Why I don't like Standard Companies

[Rosco]

WHY I DON'T LIKE STANDARD COMPANIES.

When trying to set up the right structure, there are a few things that are looked at:

• Asset protection and your level of risk
• Flexibility - what is going to change over time
• Tax minimisation - how do we save you the maximum amount of tax
• Long term goals and strategy
• MOST IMPORTANT - Can we keep it simple?

Unfortunately, a lot of advisors miss another key component: What happens if you need or want to sell?
Issues with Standard Companies - Example

Tom and Jane have a personal house worth $1 million and debt of $500k.

They have a standard company that has:

• Block of flats worth $1.5 million and debt of $1 million (purchase price $1 million)
• New townhouse worth $550k and debt $450k
• New 4 bedroom house worth $750k and debt $650k (recently purchased 2016 for $650k)
• Tom and Jane have $50k shareholders current account.

Tom and Jane decide to sell the block of flats, and net of cost receive the $1.5 million. They pay off the $1 million debt and are left with $500,000 cash!

So what should Tom and Jane do?
They want to pay off their personal house and have it debt free. This would be pretty normal and normally a good financial move. So, without talking to their advisor, Tom and Jane take the money out of the company and pay off their personal house.
One year later they are getting their Financial Statements done: Do you think there will be an issue?

Yes - there is a MAJOR issue.

Tom and Jane have taken $500,000 that they are not entitled to. An easy argument is that $50,000 is repayment of the shareholders current account (would have been nice to have a Minute), so this leaves Tom and Jane with a $450,000 overdrawn current account.

The company has to charge interest on the overdrawn shareholders current account, say six months at 5.77% (presribed by IRD) being $13,000 approximately. The company would then have to return this $13,000 as additional income in the year and pay $3,640 in additional tax at 28%.

Some people will be thinking that's easy, there is a $500k capital gain on the sale of the block of flats. While the capital gain is correct, a standard company has no easy way to distribute these gains to the shareholders. It can distribute capital gains tax free upon liquidation, but that would mean having to liquidate the company. Liquidation would be expensive and messy as the other rentals would have to be sold, which would then mean the new 4 bedroom house would be caught by the 2 year Bright-line, and there would possibly be depreciation recovery or other costs.

There are ways to fix this issue in some circumstances, but that will incur additional costs to obtain expert advice and to make the changes. Also, some of the fixes take time, and Tom and Jane could easily pay $30,000 or more in unnecessary tax!


I hope you have found this informative. If you do have a standard company (not an LTC or QC) that owns rental properties, it would be worth having a free 5-10 minute chat with me, followed most likely by a one hour Initial Meeting (fees apply) to sort out your issue and give you the best advice going forward

Ross

[Anthonyacat]

Excellent points, and it certainly is something that a lot of advisers don't seem to consider.

I for one don't dislike standard companies. They've certainly got a place in some investors' structures. Especially the buy-and-hold-forever types. My own portfolio is spread across two standard companies. It's nice having the ability to smooth out personal income taxes over a period of years by way of holding retained earnings and paying dividends later.

But it is important that the inflexibility is discussed prior to setting it up.

[kanwal13]

Hi

I am a full-time employee with income falling in the top tax bracket. The rental property I am looking to buy is cash flow positive from day one (currently in the due diligence process) The advice I have been given is that if I set up LTC I end up paying 33% tax on the surplus however with a standard company it comes down to 28%. This investment will be a buy and hold.


In future when I have equity in the property and top up my loan, and the investment becomes cash neutral or cash flow negative (with a higher rate of interest) then will converting this company to LTC be a good idea?

[Rosco]

Hi

I am a full-time employee with income falling in the top tax bracket. The rental property I am looking to buy is cash flow positive from day one (currently in the due diligence process) The advice I have been given is that if I set up LTC I end up paying 33% tax on the surplus however with a standard company it comes down to 28%. This investment will be a buy and hold.


In future when I have equity in the property and top up my loan, and the investment becomes cash neutral or cash flow negative (with a higher rate of interest) then will converting this company to LTC be a good idea?

Hi,

Is 5% really that important? How much will this actually be a year? Note this is just an interim tax, and at some point you will have to declare dividends (at a cost) and pay 5% extra up to 33%.

what happens if repairs are higher, or interest rates go up, or you take out your funds introduced? or chattels depreciation?

It really depends on your individual circumstances, but be careful that it might be awkward to get losses or capital gains out!

Ross

[kanwal13]

Thanks .... I dont think 5% is that much. I should look it getting second opinion on how i want to proceed

[Anthonyacat]

It absolutely requires a proper review of your situation.

There are times when a standard company could be good for you. For example, if you expect your personal income will drop in a few years (nearing retirement, long holiday, having kids, etc) you may only have to pay 10.5% or 17.5% tax on the earnings, instead of 33%. You'd pay the 28% now, and get a refund in a few years time.

However if not, the extra 5% tax you'd have to pay via an LTC really isn't all that much, and it protects you from problems later on if your property becomes loss-making due to big repairs or interest hikes.

[Lissica]

Interesting post Rosco. I would have paid off the personal loan first, but I understand you are using this as an example of wanting to withdraw money from the company.

It's not an issue when empire building- provided you don't need the money personally, why not keep it within the company to reinvest and have income taxed at 28%, instead of the top marginal tax rate?

Also, one can accumulate quite a large shareholder current account if they put all their savings into the investment company, which they can later withdraw tax free.

[Anthonyacat]

Lissica's middle line makes an excellent point. 5% tax doesn't make a huge difference in any given year, but the laws of compound interest make it a significant driver of returns over a couple decades, even if it does eventually need to be taxed at 33% (or whatever future top tax rate) one day.

And that raises the subsequent point, if you felt tax rates will over the medium to long term reduce (which I feel they will, but may be some time out) it may not be 33% after all.

[Lissica]

Lissica's middle line makes an excellent point. 5% tax doesn't make a huge difference in any given year, but the laws of compound interest make it a significant driver of returns over a couple decades, even if it does eventually need to be taxed at 33% (or whatever future top tax rate) one day.

And that raises the subsequent point, if you felt tax rates will over the medium to long term reduce (which I feel they will, but may be some time out) it may not be 33% after all.

Keep compounding both rental income and the capital gains within the company, and hopefully over time the rental income alone will be enough to pay the employee/s or shareholder-director/s

The way I see it, if you withdraw capital gain from the investment company, it defeats the purpose of the having one in the first place- you are losing future income generating potential. Like setting up a company to make widgets and then attempting to withdraw startup capital.

[Rosco]

Keep compounding both rental income and the capital gains within the company, and hopefully over time the rental income alone will be enough to pay the employee/s or shareholder-director/s

The way I see it, if you withdraw capital gain from the investment company, it defeats the purpose of the having one in the first place- you are losing future income generating potential. Like setting up a company to make widgets and then attempting to withdraw startup capital.

Hi Lissica,

There is no perfect answer, as everyone's situation is different. There are potential pro's and con's for each structure option.

In this example

- If a standard company, they would still have $500,000 of personal debt. The company would have $500,000 less debt, so be paying approx $25,000 less interest, so paying extra $7,000 in tax each year!
- If a different structure, the $500,000 personal debt would be paid off. So no extra income in company, no extra tax

In this example, which is quite common for property investors, the standard company would cost the investor a lot of extra tax each year!

Also other issues with standard company
- If making a loss, the loss is stuck within the company
- often a family has lower income earners, so other structures can get profits taxed at 17.5% or less. For example $1,000 to children under 16 tax free, or income to children over 16, or non working spouse. For many families the 28% is a higher tax.

Ross