I am asked this question quite a lot around this time of year. It is natural for clients to use tax refund money to pay a loan to a family member. Many times that is why the family member made the loan; they were promised that they would be paid back with tax refund money. Unfortunately, this can cause problems for both the person filing bankruptcy and the family member who is receives the funds. In a consumer bankruptcy a preferential transfer is when a family member is paid on a loan in the year prior to filing the bankruptcy. If a preferential transfer occurs then the Trustee in bankruptcy can seek to recover the funds paid to the family member. If the family member refuses to turn over the funds, the family member could be sued by the Trustee to recover the money.
The theory behind a preferential transfer is the Bankruptcy Court does not want a person with financial problems preferring or giving special treatment to a family member. In a liquidation bankruptcy or Chapter 7 all assets that are recovered by a Trustee that are not protected or exempt are paid to creditors on a pro rate or percentage basis. Therefore, the creditor who is owed the most money receives a larger portion of the recovery that the creditor who is owed less. It is a fairness type consideration and the Bankruptcy Court does not want a person who is filing bankruptcy and having financial problems to prefer their family members over other creditors by paying the family member a greater percentage than other creditors.
It is very important to tell your attorney when you first meet with the attorney about any payments to family members as that can greatly impact when the bankruptcy is filed and the type of chapter you should file. I will often advise my clients who are filing a chapter 7 not to pay back the family member until the bankruptcy is filed because most of the time the tax refund can be protected or exempt. After the bankruptcy if filed, the client can do whatever they want to do with the funds, including paying back a family member.
- Exemptions in Bankruptcy
- Property Transfers Before Bankruptcy
- Defenses to a Preferential Transfer Suit