Golden rules for investing
Friday, February 23, 2007/
A common error is to own nothing but a share of the family business. Look closely at super and discretionary trusts as a means to hold some of your personal investments and assets, writes MICHAEL LAURENCE
By Michael Laurence
SME owners should urgently take some time out from building their businesses to review how their personal investments are held. Proposed amendments to superannuation and bankruptcy laws now before Parliament will lead to significant changes in the ability of a bankruptcy trustee, in certain circumstances, to crack into super savings.
And the imminent changes for the outlook of super means a review of your overall investment portfolio is extremely timely.
SME owners should aim to hold their personal investments and other personal assets in ways that are tax-effective, provide some protection from creditors in the event of an unexpected financial setback, and are not tied to the future of their businesses.
Lawyers and accountants specialising in tax, asset-protection and investment structures have given SmartCompany these six golden rules.
1: Separate your personal and business assets
This is “an absolute must” for SME owners, says Sue Prestney, a director of accounting firm MGI Boyd in Melbourne. “You will have something to fall back on if something happens to your business.”
Prestney points out that family businesses are often passed to younger generations rather than being used as a means to finance the retirement of older generations. This provides another reason – apart from the possible failure of the business – to separate personal and business assets. Succession planning is, of course, a vital consideration for SMEs.
2: Hold investments outside your own name
This is a standard asset-protection strategy for anyone who could be held personally responsible for debts of their businesses or sued in relation to their businesses.
Stephen Mullette, a partner of The Argyle Partnership Lawyers, says business owners are typically pursued for the debts of their businesses if they have given personal guarantees to lenders. As Mullette says, many lenders require personal guarantees from directors.
3: Think ahead
SME owners should begin a pattern of savings outside their own names – and outside their own businesses – long before any suggestion of a financial setback, Prestney says. Again, this is a standard asset-protection strategy.
The Bankruptcy Act allows a trustee in bankruptcy to claw back assets and money disposed of by the bankrupt for less than market value for up to five years before the beginning of bankruptcy. A trustee in bankruptcy can seek to recover — without time limit — assets transferred with the purpose of defeating creditors.
4: Maximise super contributions
Super has the valuable combination of concessional taxation and a high degree of asset protection — and the value of both these features will soon greatly improve. Prestney says super is perhaps the first personal investment that an SME owner should consider.
First, the tax concessions of super will vastly increase after July with the introduction of tax-free retirement benefits for those aged over 60. Second, super will enjoy unlimited asset protection, also from July, except for contributions made to avoid creditors.
As already outlined by SmartCompany in several articles, trustees in bankruptcy do not have immediate and automatic access under current law to super savings up to the pension reasonable benefits limit (RBL) of $1,356,291 for 2006-07 – apart from contributions made to defraud creditors.
Here’s the really good news. The huge volume of legislation now before Parliament for the new simplified super system includes provisions to remove references to RBLs from the Bankruptcy Act, effective from July 1. This is to be consistent with the simplified super system, which abolishes RBLs from the same date.
And in the words of the explanatory memorandum for the particular super bill: A bankrupt’s entire interest in superannuation will be protected “from being divisible among creditors”. And again, this protection will not include contributions made to avoid creditors.
Stephen Mullette points out that other proposed amendments to the Bankruptcy Act include a provision to allow a court to consider a bankrupt’s past pattern of super contributions in determining whether any contributions made before bankruptcy were out of character and intended to defeat creditors.
Sydney financial planner Graham Horrocks says one possible negative for SME owners having all of their personal investments in super is that the savings are not unavailable until retirement.
A young SME owner with expectations of retirement in 40 years’ time will look upon the inaccessibility of super savings differently to a 60-year-old.
5: Use a discretionary trust
These trusts can combine valuable asset protection with tax effectiveness.
Stephen Mullette explains that an asset held in a discretionary trust is not immediately available to a trustee in bankruptcy. A bankruptcy trustee, however, has the ability to recover assets transferred to a discretionary trust with the intention of defeating creditors at any time or for less than market value within up to five years before the beginning of bankruptcy.
Mullette also warns that a trustee in bankruptcy may have access to assets held in a trust that is controlled by the bankrupt.
From a tax perspective, discretionary trusts are an excellent way to split investment capital gains and income with adult family members who have lower marginal tax rates than your own. The trustee has the discretion to distribute profits to the lowest-taxed beneficiaries.
Paul Banister, a partner of accounting firm Grant Thornton in Queensland, writes in the Australian Financial Planning Handbook 2006-07 (published by Thomson) that the discretionary power of a trustee to alter distributions each year is highly valuable. “It is surprising how markedly the income of potential beneficiaries can vary from year to year,” he says.
The trust itself is not taxed, provided realised capital gains and income are distributed to beneficiaries who are taxed at their marginal tax rates. As beneficiaries, you or your family members are eligible for the 50% discount CGT and any franking credits from a trust’s share investments. (See SmartCompany’s feature on the clever use of discretionary trusts for personal investments.)
6: Treat family investment companies with caution
Companies are unsuitable vehicles for asset protection and tax effectiveness in many circumstances. Investors should understand that:
- Trustees in bankruptcy would have access to a bankrupt’s personally owned shares in a company.
- Companies are much less flexible than discretionary trusts for income-splitting to reduce tax. However, Sydney tax lawyer Robert Richards says companies with carefully constructed constitutions can have the discretion to pay dividends on some shares but not necessarily on others.
Companies are unsuitable for holding the appreciating assets of shares and property, according to Richards, because companies are ineligible for the 50% CGT discount. Prestney of MGI Boyd emphatically adds: “Never ever hold appreciating capital assets in a company.”
Prestney says family companies can provide a useful means to hold interest-earning investments and to partially defer tax by allowing profits to build up before distribution to shareholders – who would then be taxed at their personal rates (with franking credits for corporate tax already paid).
As well, Prestney says a family investment company could make loans to the family’s discretionary trust, which could use the loan for investing in appreciating assets. (The loans must be structured in strict accordance with a division in the tax act designed to stop dividends to shareholders being disguised as loans.)
Many businesses are run through operating companies that have discretionary trusts as their shareholders that, in turn, make distributions to family members and their entities for personal investment purposes. This article, however, does not cover how an SME should be held and how its income should be directed.