When is it time to file for bankruptcy?

Troy Smith outlines what bankruptcy is, when it should be filed for and what income and assets would be available to creditors.

As speculation mounts that we may face another global financial crisis, it is reasonable to expect there is likely to be an increase in those experiencing financial and emotional difficulties.

In rare situations some may experience severe financial difficulties and may even be faced with bankruptcy.

What is bankruptcy, and more importantly for someone facing bankruptcy, what income and assets are made available to creditors.

Insolvency

Insolvency is the situation where a person is unlikely to pay their debts. In many cases a person who is insolvent may be able to pay their debts over a longer period or by restructuring their financial arrangements.

Just because a person is insolvent does not mean they will be declared bankrupt. Bankruptcy is considered to be the last option after other alternatives are seriously considered.

Under the bankruptcy legislation there are three possibilities for a person facing insolvency - debt agreements, personal insolvency agreements and bankruptcy.

Each of these arrangements is used for a different purpose.

Debt agreements

A debt agreement is used when a debtor is unable to pay their debts as they fall due. A debt agreement is made between a debtor and creditor to try and reach an achievable and sustainable repayment agreement.

The agreement may involve periodic payments or the payment of a lump sum which is equal to or less than the full amount of the debt. A debt agreement is a legally binding agreement and is an alternative to bankruptcy.

Personal insolvency agreement

A personal insolvency agreement (PIA) will allow a debtor to come to an agreement with creditors without being declared bankrupt. Under a PIA the debtor must be insolvent and the debtor in Australia (or has a connection with Australia).

A PIA involves appointing a trustee to take control of property and to put forward a proposal to creditors. The benefit of a PIA is that there are no income or assets limits, and it acts as an alternative to declaring bankruptcy. 

Bankruptcy

Those who are unable to pay their debts and unable to come to an agreement with their creditors may petition for bankruptcy. Alternatively, creditors may apply to the court for bankruptcy on a debtor. 

Where a person is declared bankrupt, a trustee is appointed to administer the person’s pre-bankruptcy assets and liabilities.

The trustee has the power:

• To sell assets of the bankrupt as at the date of bankruptcy;
• To mandate amounts from income earned after bankruptcy above a particular amount (such as from employment income and superannuation pensions); and
• To investigate the financial affairs of the bankrupt to recover property or money which has been transferred to someone else for inadequate consideration. 

Bankruptcy generally lasts for three years, although it could be extended. A permanent record of all bankrupts is kept on the National Personal Insolvency Index. Those who are bankrupt generally cannot leave the country unless they have written permission from their bankruptcy trustee. 

Income

There are no restrictions on how much income you can earn after you are declared bankrupt. However, some income may be paid to the trustee if your ‘assessable income’ exceeds a certain threshold. 

Some items included as assessable income are salary and wages, fringe benefits, business profits and some pensions/benefits. A full list of assessable income can be obtained from a debtor’s bankruptcy trustee.

To determine the amount of income that is paid to a bankruptcy trustee, the following formula is applied:

Assessed income takes into account the gross amount of income, less any taxation and Medicare levy. The actual income threshold factors in the dependants of the bankrupt. The threshold is set by the Government and updated twice yearly.

Case study 

Damian (56) is unable to meet his debts, which have become unmanageable after a divorce. He is single with no dependants, earning a salary of $64,500. He is declared bankrupt and wants to know how much of his income is paid to the bankruptcy trustee.

Step 1: Calculate assessable income
Salary income         $68,500
Less income tax $14,100
Less Medicare levy $ 1,027
Less Flood levy $ 93
Assessed income $53,280

Step 2: Trustee determines the actual income threshold amount (AITA)
AITA with no dependants = $47,265.40

Step 3: Trustee applies the formula 
($53,280 - $47,264.40)/2 = $3,007.80

Damian is required to pay $3,007.80 to his bankruptcy trustee. He may come to an agreement to pay the amount in a number of instalments (weekly/fortnightly/monthly). 

Assets

A trustee may sell some assets to pay off debtors, known as divisible assets. These include houses, apartments, land, shares and investments.

However, certain assets, known as exempt assets, cannot be accessed by a bankruptcy trustee.

These include household and personal items, tools used to earn income (up to $3,500 as at 20 September, 2011), vehicles (up to $7,050 as at 20 September, 2011), and superannuation. For a full list of divisible and exempt assets please refer to www.itsa.gov.au.

Superannuation

Amounts held in superannuation generally will not become part of the property of the bankrupt that is divisible among creditors. This applies for both amounts held in accumulation phase and/or in pension phase in the fund.

Where a contribution is made with the intention of defeating creditors, the contribution can be recovered by a bankruptcy trustee.

Provided below are situations whereby contributions may be successfully recovered by a bankruptcy trustee: 

• If at the time the contribution was made, the person was, or was about to become, insolvent
• If the contribution in question was not in accordance with a ‘pattern of contributions’ 
• If the bankrupt contributes to their own superannuation and/or that of a third party
• If a person other than the bankrupt makes contributions for the benefit of the bankrupt. 

Payments from superannuation

A lump sum payment from a superannuation fund is generally protected from a bankruptcy trustee, even if the payment is received on or after the date of bankruptcy.

Whilst the balance of a superannuation fund in pension phase is generally protected, income payments (such as pension payments) are assessed as income in the hands of the bankrupt.

This means that these payments are taken into account when determining if any income contributions should be paid to a bankruptcy trustee. 

Case study

Damian was a bankrupt who was required to pay $3,007.80 of his income to his bankruptcy trustee. He is having difficulties meeting his cost of living, paying his rent, and paying his bankruptcy trustee.

He decides to commence a transition to retirement (TTR) pension using $150,000 of his superannuation, and draw down the maximum pension payment of $15,000 (100 per cent taxable). 

Step 1: Calculate assessable income
Salary income         $68,500
Pension payment $15,000 
Less income tax $16,595
Less Medicare levy $1,252
Less Flood levy $168
Assessed income $65,485

Step 2: Trustee determines the AITA 
AITA with no dependants = $47,265.40

Step 3: Trustee applies the formula
($65,485 - $47,264.40)/2 = $9,110.30

By commencing a TTR pension and drawing down a pension payment of $15,000, Damian’s payments to the trustee have increased from $3,007.80 to $9,110.30, which is an increase of $6,102.50.

Summary

Being made bankrupt is a matter that should be avoided at all costs if possible, and there are a number of alternatives that could be considered.

Anyone facing bankruptcy needs to be aware that a trustee will be appointed to manage debts up to the time of being declared bankrupt.

In addition, income earned by the bankrupt after bankruptcy, and certain assets of the bankrupt, may be used or sold by the bankruptcy trustee to pay creditors.

Amounts held in a superannuation fund for the bankrupt are generally protected from being available to creditors.

However, the receipt of a pension by a bankrupt from a superannuation fund should be considered carefully, to avoid drip-feeding your retirement benefits into creditor’s pockets.

Troy Smith is the technical services manager at OnePath.