Bankruptcy and insolvency: what it means for your taxes

There can be few events in life more stressful than financial difficulty, whether incurred personally or through your business. If matters reach a stage where your debts become unmanageable, the ultimate destination may be bankruptcy. In 2016-17 alone, there were over 16,000 bankruptcies declared in Australia and, whilst bankruptcy or insolvency might seem bad enough as it is, throw tax into the mix and the cocktail can become even more potent.

So, how does bankruptcy affect your taxes?

You can become bankrupt voluntarily or you can be made bankrupt on the actions of a creditor. Once bankrupt, a trustee in bankruptcy will be appointed to manage your affairs and may dispose of your assets for the benefit of creditors. In addition, if you earn an income you are obliged to make regular payments or “contributions” to the trustee for the benefit of creditors out of your surplus income, which is broadly what the trustee assesses is an appropriate amount taking into account your income and the amount you need to maintain yourself and your dependents.

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The normal period of bankruptcy is three years, plus one day.

Tax Returns

You still need to lodge a tax return in the normal way, even though you are bankrupt.

If you receive a refund from the ATO which relates to income earned before you became bankrupt (regardless of when you receive it), that will constitute an asset of your bankrupt estate and will be claimed by the trustee of the estate.

If you receive a refund from the ATO which relates to income earned during the period of bankruptcy, this will be treated as income by your trustee in bankruptcy. This means that if you fall into arrears with payment of your assessed income contribution, the trustee may claim the tax refund up the amount of the arrears.

Once your bankruptcy is discharged, any tax refunds which arise can be kept by you.

Where you were behind with lodging tax returns up the date of bankruptcy, the ATO is likely to push the trustee to get up to date with all outstanding income tax returns, BAS’s, etc in order that the amount of any tax debt can be established. Failure to do so is likely to result in the issue of default assessments, based on estimated figures available to the ATO through third party and other information sources. Such assessments are unlikely to be fully accurate (and any inaccuracies will often not be in your favour) so it is in your interests to take the time to ensure that your tax obligations are up to date before the ATO reaches that step.

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Capital Gains Tax on asset disposals

As noted above, a bankruptcy trustee is very likely to look to dispose of some of your property to clear your debts. Many of these disposals will give rise to Capital Gains Tax (CGT) liabilities.

Under the tax laws, the vesting of your assets in a bankruptcy trustee is ignored. This means that where a disposal is made by the trustee, the tax law still deems the disposal to have been made by you. So, if a capital gain or loss arises, you (not the trustee) will be liable and will need to record the disposal in your tax return.

Running a business

Whilst you are bankrupt you can’t be a company director or secretary for the term of the bankruptcy.

You can however be a sole trader. If you have an existing ABN when you become bankrupt, the trustee will advise the ATO of your bankruptcy. The ATO will note the date of your bankruptcy against the ABN. If you wish to continue to use the ABN you will need to contact the ATO to arrange for your ABN to be reactivated. Regardless of bankruptcy you will still be responsible for lodging your BAS Statements. There is no restriction on applying for an ABN after becoming a bankrupt.

TIP: If you wish to remain in business, you should trade under your own name because if you trade under a business name or an assumed name, you will be required to disclose your bankruptcy status to every person that you deal with.

If you are relient on tools to do business (for instance, if you’re a tradie), the trustee will not normally dispose of those tools where the value is up to $3,750.

What if the ATO is a creditor?

Any refund you are entitled to during the period of bankruptcy may be retained by the ATO to offset any pre bankruptcy income debt and/or offset any Family Assistance or Child Support debts incurred. Any debt still outstanding to the ATO after your bankruptcy is discharged which formed part of the bankruptcy cannot be recovered by the ATO.

Student loans

HELP, SFSS, TSL and SSL loans still need to be paid as if you had not been declared bankrupt.

Tax losses

Where you have incurred a tax loss before becoming bankrupt (possibly from operating a business or having a negatively geared investment property), or before being released from a debt by the operation of a law relating to bankruptcy, you can’t deducted that tax loss in any income year subsequent to the bankruptcy or release.

The reason for this provision is to prevent taxpayers from claiming a deduction for debts which the taxpayer is no longer obliged to pay.

However, where a debt which contributed to the tax loss is voluntarily repaid in a future year, you can claim a tax deduction in that future year to the extent that the repaid debt was taken into account in calculating the loss in the first place (so a repayment of a debt that wouldn’t have been tax deductible – and hence wouldn’t have contributed to the loss – won’t be tax deductible).

This can arise either during bankruptcy or after release from bankruptcy.

Mark Chapman is the Director of Tax Communications at H&R Block.