Recognizing Red Flags to Avoid Problems in Bankruptcy
If you are considering filing for bankruptcy, there are many factors that must be considered. It is therefore of utmost importance for your bankruptcy attorney to have a thorough knowledge of your financial and legal situation. When meeting with new clients, I take the time to talk with the client and review all necessary information. I ask a lot of questions, not only to gather the information needed to prepare the bankruptcy petition, but also to determine if there are any potential problems. Often, these issues can be addressed by proper planning. If necessary, we will wait to file the bankruptcy petition to allow certain time periods to pass. Below are some of the “red flags” that can lead to trouble if not addressed prior to the bankruptcy filing.
Problem: Asset Transfers
Transfers of assets for less than fair value, when the debtor was either insolvent at the time of the transfer, or was made insolvent by the transfer, are considered fraudulent or voidable and can be recovered by a Chapter 7 trustee. This usually arises in the context of a transfer from the debtor to a spouse or other family member. If the debtor did not receive fair value in return, then the reason for the transfer is not relevant. In addition, transfers made with intent to defraud creditors are considered to be fraudulent conveyances, regardless of the insolvency of the debtor. Keep in mind that the Statement of Financial Affairs, which must be filed with the bankruptcy petition, only requires disclosure of transfers made within the two years preceding the bankruptcy filing. However, at the meeting with the bankruptcy trustee, the debtor will always be asked about transfers made within the prior six years. This is because the statute of limitations for fraudulent conveyances in New York for transfers made before April 4, 2020 is six years. Under current New York State law, the statute of limitations for what are now called “voidable transfers” is four years for transfers made on or after April 4, 2020 (or, if the transfer was made with actual intent to defraud a creditor, then one year after the transfer was, or could reasonably have been, discovered, if later than four years). A Chapter 7 trustee in New York can recover fraudulent conveyances/voidable transfers made within the foregoing time periods.
Solution:
Wait to file. The simplest answer, ifpossible, is to wait until the applicable time period has passed before filing the bankruptcy. This is a realistic solution only if the four years/six years will be expiring sometime in the near future.
Undo the fraudulent transfer. Fraudulent transfers in New York can be “undone” by transferring the asset back to the debtor. Whether this makes sense, depends on the value of the asset and whether or not it can be exempted in a Chapter 7 bankruptcy. However, it is important to consult with a bankruptcy attorney before transferring assets back to the debtor. Under certain circumstances, it may be necessary to wait one year after re-conveying the property to file the bankruptcy petition.
File under Chapter 13. When filing a Chapter 13 bankruptcy, fraudulent transfers are considered in a “liquidation analysis” of the Chapter 13 plan. That is, the amount to be paid to unsecured creditors must be at least what they would receive in a Chapter 7. So, to the extent that a fraudulent transfer could be recovered by a Chapter 7 trustee, the value of that property must be considered in determining whether the Chapter 13 plan proposes to repay creditors a sufficient amount.
File the bankruptcy anyway. A fraudulent transfer made within one year of the filing, with the intent to defraud a creditor, or the bankruptcy estate, can result in a denial of discharge. However, aside from that, fraudulent transfers usually will not affect a debtor’s discharge. The consequences of a fraudulent transfer will fall upon the recipient of the property. If this is a spouse, then filing the bankruptcy can be a problem. However, if the property was transferred to, for instance, a former girlfriend/boyfriend, then filing the bankruptcy may not have any negative consequences for the debtor.
Problem: Cash Income
Problems will inevitably arise when debtors are paid in cash. Individuals working “off the books”, i.e. their income is not reported by their employer, and is not reported on the debtor’s tax returns, should not file for bankruptcy until the situation is resolved. When filing for bankruptcy, debtors must disclose their current income; the income that they have earned in the six months preceding the bankruptcy filing; and their income for the prior two calendar years. In addition, debtors must provide the bankruptcy trustee with their most recently filed tax returns.
Solution:
If working for an employer, the debtor should be put on the employer’s payroll, with all income reported. However, keep in mind that the debtor must accurately disclose his or her actual income for the preceding six months, as well as the prior two calendar years. If there are insufficient records to document the debtor’s income for the preceding six months and/or two calendar years, then the debtor should wait the necessary time before filing for bankruptcy.
If the debtor is considered to be an “independent contractor”, then it is important that all income is deposited into a bank account, so that the income can be documented. Expenses should then be paid for by check or debit card. The debtor’s tax return should reflect their actual cash income.
If the debtor is self-employed, there should be a separate bank account for the business. Business expenses should be paid from the business account. All income and expenses should be documented so that the net business income can be determined.
Debtors must disclose any rental income from apartments or rooms in their homes. If paid in cash, there should be bank deposits to document the income. Preferably, the rent should be paid to the debtor by check or electronic payment.
All of the above scenarios could result in discrepancies between the debtor’s actual income and the income reported on the debtor’s tax returns. If necessary, the debtor’s tax returns should be amended. While this may result in additional tax liability (which would not be dischargeable), it is the preferable course of action. Otherwise, the debtor may be asked by a bankruptcy trustee to explain the discrepancies. Or worse, the debtor could be faced with a possible inquiry by the I.R.S. or state tax department.
Problem: Preferential Payments to Insiders
Debtors who have borrowed money from family members or friends often wish to repay these loans before filing for bankruptcy. If repayment was made within the one year preceding the bankruptcy filing, a Chapter 7 trustee can recover the money that was paid and redistribute it among all of the debtor’s creditors.
Solution:
Wait at least one year from the date of the repayment before filing for bankruptcy. This eliminates the problem entirely.
Have the friend or family member return the payment. This is considered a new loan and will serve to undo the preferential payment. This will only work if the amount of the new loan is within the debtor's exemption limits.
Problem: Recent Credit Card Usage
Using credit cards in the period leading up to the bankruptcy filing must be avoided. If there has been substantial recent usage on the credit cards, especially for purchases that are not essential, the debtor can be denied a discharge, or the debts can be deemed nondischargeable.
Solution:
Under certain circumstances, it may be advisable to wait six months to one year after using the credit cards to file for bankruptcy. This will allow a sufficient amount of time to pass so that the credit card usage is not an issue. If the debtor can make minimum payments on the credit cards, this will show a good faith intention to repay the debt and will also prevent the commencement of legal action against the debtor while waiting to file for bankruptcy.
Andrew M. Doktofsky P.C. is a debt relief agency. I help people file for bankruptcy relief under the Bankruptcy Code.