What part does taxation play in the processes of bankruptcy and insolvency, often as a result of financial distress?
It is a question many Australians would ask when going through maximal debt.
In fact, tax liabilities, often ignored, are critical in determining the nature of outcomes within the bankruptcy and insolvency processes, including asset management and transfer as well as future obligations to pay debts.
Taxation is an important subject that every organisation or individual in financial distress should understand-how it relates to such scenarios.
This blog intends to set out major tax issues in bankruptcy and insolvency and their clear effects on your personal finances.
The impact of bankruptcy on taxes
Bankruptcy means an individual or business is unable to repay its debts which may be voluntary or made by creditors. Bankruptcy is declared after which a trustee is appointed to oversee the financial affairs of the bankrupt that include dealing with taxation-related matters.
Key Tax Implications During Bankruptcy
| Aspect | Details |
|---|---|
| Lodging Tax Returns | Tax returns must still be lodged during bankruptcy. Any refunds relating to income earned before bankruptcy are considered part of the bankrupt estate. Refunds for income earned during bankruptcy are treated as income by the trustee. |
| Capital Gains Tax (CGT) | Disposals of assets by the trustee can trigger CGT. The tax law deems these disposals to be made by the individual, not the trustee, so the bankrupt person remains responsible for reporting gains or losses. |
| Tax loses | Tax losses incurred before bankruptcy cannot be carried forward to future years. Voluntary repayments of previously forgiven debts may allow partial deductions later. |
| HELP and Other Loans | Student loans, such as HELP and TSL, must still be repaid even after declaring bankruptcy. |
The role of the trustee
The appointed trustee plays a central role in managing a bankrupt person’s assets and finances. Their primary duty is to settle debts owed to creditors, which includes working closely with the Australian Taxation Office (ATO) on any outstanding tax obligations.
If tax returns are overdue at the time of bankruptcy, the trustee must ensure these are lodged promptly. The ATO can issue default assessments based on available data if returns are not submitted, often resulting in higher assessed debts.
Income contributions during bankruptcy
Bankrupt individuals earning an income must make regular contributions to their trustee. These contributions are calculated based on income thresholds and take into account necessary living expenses for the individual and their dependents.
Current Income Thresholds
| Number of Dependents | Net Income Threshold (AUD) |
|---|---|
| None | $67,150 |
| One | $79,150 |
| Two | $85,150 |
| Three | $91,150 |
| Four Or More | $97,150 |
Business operations and bankruptcy
Bankruptcy imposes several restrictions on business activities:
- You cannot act as a company director or secretary during bankruptcy.
- Operating as a sole trader remains an option, but the trustee must notify the ATO about your bankruptcy. The ABN associated with the business must be reactivated if the business continues.
- Tools essential for business operations, valued up to $4,200, are typically exempt from sale by the trustee.
It is crucial to trade under your personal name to avoid disclosing your bankruptcy status to all business associates.
The ATO’s role as a creditor
The ATO is often a major creditor in bankruptcy cases. If you owe tax debts to the ATO:
- Any tax refunds during bankruptcy may be offset against pre-bankruptcy debts or other liabilities, such as Family Assistance or Child Support.
- Once bankruptcy is discharged, remaining ATO debts that were included in the bankruptcy cannot be recovered.
However, some tax-related obligations, like outstanding student loans, remain payable despite bankruptcy.
Other considerations
Overseas travel restrictions
Bankrupt individuals must seek written permission from their trustee to travel overseas. Travelling without consent is an offence and can lead to penalties.
Asset management
While ordinary household items and vehicles valued up to $9,100 are exempt, most other assets, including properties, may be sold to repay creditors.
Credit impact
Bankruptcy affects credit ratings and future borrowing ability. Credit reporting agencies record bankruptcy for:
- Five years from the date of bankruptcy, or
- Two years after bankruptcy discharge, whichever is longer.
Special tax considerations
Specific financial obligations
- Student loans (HELP, SFSS, TSL, SSL) remain payable
- Tax losses incurred before bankruptcy cannot be deducted in subsequent years
- Voluntary debt repayment may restore tax deduction eligibility
Long-term tax implications
Bankruptcy’s tax consequences extend beyond the three-year and one-day standard period:
- Recorded on National Personal Insolvency Index
- Impacts credit reporting for minimum five years
- Potential restrictions on future financial activities
Seeking professional guidance
Given the complexity of tax implications during bankruptcy, professional advice is crucial. The National Debt Helpline (1800 007 007) offers free, confidential financial counselling to help navigate these challenging circumstances.
The reality check is that at times understanding the intersection of taxes and bankruptcy can be complex, but you don’t have to face it alone. At KPG Taxation, our experienced tax return accountants are here to provide you with personalised advice to help manage your tax obligations during financial challenges. Contact us today for tailored solutions to ease the process and secure a clearer financial future.
