Paying Back Family Loans Before Filing Bankruptcy Can Backfire

One of the common concerns clients bring to my attention is whether they should repay loans to family members just before they file for bankruptcy.

While the intention behind repaying these debts may seem noble, it’s generally a bad idea. The consequences are dire, both for the filer and a family member who accepts repayment. Imagine repaying a loan to assist a loved one, only to have those funds reclaimed by a bankruptcy trustee. Such a scenario not only strains familial relationships but also exacerbates financial strain.

The bankruptcy code defines an “Insider” as any individual with a close personal or business relationship with the debtor. When a debtor makes payments to an insider, such as repaying a loan to a parent or child, it raises red flags for creditors and bankruptcy trustees.

Here's where the one-year look-back period comes into play. Bankruptcy Trustees have the authority to scrutinize financial transactions occurring within the year leading up to the bankruptcy filing and to “undo” any payment made preferentially to any insider. This means the Trustee will sue your family member to recover the loan you repaid. Any payments made to an insider during this period are subject to retrieval by the Trustee.  The trustee will recover that preferential payment and distribute it equally among all of the creditors, pro rata.

“Preferential payments” (sometimes called just “preferences”) refer to transactions where a debtor pays one creditor, preferentially, over others in the period leading up to bankruptcy. The bankruptcy code empowers trustees to retrieve such payments to ensure equitable distribution among creditors. Therefore, repaying family loans shortly before filing for bankruptcy can be seen as an attempt to favor certain creditors over others, which undermines the principles of bankruptcy law. For family members who receive preferential payments, the repercussions can be distressing.

This is where the role of an experienced bankruptcy attorney becomes invaluable. During a consultation, individuals can explore strategies to minimize risks for family members who have received preferential payments or who have extended infra-family loans. I can offer insights into the timing of bankruptcy filings, alternative repayment arrangements, or legal defenses to mitigate potential liabilities.

Rather than hastily repaying family loans before filing for bankruptcy, individuals should prioritize transparency and seek professional guidance. Open communication with family members about the impending bankruptcy filing is also important to managing expectations and fostering understanding amidst challenging circumstances.

In conclusion, while the instinct to repay family loans before filing for bankruptcy may stem from a sense of duty or gratitude, it often proves to be a misguided step. By enlisting the services of an experienced bankruptcy attorney, individuals can navigate the complexities of bankruptcy proceedings while safeguarding the interests of both debtors and their family members.