Heading for bankruptcy? Paying your children’s college expenses could create “clawback” headaches for them and their college

Many parents in financial difficulty still place a priority on helping their children with tuition and other college expenses. While this is entirely understandable, parents who pay colleges for their adult children could be creating problems for both their children and the colleges if they later file for bankruptcy protection.

Recent reports in the Wall Street Journal and elsewhere have exposed a growing trend: bankruptcy trustees are suing colleges to “claw back” money paid by parents in bankruptcy. This has led the colleges to seek payment from the students, or to withhold transcripts until the money is repaid. It has even spawn a proposed bill in Congress to prevent bankruptcy trustees from filing such suits.

The underlying legal theory for such “claw-back” suits is not that novel. Trustees have the right and indeed the obligation to pursue getting back money or property that a debtor in bankruptcy has “fraudulently” transferred, so the money can be made available to pay creditors (and to pay the trustee and his attorneys). The payment need not have been done with actual intent to defraud creditors. It is sufficient if it was made without the parent/debtor getting “reasonably equivalent value” in return for what is paid, and if the payment was made at a time the parent was insolvent or unable to pay current or anticipated debts.

In essence, the trustees argue, the parents paying the college education expenses of an adult child are making a gift to that child. Gifts are by definition not made for “reasonably equivalent value”. They take away money that could have been used to pay the parent’s creditors.  Love and affection are not considered “reasonably equivalent value”.

If the parent takes out a loan or co-signs a student loan for the child but all the money goes to the child or her college, the effect is the same. It is still an avoidable gift.

Ironically, if the parent making the payment is required to do so under a divorce settlement incorporated into a divorce decree, the problem disappears. Why? Because the parent has a legal duty to pay that is enforceable by the divorcing spouse, and by making the payment the parent is relieved of part of that obligation. This is no different than when one pays a debt that is owed. The corresponding reduction in debt creates reasonable value in exchange.

Generally, in New Jersey, parents do not have a legal obligation (absent a divorce situation) to support their children after they achieve the age of majority or become “emancipated”.

There are ways around this problem for parents in financial difficulty. One option is to file bankruptcy first, then pay the college expenses out of future income or assets that are protected in bankruptcy (such as pensions or profit sharing plans),  after the bankruptcy is over. But for most people in this situation, they and their children need to have a sober and honest discussion about what is practical and in every one’s best interests in the long run.

Careful planning and advice of qualified professionals is a must. These are difficult decisions and should be thought through carefully as part of a broad based plan for getting a “fresh start”. With years of trustee and bankruptcy experience, we have the ability to help distressed parents sort it all out.

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