Filing Taxes Before Filing For Bankruptcy: Why Bother?

Far too frequently, people who are considering filing for bankruptcy simply stop filing their taxes. Given the fact that over half of our clients are looking to alleviate some sort of governmental tax debt in bankruptcy, it's not surprising that at least once a day someone will say, "Why should I file my income taxes if I am just going to file for bankruptcy?" If I only had a dollar for every time I've heard that...

Of course, if I did have a dollar for every time I've heard that, it would be a substantial enough amount of money that I would have to claim it on my income taxes!

In essence, the relationship between filing taxes and filing bankruptcy (at least as it applies to today's discussion) can be drawn from three simple statements:

• All Canadian citizens are required to file taxes each year;
• Even though all Canadian citizens must file taxes, not all will declare bankruptcy;
• All Canadian citizens who do file bankruptcy must also file taxes in order to discharge their debts.

To help clarify the connection, I'll explain a bit more about the requirement to file taxes in and out of the context of filing bankruptcy, as well as share some tips for ensuring your post-bankruptcy financial health in the future by addressing some tax-related concerns now.

The Core Complication

When I am approached with the question of why clients should bother filing taxes if they are just going to turn around and file bankruptcy, I respond by putting the problem into layman's terms: It is illegal not to file your tax returns. (Interestingly, failure to pay your taxes is not illegal–we'll talk about this momentarily).

Moreover, filing bankruptcy does not relieve you of the requirement to file tax returns. In fact, you are not eligible to be discharged from bankruptcy if the tax return for the year immediately preceding your bankruptcy, as well as the return for the year of your bankruptcy, are not filed.

I know there will be people that don't like my use of the term "illegal" and, in a technical sense, they are correct to question the use of the term. Not filing your income tax returns isn't covered in the Criminal Code of Canada, but it is considered an offence under the Income Tax Act (ITA) punishable by a fine and or imprisonment. I'm of the opinion that, if they can throw you in jail for not filing, then that makes it illegal.

The fines and possible imprisonment I am talking about are not to be confused with the interest and penalties CRA is allowed to assess against people who file their taxes late. Section 162 of the ITA sets out the interest charges for filing late. They even have super-penalties (double interest) if you are foolish enough to file late again. Anyone who has ever been late with a balance due can tell you the interest charges add up extremely fast. It only takes three or four years for a tax debt to double due to interest and penalty charges if you leave it unpaid.

So, to sum up point #1, failure to file your taxes results in serious consequences, and failure to address those consequences immediately results in hefty hits to your already burdened pocketbook.

Counting The Cumulative, Long-Term Costs

Earlier I said that it was illegal not to file your taxes, but not illegal not to pay them. Allow me to explain.

By filing your taxes you allow the government to determine how much tax you are supposed to pay; this is called your Notice of Assessment. Once you have been assessed, the government has the right to commence collection activity. The Crown can garnish your wages, seize your bank account, contact anyone who owes you money and demand payment, or simply seize and sell your home or any other assets you may own.

All of this is very unpleasant (although not as unpleasant as being thrown in prison), but it can be stopped by filing either bankruptcy or a proposal to your creditors. Tax debts are treated just like credit card and other debts when you file for bankruptcy. Garnishments on your wages stop, bank accounts are released, and assets that haven't already been seized or sold are protected under the law.

These very protections under the Bankruptcy and Insolvency Act (BIA) cause people to think there's no need to file their taxes if they are going to file for bankruptcy anyway. Unfortunately, they are mistaken.

At the very least, when you file for bankruptcy, your trustee is required to see that the tax return for the year you file for bankruptcy and the immediately preceding year are filed. If they are not then you will not be released from bankruptcy and all of your debts will remain payable.

Sections 22 and 128 set out the requirements to file and Section 158 of the BIA makes it a requirement for anyone who files for bankruptcy to assist their trustee with the administration of the bankruptcy, which includes filing their outstanding tax returns.

This is the point that, when I am explaining all this to people, someone realizes the BIA only requires two years’ tax returns to be filed (the year of bankruptcy and the year before). They invariably ask, "Does that mean I don't have to file all of the other years before that?"

In order to be discharged from bankruptcy you do not, but (and it is a big but) CRA still has the right to send you a Requirement to File Notice and the BIA doesn't protect you from the consequences of not filing—the consequences being a fine or imprisonment.

Admittedly, that is unlikely. What is much more likely is that CRA might oppose your discharge from bankruptcy. When this happens you will be required to appear in court and explain why you should be released from your debts.

CRA will argue that because you haven't filed all of your outstanding tax returns you haven't demonstrated good faith in the process. They might further argue that you should have to repay a portion of your tax debt “just because."

The court has the right to set any terms or conditions that they think are reasonable and fair on your release from bankruptcy. Orders to repay 10% to 50% of your taxes payable are not uncommon, particularly when CRA argues that you haven't filed all of your returns as required under the law.

Further, when you appear before a court of any kind, you want to be able to say that you have done absolutely everything within your power to follow the law and adhere to their guidelines. At a minimum, even if they don't give you what you want, you have nothing to lose by playing by the rules along the way. At best, you come across as a law-abiding citizen who needs a break, and courts are much more inclined to grant breaks to "team players."

As a final recap, here are some quick takeaways from today:

• File your taxes every year regardless of your bankruptcy potential.
• Keep meticulous records.

Exact record-keeping is particularly valuable for another couple of reasons. First, if you are at the point financially where you must file bankruptcy, every accounting error will add up, and if a creditor makes a mistake, you will have the means to correct their miscalculation. Alternatively, keeping precise records helps you keep track of what you owe and what it will take to alleviate the debts permanently.

But perhaps more importantly, monitoring your spending can help you maintain control over your finances from the beginning and could even help you avoid bankruptcy altogether.

We all know that a penny saved is a penny earned...just be sure to claim these pennies when you file!

Ted Michalos, Founder & Trustee of Hoyes & Michalos, B.A.S., C.A

Ted Michalos has been a Chartered Professional Accountant (CPA) for 20+ years and has served as a Licensed Trustee since 2000. As a co-founder & President of Hoyes & Michalos, he speaks regularly at local commerce and professional events including with the Ontario Bar Association and has testified before the Canadian Senate on issues of bankruptcy legislation. Michalos has hosted a number of YouTube talks on bankruptcy and frequently is interviewed by Canadian media outlets. Prior to founding Hoyes & Michalos, he held accounting positions at Deloitte & Touch and PricewaterhouseCoopers.