Here’s The 5-Part Test To Preference Avoidance Nirvana

Here’s The 5-Part Test To Preference Avoidance Nirvana

By |March 28th, 2012|

bankruptcy preference avoidance testYou paid a creditor prior to filing for bankruptcy. Now what?

You’re freaking out that the trustee will look to avoid the payment as a preference.

In the words of the immortal Douglas Adams, don’t panic. Just because you’ve got a preference problem on your hands doesn’t mean the trustee’s going to step in.

Avoidance is not an automatic right; there are, after all, rules to this game.

In fact, there is a 5-part test in 11 USC § 547(b) that’s got to be satisfied in order for the trustee to pull the trigger on an avoidance action.

Payment Must Be To Or For The Benefit Of A Creditor

This may sound like a no-brainer, but you’ve got to make a payment to a creditor or for the benefit of the creditor. That includes not only paying money towards a debt, but also some of these actions:

  • giving an unsecured creditor a lien against property during the preference period
  • selling property with the intent to use the money to pay off a particular debt
  • setting up an automatic deduction from your bank account
  • becoming liable for an income execution (wage garnishee)

Payment Must Be For Or On Account Of An Antecedent Debt

You’ve got to have had a legal responsibility to pay the debt when you made the payment or transferred the property in order for it to have been a preference subject to avoidance. Paying your friend’s debt doesn’t count.

Another situation where the antecedent debt rule may not have been fulfilled would be if there were some sort of legal shenanigans at play when the debt was incurred. If you didn’t really owe the money because of some flaw in the transaction, paying it back may have merely leveled the playing field.

You Must Have Been Insolvent

Let’s say you paid a friend or relative 11 months before you filed for bankruptcy after selling your house. You didn’t owe anybody else any money at the time, and you had some money left over. Your personal balance sheet was in the black at the time, so you were not insolvent.

Regardless of the fact that the repayment was within the preference period (1 year for insiders, if you recall), it’s not subject to avoidance because you weren’t insolvent at the time the payment was made.

It’s Got To Be Within The Timeframe For A Preference

Remember Aunt Millie? When you pay back money to a friend or family member, it’s a preference only if it’s done within one year of the filing of your bankruptcy petition. Payments made to any other creditor is a problem only within 90 days of filing for bankruptcy.

Creditors Have To Do Better

Let’s say you paid last year’s tax debt of $15,000 a week before filing for bankruptcy. Most likely, the IRS isn’t going to be subject to avoidance of a preference; that’s good for you because it if were, you’d walk out of bankruptcy owing the government for the tax debt you already paid.

It’s an avoidance preference only if the payment enabled the creditor to receive more than it would have gotten in a Chapter 7 bankruptcy had the transfer had not been made, and the creditor received payment of the debt to the extent provided by the bankruptcy laws.

Remember that creditors get paid according to certain legal priorities. If you pay a creditor before filing your case and the avoidance would result in that creditor getting paid the same amount anyway, there’s no point in subjecting the payment to avoidance.

Knowing that the money will just go round and round, the court’s not going to indulge in a trustee’s whims.  Leave the funds where they are, goes the reasoning.

Run Your Own Test

In my practice, watching the money trail is important to figuring out what’s going to happen once the case is filed.  Failing to do that results in uncertainties for my client as well as for me.  I don’t like surprises, especially when I’m dealing with your financial future.

Image credit:  Jim Linwood

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About the Author:

I've been a consumer protection lawyer since 1995, working to help people end their bill problems. I'm a faculty member at the Student Loan Law Workshop, a nationally recognized speaker, and a long-time member of both the National Association of Consumer Bankruptcy Attorneys and National Association of Consumer Advocates.