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Paying a Nondischargeable Debt On Eve of Bankruptcy

Suppose Joe owes $10,000 on a recent tax debt to the IRS, a few other unsecured debts totaling another $30,000, and the IRS just seized $10,000 from Joe’s savings account. If Joe files Chapter 7 bankruptcy within the preference period, the trustee can force the IRS to return the money to the bankruptcy estate – that is without dispute (as long as the preference payment rules are satisfied). However, what happens to the IRS debt is a gray area.

A similar issue was addressed by the Ninth Circuit Court of Appeals in the case of In re Laizure, 548 F.3d 693 (9th Cir.2008). In that case the debtor made a large payment to a creditor on the eve of bankruptcy to repay an embezzlement loss. The lower courts stated that the creditor no longer had a claim against the debtor – only the bankruptcy estate. The Ninth Circuit disagreed, and reinstated the creditor’s nondischargeable claim against the debtor.

In reaching its decision, the Laizure court stated that a claim determined and allowed under § 502(h) of the Bankruptcy Code retains the same characteristics it held prior to the filing of the bankruptcy petition. The court cited In re Bankvest Capital Corp., 5 F.3d 51 (1st Cir.2004), as persuasive, which held that that a secured creditor’s claim that is avoided as a post-petition transfer is entitled to that same secured claim following turnover to the trustee. See also David Gray Carlson, Security Interests in the Crucible of Voidable Preference Law, 1995 U. Ill. L.Rev. 211, 356 (1995) ("Payments received by a secured party are analytically different. Prior to bankruptcy, the ‘payment’ extinguished the antecedent debt. Once the payment is returned, it ought to be the case that the old debt, once dead, is now revived. This is universally assumed to be true, and § 502(h) more or less supports this conclusion[.]").

Following this rationale, the trustee in Joe’s case would force the IRS to turn over the $10,000 seized from Joe’s bank account, pay himself attorney fees and costs, and distribute the remaining funds to unsecured creditors, including the IRS. Since the IRS debt is reinstated as a nondischargeable debt, after the bankruptcy Joe still owes the IRS a remaining balance. While it is not clear that other courts would apply this line of reasoning for every pre-petition payment, it is certainly a potential trap for the unwary and could create unnecessary litigation!

The moral of this story is that bankruptcy law is challenging. In Joe’s case, he did not actually owe the IRS anything on the date he files bankruptcy. It was only after the trustee compelled the return of the payment that the debt was reinstated. Your bankruptcy case deserves an experienced bankruptcy attorney who is able to see beyond the actual circumstances to the potential liabilities in your case. Don’t risk your fresh start – get experienced help today.