So, When Did You Know You Were Broke?

A favorite trap for creditor attorneys at the 341 meeting is to ask the debtor, “So when did you first recognize that you needed to file bankruptcy?” If the creditor can get you to nail down a date that you were insolvent, the creditor can use that evidence against you. If you say that you have had financial difficulties for years, the creditor attorney may ask if you thought you should have filed bankruptcy, say last June? The creditor may attempt to draw out an admission that out were insolvent when you either transferred property or incurred debt. That could make your actions illegal or avoidable under state or federal law.

In some cases it is beneficial to be “broke” when a transaction occurs. For instance, when a large debt is “written off” or forgiven by a creditor, the amount of the forgiven debt becomes income that is taxed to the debtor. At the end of the year, the creditor may issue a 1099 identifying the forgiven debt and the IRS expects you to pay taxes on that amount. If you wait until to file bankruptcy until after the debt is forgiven, the tax debt may remain, even if the debt is ultimately discharged. Fortunately, a tax debt is not owed if the debtor was insolvent at the time the debt was forgiven.

A trap arises for the debtor when he is insolvent and continues to incur new debts. Suppose you were actually insolvent a year before your bankruptcy filing, but supplemented your income by using credit. A creditor may make a compelling case that this debt was incurred by fraud, and it should be excepted from your bankruptcy discharge.

Another problem for the insolvent debtor arises when property is transferred before filing bankruptcy. A transaction may be deemed fraudulent and avoidable when the debtor received less than reasonably equivalent value for the exchange AND was insolvent on the date the transfer was made (or became insolvent as a result of the transfer). For instance, suppose a panicky debtor recognizes that he is insolvent and needs to file bankruptcy, so he sells his $20,000 classic muscle car to his brother for $10. When he visits his bankruptcy attorney he will learn that pursuant to Section 548 of the Bankruptcy Code, that transfer may be considered fraudulent and avoidable if made within two years of his bankruptcy filing. In some cases this time period may be extended under state law.

The moral of this story is this: seek professional help when you first start experiencing serious financial problems. What may seem like a good short term financial fix may actually hurt you in the long run. In some cases, you may only be causing more financial suffering for yourself and your family.