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Sending your Business to the Wall!
Or Forced to adopt Wealth Strategies of Rich!
The ATO’s Final rulings on Family Trust entitlements
Sensational headlines followed the release of the Australian Taxation Office’s final ruling on Family Trust entitlements (TR 2010/3) on 2 June 2010, including the statements such as: “Families using Trusts to own and operate business may be sent to the Wall”.
One fact is clear; the majority of business owners using Family Trusts to run business will need to take some action following this Ruling. The Harvest Accounting Group will be in contact with you soon to discuss the accounting implications of this ruling and the best action for your business.
So why have a Family Wealth Advisor write an article on an accounting topic I hear you ask?
I believe the Silver Lining in this Ruling is it now forces Family Business owners to adopt a strategy all my High Net Worth clients already use. This strategy of Paying Yourself First, if used correctly, will help accelerate your Family Wealth.
Before launching into this strategy, let us examine the old strategy of how Family Trusts were used to run business and minimise tax as well as explore the implications of the ATO’s final ruling on this structure.
The Old Strategy: Declare profits but retains cash
We all know the old strategy! Your Family Trust owned and operated your Family Business. That part was pretty straight forward.
Then either you had a Company as the trustee of your Family Trust or you owned another Company that was not involved in the family business in any way, which your accountant probably referred to as a “Bucket Company”. This is where it starts to get a little confusing.
You’re not quite sure what this “Bucket Company” does, but your almost certain it has never bought, sold or manufactured a Bucket, nor does it ever seem every likely to.
Then at the end of financial year, your accountant sits you down, looks you in the eye and says your business made the following Profit over the last 12 months. You stare back at your accountant, hoping to catch a cheeky glimmer in their eye or even a slight upturn of the mouth; anything that would indicate the beginnings of some elaborate practical joke. You’re not quite sure why you look for these signals, for it is not in the nature of an accountant to make practical jokes, but you are an eternal optimist.
After a few seconds you give up staring at your accountant, lean back in your chair and feel your spirits start to fall. You vow to go back to the office and check your bank statements, but you are willing to bet your mother in law that the Profit figure your accountant just told you is not currently sitting in your bank account. You ponder this strange, mystical world these accounting folk live in, where Profit seems to be abundant, but yet Cash is scarce.
And that’s the good news!
Your accountant now informs you that Tax must be paid on your Business Profits, not your cash balance. You don’t know much about tax, but you do know the top rate is 45%. Your spirits begin sinking further as you contemplate paying up to almost half your profits to the Australian Taxation Office!
This is where your mild mannered Clark Kent of an Accountant suddenly turns into Superman and says they can help minimise this tax burden for you.
Your spirits Lift!
To achieve this tax minimisation strategy, your now external underwear wearing accountant instructs you to pay profits from your Trading Trust (business) to yourself, your children, your spouse and finally to the Trustee Company or that strange “Bucket Company”. Now all is clear; the Bucket Company receives it name because it captures all the surplus profit from the Family Business, helping cap the family tax rate at 30%.
Clever strategy you think, but your spirits begin sinking again as you realise the business can’t afford to pay these Profits in cash to the nominated family members and the Bucket Company. It needs the cash to keep growing, paying bills and operating.
Your accountant, impervious to your emotional swings, informs you there is no need to actually pay cash to your family members and Bucket Company, despite Profits being declared to them. You look closely at your accountant’s face; No smile, No Joke.
Your spirits Soar!
You leave the meeting; remember hearing something about “Unpaid Present Entitlements”; having no idea what it meant but vowing to name your next child by this mystical accounting name.
Impact of Taxation Ruling on Old Strategy
The Australian Taxation Office Ruling now treats some Unpaid Present Entitlements as Loans. Loans from Private Companies to associates fall within Division 7A of the Income Tax Assessment Act. Division 7A requires loans to be properly documented with a loan agreement, be repaid within 7 years, payments to be made every year and commercial interest to be charged on the loan. So what does this mean?
You can no longer use the old strategy of declaring profits but not paying cash from the Family Trust to your Bucket Company, as the Taxation Office treats this as a loan which must be repaid over a period of 7 years, with interest. And your business is required to make payments on this loan every year.
If you don’t make these loan repayments, the Tax Office will treat the loan as a dividend from your Bucket Company to your Family Trust. This means your Family Trust will have to pay 45% tax on the full amount of the unpaid present entitlement / loan. A very bad outcome!!
That is why some articles are saying some family business will go to the wall; as they do not believe they will be able to take cash out of their business to repay these loans. And if they don’t repay the loans, the unpaid present entitlement ends up being taxed at the highest marginal tax rate, resulting in a very high tax bill (a very nasty result!).
The New Strategy: Pay Yourself First
Without restructuring your business, the new strategy is exactly the same strategy as the old strategy, with one major difference. You must now pay cash from your business to anyone your Trust declares profits to, which is normally yourself, family members and that Family Bucket Company.
Or a Division 7A loan must be established on profits the Trust declares. This loan must be repaid over a period of time, which once again, requires your business to start paying actual cash out of the business every year to yourself.
Wait, I hear you say, wasn’t that the best part of the Old Strategy; being able to minimise tax without taking cash out of the business and creating undue financial stress. Well yes it was if you want to live in Ground Hog Day and be in the same position next year, being short of cash. But now the ATO will not allow it. The new strategy requires a mind shift.
I firmly believe the quality of question you ask determines the quality of life you live. The question before us is how can this Taxation Ruling increase my family wealth? This is a great question, and much better than “Will this Ruling send my business to the wall?”
I believe the answer is to start Paying Yourself First. In fact the ATO is forcing you to.
And I’ll let you in on a little secret. All my High Net Worth clients Pay Themself First; it’s one of the keys to their success. Without going into the details of this concept (as I will cover in detail in another article), let me just say these clients value themself and always pay things in order of priority. Because they put a high value on themself, they always pay themself first. That is they pay themselves before the tax man, before their employees and before their business creditors.
That is not to say they don’t pay the tax man, their employees and business creditors, for to avoid this would result in bankruptcy. Rather, they pay themself first and then, with their internal drive and motivation, demand from themself, their business and their employees that they go out into the world and produce enough income to cover the tax man, their salaries and the creditors.
If you didn’t value yourself enough to do this, the Taxation Office is now forcing you to adopt a similar strategy. And they are providing you with the motivation to do so, because the consequences of not doing it are very nasty indeed.
Now, you can see the ATO ruling a gift, as it is forcing you to do what the wealthy have always done. That is, to start taking money out of your business and paying yourself.
That’s great, I hear some of you say, but how can I afford to start paying money to myself first when I am currently struggling to meet the financial needs of the business?
Great question and the answer is to work with two key advisors:
Your Family Wealth Advisor helps identifying your core values, what is most important to you and your family. They will identify the wealth you need to live the life you desire and then create a financial strategy on how to achieve that wealth in a clear time frame.
Your Accountant helps structure your business and wealth to minimise tax and create levels of asset protection. For clients running a business, they assist with management of your business’s lifeblood, which is cash flow. They can assist by helping create financial discipline and cash flow budgeting, which will identify the cash available to start paying yourself.
By working with your Family Wealth Advisor and Accountant, you will have a clear strategy on how to accumulate the wealth your family needs to live the life you desire within a time frame consistent with your goals. You will also have a clear plan on how best to use the cash in your business to achieve this outcome. And to top it all off, you will have the most efficient structure to build wealth, protect your wealth and minimise tax along the journey.
In my experience, a clear strategy on how to achieve the Life you desire dramatically increases the chances of you attaining that goal. It provides the motivation and drive you need.
What to do with the Cash?
Assuming you successfully adopt the strategy of paying cash to yourself, the question now is what do you do with this money?
Do you increase your lifestyle, reinvest it back into your business or start to build a Family Wealth Pot, full of property, shares, bonds and cash.
Well to go back to my wealthy clients, the other key to their success is they tend to acquire assets that appreciate in value. They do this, because they value themselves and demand their assets reward them, not punish them. So when they pay themselves first, they always use part of this cash to accumulate assets like Investment properties, shares, business, bonds and cash. These assets pay cash to them for the rest of their life, before they even get out of bed each morning.
They know every $1,000 put into their Family Wealth Pot increases their passive income by another $50 every year. This may not seem like a lot, but these $1,000’s add up very quickly. And before you know it, you have a $1 million Wealth Pot, paying you $50,000 every year for the rest of your life, growing with inflation.
So What Are We Saying?
Take cash from your business every month and invest part of this cash into Investments that will provide you with income for the rest of your life. When you have more money hitting your bank account before you get out of bed to support the day you desire to live, then my friend you have attained financial independence and I have achieved my goal, of guiding you there.
All Eggs in one Basket!
I know some business owners are saying they would prefer to invest all their money back into their business, with the view of one day selling the business. And they hope the sale proceeds from the business will create the financial independence they require.
Two comments:
In my experience, this is the plan of almost every other business owner and many business owners will unfortunately not achieve this objective. And when the masses tend to be heading in one direction, then the master tends to head in the opposite direction.
Secondly, by putting all your eggs in one basket you are breaking one of the fundamental rules in building wealth, which is to diversify your wealth across a range of investment classes.
A by product of demanding your business pay cash to you every month is it forces your business to become more efficient and profitable. It has to; otherwise it will not be able to afford the ever increasing payments you keep making to yourself.
Guess what happens to a business that is increasing revenue and profitability every year. That’s right, it is easier to sell and more likely to achieve the highest price. So should you decide to sell the business, you maximise the sale price and therefore the contribution to your ever growing Family Wealth Pot by adopting this strategy. And if you work with your Accountant and Family Wealth Advisor, the tax payable on the sale of the business can be reduced or even eliminated in certain circumstances.
Summary
Yes the Taxation Ruling will require Family Business run by a Family Trusts to take action. I also acknowledge that some of these actions may be painful for some.
And there are advisors in the market who see this ATO decision as a disaster for small business, with the potential to force many to the wall.
However, remember the Quality of life you live is based on the quality of questions you ask and the right question to ask now is: How can this Tax Ruling improve my business and family wealth?
I believe by working with the Harvest Accounting Group & Family Wealth Advisory, you will find some of the answers to that question, which will help set your business and family wealth plans on the path to achieve the life you desire to live.
Michel Bova practiced as a Senior Tax Consultant with KPMG, Tax Manager for JP Morgan Chase and now is Managing Director of Family Wealth Advisory*. He has degrees in Law & Accounting and specialises in providing Financial Advice to Family Business Clients and High Net Worth Families.
*Family Wealth Advisory is a corporate authorised representative of Charter Financial Planning Limited (AFSL 234665). This editorial provides general information only. Before making any financial or investment decisions, we recommend you consult a financial planner to take into account your particular investment objectives, financial situation and individual needs. Charter Financial Planning and its Authorised Representatives do not accept any liability for any errors or omissions of information supplied in this editorial.”
Stay tuned for my next article, where I explore how to ensure the Family Wealth Pot remains in the hands of your family, should you or your partner die. We will also explore how to set up tax free income to your children in this scenario.
Article by Michael Bova
Managing Director
Family Wealth Advisory
P: +61 2 9233 2333
www.familywealthadvisory.com.au
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