Potentially Nasty Surprise for Chapter 7 Filers with Children in College
Debtors file bankruptcy to get a fresh start, not always realizing what that means practically speaking. Most people understand that if you file Chapter 7 then any non-exempt assets will be sold by the trustee to pay off creditors. Much less known is the ability of the trustee to recover money from third parties for the benefit of creditors using the power to avoid preferences or to recover fraudulent transfers.
A recent Wall Street Journal has highlighted a new trend: tuition recovery lawsuits. Where a parent pays the tuition of a child, whether directly or not, then the parent has made a transfer to a third party that is potentially recoverable by the trustee. Under fraudulent transfer law, where a debtor makes a transfer and does not receive “reasonably equivalent value” in return, i.e. not an even trade, then the trustee can demand the third party pay the trustee an amount equal to the bargain element of the transfer.
Thus payment of tuition for a child may potentially be a transfer for less than reasonably equivalent value because the parent does not get anything tangible in return. Indeed, the Wall Street article highlights several cases where children or colleges/universities have been required to pay the trustee because such payments are not made with the expectation of receiving an “economic” benefit.
Where courts have heard the issue, it has gone both ways, which leaves a potential debtor with children in college in an awkward position. Does the debtor delay or avoid bankruptcy because of the potential for the trustee to sue to recovery tuition payments by the debtor. I do not think I have to point out the potential mischief this could cause to the relationship between parent and child. All may not be lost though, as a result of the Wall Street article a member of Congress has introduced legislation to remove the ability of the trustee to sue to recover such payments but we will have to wait and see if it passes.
This nasty surprise can be mitigated or avoided with proper planning but it is always good to consider the potential problems that might arise. If you have any questions about this post, please feel free to contact me and I will be more than happy to talk your ear off about this or any other bankruptcy topic.