Be Able to Loan the Money Back to You

There is another possibility that is sometimes worth exploring.

Suppose you borrowed $5,000 from your parents and repaid them $5,000 within the year before filing bankruptcy.

Now you are preparing to file bankruptcy, and you need that money to pay your bankruptcy attorney and other necessary expenses.

Your parents may be willing to lend you some or all of the money back.

This is not necessarily a solution that eliminates the preference issue, but it may help.

Under Section 547(c)(4) of the Bankruptcy Code, a subsequent advance of new value by a creditor can sometimes reduce or eliminate the amount of an otherwise avoidable preference.

In other words, if your parents received $5,000 and subsequently loaned you $5,000 in genuinely new money, that subsequent advance may qualify as a defense to the preference claim.

There are specific legal requirements that must be satisfied. The subsequent loan must constitute actual new value, and the statutory requirements concerning subsequent transfers and repayment must also be considered. It is not an automatic dollar-for-dollar credit in every situation.

The important thing is that both transactions must be disclosed.

You must disclose the original payment to your parents, as well as the subsequent loan from your parents back to you.

Do not try to characterize the original payment as something else or simply omit the transactions from your bankruptcy paperwork.

4. Your Parents May Voluntarily Return the Money

Depending on the circumstances, another possibility is that your parents may voluntarily return the money they received.

For example, if your parents understand that the repayment could create a problem in your bankruptcy case, they may be willing to return the money so that the trustee’s potential claim can be addressed.

Any return of funds must be properly documented and disclosed. The timing, purpose, and legal treatment of both transfers matter.

This is something that should be discussed with your bankruptcy attorney before anyone moves money around.

What If You Need to Pay Your Bankruptcy Attorney?

This is another situation I encounter.

Sometimes people have already repaid their parents and then find themselves needing to file bankruptcy. They may not have enough money left to pay their bankruptcy attorney.

If their parents are financially able to help them again, a new loan may be possible. As discussed above, a subsequent advance of new value may provide a defense to a preference claim under Section 547(c)(4).

The important distinction is that the new loan must actually be new money. Simply changing the paperwork or creating a new promissory note for the old debt does not accomplish the same thing.

I always want to know the complete history of the transactions so that we can properly evaluate the situation before filing.

Does the $600 Rule Mean the Trustee Can Take Back Any Payment Over $600?

Not exactly.

There is an important exception under Section 547(c)(8) of the Bankruptcy Code.

In an individual bankruptcy case involving primarily consumer debts, the trustee cannot avoid a transfer if the aggregate value of the property involved in the transfer is less than $600.

This is a relatively small threshold, but it is important to understand that exceeding $600 does not automatically make a payment recoverable.

The trustee still has to establish the other requirements of a preferential transfer, including that the payment was made on account of an existing debt, that you were insolvent when the payment was made, and that the payment allowed the creditor to receive more than they otherwise would have received in a Chapter 7 bankruptcy.

For payments made between 90 days and one year before bankruptcy to an insider, the trustee generally must establish insolvency at the time of the transfer. The automatic presumption of insolvency only applies during the 90 days immediately before filing.

Consequently, every case needs to be evaluated based on its particular facts.

My Advice: Tell Your Bankruptcy Attorney About Any Payments to Family Members

I have been practicing bankruptcy law for 35 years, and I have seen this situation many times.

I understand why you want to repay your parents. They helped you when you were struggling financially, and you want to do the right thing.

There is nothing inherently wrong with borrowing money from your parents or other family members. There is also nothing inherently wrong with wanting to repay them.

However, if you are considering filing bankruptcy, you need to understand that payments made to family members can create complications that would not necessarily arise if you had simply paid your ordinary monthly bills.

My advice is simple: Before you file bankruptcy, tell your attorney about every payment you made to your parents, siblings, children, or other close family members during the year before filing.

Do not leave anything out because you think the amount was too small or because you feel embarrassed about having borrowed money from family.

I would much rather know about a $5,000 payment to your parents before we file your bankruptcy than have the trustee discover it after your case has been filed.

The bankruptcy petition requires full disclosure of these transactions. We can then evaluate the circumstances, determine whether a preference issue exists, and discuss the best way to address it.

In many situations, there are practical solutions that can avoid unnecessary complications for both you and your family.

If you are considering filing Chapter 7 bankruptcy in the Eastern District of Michigan and have repaid money to your parents or other family members, contact my office before filing. I can help you evaluate the potential preference issue and determine how best to proceed.

Walter Metzen
Board-Certified Specialist in Consumer Bankruptcy
Law Offices of Walter Metzen
313-962-4656

Legal references: 11 U.S.C. §§ 101(31), 547(b), 547(c)(4), 547(c)(8), and 548.