The pitfalls of preferential payments
If, for instance, you paid back a personal loan to a relative shortly before filing bankruptcy, that's a “preferential payment.” Your Trustee would likely demand that the money be handed over to be divvied up between all creditors. By paying a close relative before another creditor, you show them preference. This is similar to the new bankruptcy controversy brewing in many states. Except, in this case, the Trustees are looking further back at money parents have spent on their kids.
A Trustee can sue to recover money a bankruptcy filer spent even a couple of years ago if they determine that the filer didn't receive “reasonably equivalent value.” Bankruptcy Code Section 548 addresses fraudulent transfers of property by the debtor prior to bankruptcy. For instance, if you gave your car to a friend prior to bankruptcy to avoid it being part of a Chapter 7 case would likely be considered a fraudulent transfer.
However, if you traded the car for a lesser value car plus a computer and a sofa because you needed those things, that would likely not be a fraudulent transfer. The Trustee investigating the claims looks to determine whether the debtor's actions harmed creditors. They also look for actions that may have rendered the debtor insolvent. Because college tuition, in most cases, is so high, it could be argued that a debtor already struggling financially could be pushed into insolvency by paying it.
Why equivalent value matters
Additionally, some Trustees have argued that because the tuition payments are for the education of the debtor's offspring, the debtor didn't receive any equivalent value. Trustees in some cases have sued (or threatened to sue) colleges to recover tuition. In some cases, schools will negotiate and pay back a smaller amount to avoid the prospect of a lawsuit. But what does a lawsuit like this mean for the students? Results can vary.
In one case, a college allowed the student to graduate after the bankrupt parent agreed to a repayment plan for the tuition they surrendered to the Trustee. Other students could potentially have credits taken away, be told to hand over replacement funds or see their diplomas put on hold until they repay that money. Fortunately, some bankruptcy judges have pushed back against this trend. Pennsylvania Bankruptcy Judge Thomas Agresti ruled against a Trustee's attempt to take back $85k of tuition.
He wrote in his opinion, “Even though there may not strictly speaking be a legal obligation for parents to assist in financing their children’s undergraduate college education - there is something of a societal expectation that parents will assist with such expense if they are able to do so.” But in New York, a bankruptcy judge went the other way and supported the Trustees claw back of tuition. Judge Cecelia Morris said in her ruling, “The Court is not aware of any law requiring a parent to pay for a child’s college education.”
Protect yourself from Trustee backlash
So how can you avoid a similar outcome in your bankruptcy case? There are some strategies an experienced bankruptcy attorney can employ to protect you and your student. Filing a Chapter 13 rather than a Chapter 7 may help. Also, filing bankruptcy before your child starts college can help. Having your child take out student loans that you can later help them pay off may help instead of scraping up cash that can trigger a Trustee action. There are also several things to avoid prior to bankruptcy. It's best to speak to a bankruptcy attorney before you take any steps that may cause problems if you're deep in debt and have a child in college or heading there soon.
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