The mechanics, and tax consequences, of insolvency

It is unlikely to be an aspiration for any individual or business owner, but the words “going broke” can still have unfortunate resonance — even though there are many instances where “fault” lies with circumstance rather than personal or even a business’s shortfall. But hitting the wall does not necessarily mean there can be no come-back — even Donald Trump was bankrupt in the early ‘90s.

One central difference between bankruptcy and liquidation is that the former will apply for individuals going broke in their personal capacities, such as sole traders, but companies will look at either going into administration or liquidation.

It is generally less complicated to wind up the business of a sole trader who has declared bankruptcy than to wind up a business run through a corporate structure, a trust or partnership. The sole trader is also less complicated to wind up because the principal of the business is also personally responsible for all debts and liabilities accrued by the business. To wind up business as a bankrupt, a trustee is appointed (either by yourself or by your creditors) to conclude all current contracts, sell remaining stock and other assets, pay outstanding debts and creditors, and notify all concerned (the bank, customers, suppliers).

For any business with an ABN, the Tax Office says you need to notify it that you have ceased trading within 28 days of doing so, and to cancel registration for GST, if applicable, within 21 days of cessation of trading. You can keep and re-activate the ABN if things pick up for you in the future, but if it is kept active you will still have to lodge activity statements.

Voluntary administration

If your company can’t pay its debts and is insolvent, voluntary administration and liquidation are two of the key options. Voluntary administration is where a company’s directors hand over the business to a professional administrator to decide on the best plan of action.

The definition of insolvent is when liabilities total more than the value of assets, and debts cannot be paid. Insolvent trading is where a business continues to incur debts even though the owner or directors are aware, or should be, that the business cannot pay them. A business’s principals in these cases can be held personally liable, and even face jail time in the most extreme cases.

Voluntary administration can be a way for businesses in financial distress to get some wriggle room from creditors. Going into administration could stave off having to go into liquidation if the business is administered in such a way to maximise the chances of it continuing in business (or if that’s impossible, then to at least get a better result for creditors and shareholders upon the inevitable liquidation). The first step is a meeting of directors and appointment of an administrator, who will try to salvage the business’s financial standing.

Apart from a voluntary administration, an administration can also be initiated by a secured creditor or the company’s shareholders. The company may also be put into receivership, which is where an external receiver takes over the company’s assets and sells them to pay off secured debt.

The liquidator

If going into administration or receivership does not lead to a viable arrangement, then liquidation is the alternative. Liquidation is the formal process for winding up a company’s financial affairs to settle debts with the proceeds of the sales of its assets.

A vote of creditors or a court order can put a business into liquidation, or the business can do so voluntarily. The appointed liquidator will prioritise creditors into certain classes, with secured creditors first (those whose claims against the company are protected by a charge over a specific asset or group of assets – like a bank that issues a mortgage), then unsecured creditors (with contractual rights to receive a set amount of money but not backed by a charge over a specific asset) and lastly shareholders.

Generally, the claims of one priority class must be fully satisfied before those of the next priority level down get to see a cent. There may be pro-rata payments among claimants at the same priority level if not enough funds can be cobbled together. (The liquidator’s costs are always met however.)

The liquidator’s job is to get the best result for creditors and shareholders, and part of this can be collecting, valuing and selling all assets. If any insolvent trading is uncovered, company directors can also be sued by creditors to recoup funds.

If continuing trading is in everyone’s best interests, then the liquidator can go down that path. Another outcome of this can be to be able to sell the business as a going concern, as well as perhaps to finish and sell work in progress — the aim is to wind up the company, but to do it in a commercially practical way.

Disposal of assets

Of course, as with every other stage of the business life cycle, you will have to factor in the tax consequences of dealing with the business’s financial woes. If assets are sold to pay debts, the proceeds would still be subject to tax as ordinary income or as capital gains in the usual way. But be aware that if the business has to sell its trading stock or other assets at bargain prices (below market value), in some instances tax law may nevertheless treat the sale as having been made at market value anyway, regardless of how much was actually received.

If you are a sole trader winding up your business or if you own shares in a company being wound up, and you sell the assets of the business or the shares in the company, you will still be subject to tax on the sales. But where the sale is taxed under the CGT rules, you could be entitled to various tax exemptions and concessions under the small business CGT concession rules (see separate story on page 5). In the best-case scenario, 100% of a capital gain could be tax-free.

If a creditor or a lender decides to forgive part or all of a debt or a loan (that is, releases the business from the obligation of paying the amount back), the amount may fall under the “commercial debt forgiveness” rules. In essence, the business may have to reduce the value of its tax losses (and there may be some if the business has been in strife for a few years) by the amount forgiven. However the forgiven amount would not be assessable income, and sometimes there may be no tax consequences at all.

On a couple of related notes, if you (or your company) cancel contracts in the course of winding up, there may be capital gains or losses as a result – intangibles such as contractual rights come within the CGT regime. And if you are a shareholder of a company being liquidated, any distribution you receive from the liquidator should be tax-free to the extent that it is a return of your original investment amount; anything above that amount is likely to be taxed as a dividend.

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