What are Preferential Payments in the Bankruptcy Process?

 

The idea behind the federal bankruptcy system is to provide debtors and creditors with a fair way of dealing with and ending bad financial relationships. To make the system fair for all creditors, the bankruptcy court trustee may look back over time to see if there were any preferential payments made by a debtor to his creditors that might make it unfair for all of a filing debtor’s creditors. So, what are preferential payments in the bankruptcy process?

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Is your payment a preferential payment? (Photo credit: @cdharrison)

Definition of Preferential Payments in Bankruptcy Process

Preferential payments are payments made to creditors within 90 days of a filing bankruptcy or within one year if the creditor is considered to be an insider. A payment is designated as preferential if it gives the creditor more than the creditor would receive in a debtor’s chapter 7 case.

Under bankruptcy law, the trustee is able to cancel or avoid any transfer of the debtor’s assets if the transfer is considered preferential and is for the benefit of the creditor; if the transfer was made while the debtor was considered insolvent; and/or if the debt payment was made for a debt owed prior to the transfer.

How an Insider may Affect Preferential Payments

In bankruptcy law, an insider is treated differently than others who may be associated with a bankruptcy case. Generally, an insider can be considered to be: any relative of the filing debtor; general partner of the debtor; a corporation of which the debtor is legally
associated; a corporate entity in control of the debtor; or a partnership where the debtor is a general partner.

The significance of being considered an insider in the bankruptcy process is in the way bankruptcy laws treat them. A creditor is treated differently in the
bankruptcy process in the look back time. The look back time a bankruptcy court can consider property transfers is one year for
insiders.

Being determined to be an insider by a bankruptcy court trustee may come as a shock to the uncle who was repaid a debt by his nephew six months before his nephew files for bankruptcy protection. The bankruptcy court might see the payment as preferential payments to an insider and take the
money back as part of the bankruptcy estate. The bankruptcy court would then take the money retrieved by the trustee and evenly divide the money out for payments to unsecured creditors. This is the only fair way of dealing with a debtor’s creditors. A debtor cannot show partiality in paying their debts under bankruptcy law.

When Preferential Payments are Not Made to Insiders

When it comes to preferential payments that are not made to insiders, bankruptcy law doesn’t differentiate in how the trustee might avoid the transfer. The look back time is the only thing different in preferential payments for insiders and non-insider creditors.

For example, if you recently bought a large appliance on credit 60 days before you file for bankruptcy, and you decide to pay the creditor off in full so they will not take your appliance back, you have potentially made a preferential payment. If the amount you paid is more than the creditor would receive if you file a chapter 7 bankruptcy, it is likely the trustee will recover the funds.

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