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How Are Creditors Paid in Bankruptcy?

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What Is the Priority of Distribution to Creditors?

Bankruptcy distribution follows an order of priority. This means that some creditors are paid before other creditors, if they are paid at all. Creditors are divided by classes and each class is paid in full before the next class. If there is not enough money to pay each member of the class in full, each member will be paid an even percentage. This is true regardless of the type of bankruptcy the debtor files.

For instance, domestic support must be paid before employee benefits. If the bankruptcy debtor has $5,000 in the debtor’s estate and the debtor owes $4,000 in domestic support, employees of the debtor will only be paid $1,000. If the employees are owed more than $1,000, then the $1,000 will be distributed evenly among those employees.

Does the Priority of Distribution Apply to All Types of Bankruptcy?

Yes. There are three major types, or chapters, of bankruptcy. Chapter 7 is liquidation bankruptcy. Chapter 11 and Chapter 13 bankruptcies are repayment bankruptcies. The priority rules apply to all chapters of bankruptcy, although the nature of the chapter affects how the creditors are paid. In Chapter 7, where non-exempt property is sold, the creditors are paid from the profits by priority. In Chapter 11 or 13, the creditors are repaid according to the repayment plan, which must conform to the priority rules.

Why Are Some Creditors Paid Before Others?

Creditors are paid in a certain order in order to protect creditors society believes should be protected. Bankruptcy administers are always paid because the law needs administers in order for the bankruptcy system to function, domestic support is protected because society wants to protect families, and so on.

Which Creditors Have Priority?

First, any unpaid portion of the United States Bankruptcy Court filing fee is paid off. The bankruptcy court is paid first.

Next, secured creditors are paid, such as the debtor's mortgage or car lender. This means that secured creditors will always be paid unless they become unsecured. Secured creditors are always paid because the collateral property the secured creditor claims legally belongs to the creditor unless the debtor paid off the loan.

The next classes of creditors are priority unsecured creditors. These are creditors who are owed money, but haven’t claimed a specific property as theirs. The first class of priority unsecured creditors is domestic support, such as child support or alimony.

The second class of unsecured creditors are the costs of administration in bankruptcy. The cost of administration in a bankruptcy case includes referee’s fees, trustee’s fees, clerk’s fees, witness fees, and accountant fees (if approved by court). The cost of administration also includes "one reasonable attorney’s fee." Services rendered must specifically be for the bankruptcy, and directly related.

The next major class of creditors is employees. Employee wages, salaries, commissions and benefit plans are paid after the bankruptcy court, secured creditors, domestic support, and cost of administration have been paid. Interestingly, employees have a payment cap and a time cap. Each employee may only collect up to $11,725 and only if the employment compensation was earned 180 days before the employer filed for bankruptcy.

The last major priority unsecured creditors are government taxes. "Taxes" includes income, property, employment and any tax the debtor is liable in whatever capacity. However, each individual tax is subject to a different time cap. For instance, a property tax can only be collected if the tax was incurred one year before the commencement of the case.

Do I Need an Attorney?

Bankruptcy is often very difficult to navigate because bankruptcy is extremely procedural. If you are a debtor, the priority of creditors can be used to pay off some obligations while completely discharging other obligations. If you are creditor, the fastest way to get paid is to convince the court that you are high up in the priority system. Either way, a bankruptcy attorney can help you get the most from the priority system of creditors.

Photo of page author Jason Cheung

, LegalMatch Legal Columnist

Last Modified: 04-19-2018 08:15 PM PDT

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