Hidden Traps When Borrowing Money from Family to Pay for Bankruptcy

October 28, 2014

Paying for bankruptcy can leave you broke. The typical bankruptcy case involves credit counseling and financial management class fees; court filing fees; and attorney fees. In many cases, paying for bankruptcy is beyond the means for many struggling individuals.

Borrowing money is a common way to fund a bankruptcy case, especially from family members or friends. There is nothing wrong with borrowing money to pay for bankruptcy, but there are some hidden dangers.

First, by borrowing money, you have created a debt that must be reported during your bankruptcy. Even if you borrowed from a family member with the intention of paying it back, all debts must be reported. The bankruptcy court will send out notices of your bankruptcy filing to all of your creditors, including family members who are owed money, and they are invited to attend your Section 341 meeting (also called the “meeting of creditors”). Not disclosing a creditor or debt may be considered an intentional fraud on the bankruptcy court, which may lead to denial of discharge or even criminal prosecution.

Second, now you may be thinking, “If the money was a gift, then my family member is not involved in my bankruptcy case.” That is true. However, cash gifts are also reported to the bankruptcy court and are included in your bankruptcy means test calculation. The means test is used to determine eligibility for Chapter 7 bankruptcy, and the minimum length of time and required payment for a Chapter 13 case. Loans that are intentionally misrepresented as gifts may also lead to fraud charges.

Third, repayments before filing bankruptcy can create headaches. Consider the following example:

John borrows $2,000 from his mother to pay bankruptcy fees. His attorney notes that he is expecting a large tax refund, so she suggests that John postpone the bankruptcy filing until after he receives and spends his income tax refund. The next week, John receives his normal paycheck and pays his mother in full. Two days later, John gets his tax refund and spends it on regular living expenses. John’s attorney verifies that John properly disposed of his tax refund and files his case (unaware that he paid his mother).

The debt John repaid to his mother is called a “preference payment” and receives special treatment under the federal law. A preference payment generally means that one creditor received payment shortly before the bankruptcy case that other creditors did not. In other words, John preferred to pay his mother and not his other creditors. During the bankruptcy case, the trustee can demand that John’s mother pay over the $2,000 to the bankruptcy estate for fair distribution to all creditors. Preference payments are bad, especially when made to family members. There is a twelve month look-back period for preference payments to “insider creditors,” including family members, friends, and business partners.

Many bankruptcy debtors borrow money from family before filing bankruptcy. In most cases there are no complications, but there are potential traps. The best advice is to fully and completely discuss your financial situation with your attorney before making any transfers of money.

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