Many people are fortunate enough to have family or friends who are willing to help them in times of financial instability. In fact, for some, this may be the only way to keep afloat since family and friends generally don’t care about your credit score or charging you outrageous interest rates. So should you pay back your family and friends before filing for bankruptcy? The shortest answer to this question is no. There are no advantages to repaying family or friends within a certain time period before filing for bankruptcy. In fact, doing so could actually hurt the people that trusted you would repay them. 

However, there are other ways to pay back family and friends that the courts allow and won’t negatively impact the family member or friend who has loaned you money. 

There are five different types of bankruptcy filings, but for clarity’s sake, we’ll be emphasizing Chapter 7 and Chapter 13 bankruptcy-related issues as they are two of the most common ways to file.

What is the Difference Between Chapter 7 and Chapter 13?

Filing for Chapter 7 bankruptcy is centered on liquidating assets while filing for Chapter 13 bankruptcy focuses on reorganization. 

Chapter 7 looks at assets that you owned at the time you filed. In most cases, Chapter 7 rules protect assets that are classified as exempt at the time you file versus unsecured debt which is not protected. Unsecured debt includes things like credit card debt, medical debt, and personal loans. 

Chapter 13 takes into account your financial situation before filing for bankruptcy, too, but mainly focuses on developing a payment plan to address secured debt (which includes things like your house or car). 

This is a very broad overview of these two types of bankruptcy filing but you should discuss these options at length with a lawyer who specializes in bankruptcy. 

What’s Wrong with Repaying Family or Friends Before I File for Bankruptcy?

It may seem like the best, most fair option in your eyes, but in the court’s eyes this would be considered “preferential.” Meaning, you have prioritized payments to family and friends over all other creditors, which is not allowed. 

A bankruptcy trustee can use look-back periods during which preferential ‘insider’ and ‘non-insider’ creditors were paid to determine whether the court is allowed to reclaim those payments. 

Payments made to non-insider creditors within 90 days of the bankruptcy filing may be subject to the court’s right to claw back those payments. Payments made to insider creditors (especially if the loan was informal and not well documented) are more heavily scrutinized and subject to a look-back period of a year. 

Who Is an Insider?

Examples of inside creditors subject to a one-year look-back period include:

• Parents
• Grandparents and great-grandparents
• Children, grandchildren, and great-grandchildren
• Siblings
• Nieces and nephews
• Aunts and uncles
• Friends
• A general partner 
• The relative of a general partner
• LLC Members
• A corporation of which the debtor is a director, officer, or any other person in control of the company 

And it’s important to note that the court can scrutinize any insider or non-insider payments made during a look-back period to determine whether they qualify as preferential. Typically payments made to insiders are more closely scrutinized by the bankruptcy trustee.

What Happens When a Loan Repayment is Deemed Preferential?

Let’s use one example to illustrate the outcomes of making preferential payments during a look-back period. 

Say you’ve been out of work as a result of the COVID pandemic and you ask your parents for a $2,000 loan to help you stay afloat until you can find a job. If things don’t improve and you find yourself considering bankruptcy, you may be tempted to pay back the $2,000 before filing. However, your parents would be considered insiders and this payment to them is likely to be considered preferential and thereby the trustee can demand repayment from your parents. This might put your parents in a pinch if they’ve already spent that $2,000. 

It’s far better to file bankruptcy where your parents would be considered a creditor just like every other and receive loan payments from the court without giving them preferential treatment. 

Calling on the Experts

At the end of the day, to protect yourself and those insiders you’re tempted to give preferential treatment,  talk with an experienced bankruptcy attorney, disclosing all debts and creditors whether family members or a mortgage lender. 

Your attorney can help with debt elimination and can minimize the likelihood a trustee will reclaim payments made during a look-back period. The Indiana bankruptcy attorneys at Sawin & Shea, LLC are specialists in navigating the bankruptcy process. If you’re considering filing for bankruptcy, call us at 317-759-1483 or request your free consultation online.