The Surprising Benefits: Use “Preference” Money to Pay a Favored Debt
When a creditor is forced to pay back recently received money through “preference” law, that money can go to pay a debt you want to be paid.
Last week we introduced the law of preferences. This law says that if a creditor takes or receives money from you within the 90 days before you file your bankruptcy case, the creditor may need to pay it back. There are some complicated conditions that may apply, but in many situations the creditor does need to pay it back. See Section 547 of the Bankruptcy Code.
We ended last week by asking where this returned money goes. What good does it do you if that money just goes to your Chapter 7 trustee? After all, this liquidating trustee’s job is to distribute that money among all your other creditors. So how does that help you?
Chapter 7 Trustee’s Collection of Bankruptcy Assets
It’s true that under Chapter 7 “straight bankruptcy” it’s your bankruptcy trustee who makes a creditor return a “preferential payment.” The Bankruptcy Code says “the trustee may avoid” a preference payment. It’s not you, the debtor, who has that role. Section 547(b). (“Avoid” means requiring the creditor to pay the recently received money back, but to the trustee.)
That returned money then goes into the pool of money the trustee uses to pay your creditors. In most consumer Chapter 7 cases that’s the only money available to the trustee. That’s because everything that most debtors own is protected through property exemptions. Exemptions are categories and maximum amounts of assets that you can keep in bankruptcy under state and/or federal law. So, when a trustee avoids, or undoes a creditor’s preferential payment, that money is all the trustee has to work with.
Whether the trustee only has the preference money or also liquidates an unprotected asset, what happens to the resulting money?
Chapter 7 Trustee’s Distribution of Bankruptcy Assets
Once the trustee has received the preference money (plus any other money from liquidating assets), he or she is required by law to then distribute that money in a very specific way. The law is laid out in the Bankruptcy Code’s Section 726, “Distribution of property of the [bankruptcy] estate.”
The distribution rules say that “priority” debts get paid in full before anything goes to any other debt. Section 726(a)(1) says the money first goes to debts under Section 507, which are a listing of the priority debts.
When an “Avoided Preference” Directly Benefits You
Simply put, if you want or need to pay a debt that’s a “priority” debt, the trustee will pay it. The trustee will pay it out of the money it got from the creditor by “avoiding” the preference payment. The trustee will pay your favored priority debt before paying any other debt.
For example, an unpaid child support payment or recent income tax debt would be a priority debt. These debts could not be discharged—legally written off—in a bankruptcy case. So you’d have to pay them after your Chapter 7 case was completed. But the trustee would pay such a debt from the preference money. That would either eliminate or reduce what you’d have to pay yourself.
If your priority debt that you’d like to be paid is larger than the amount of money the trustee has from the preference, the trustee would only pay part of that priority debt. If the trustee has more than enough money, he or she would pay off the whole priority debt.
(The trustee also gets paid a fee out of the same money, so you need to take that fee into account. The fee is based on a sliding scale: a maximum of 25% on the first $5,000 distributed, 10% on the next $45,000, etc. See Section 326(a).)
Conclusion
Preference law can make a creditor give up money it took from you shortly before you filed your bankruptcy case. Then this same money can instead go to pay a priority debt which you very much want to get paid.
This is quite a nice benefit of bankruptcy. You can force one of your less important creditors in effect to pay your most important creditor!