A structure complementary to super

Superannuation balances can be effectively complemented with private companies for a more sound investment wealth structure, but, as with all financial decision-making, it requires careful planning, Michael Hutton, wealth management partner at HLB Mann Judd Sydney, writes.

While we all take different financial paths in life, there are a few basic road maps that investors should try and follow in order to provide some peace of mind as retirement age draws closer.

The key to building wealth is not necessarily an ability to invest in the next big investment trend or picking the eyes out of the share market. As simple as it sounds, the secret to wealth creation is earning more than you spend, coupled with effective and efficient planning.

There are multiple strategies that could be considered when building wealth, but they should all focus on three key areas: reducing debt, increasing investment wealth in the right structure and superannuation planning.

Increasingly, the latter two strategies are intertwined.

In the past, many investment strategies centred on accumulating wealth within superannuation funds to gain access to attractive tax benefits. This has been stymied in recent years due to the imposition of caps and strict limits on amounts that can be contributed to superannuation.

Investment restrictions, limitations on accessing benefits and the requirement to wind up superannuation upon death also impinge on the attractiveness of super as a means of accumulating substantial levels of wealth.

So other structures for accumulating investment wealth have become more prevalent. Investments can, of course, be held personally or jointly. But to improve tax efficiency and asset protection, many are turning to the use of family trusts or investment companies as their structure of choice.

Using a blend of a trust and private company structure can often work well where investments such as substantial capital growth assets or concessionally taxed assets are invested in a trust and the balanced portfolio in the investment company.

Looking at the different structures

Retirement savings, primarily through superannuation, is often the second largest asset people have, but you don’t own your super, it is held in trust for you.

All working Australians have some form of superannuation fund, but wealthier individuals have often also used the structure of a family trust to hold their wealth.

The benefits of building wealth within a family trust have long been obvious and come down to tax effectiveness and accessibility of funds compared to superannuation.

However, for some families, establishing a private investment company through which to funnel additional wealth can be equally, if not more, effective than a trust.

Investment companies are increasingly being viewed by wealthy families as a simple and effective wealth management vehicle. An investment company is perpetual and makes an ideal investment structure for families looking to build and protect their assets for future generations. Families should review their investment structure periodically to ensure it is continuing to meet financial goals.

There are a number of benefits to be derived from having this type of structure in place, including access to the 30 per cent corporate tax rate, discretion to distribute or reinvest some or all the income and shareholders being able to receive franking credits on dividends.

Conversely, there are some restrictions to this structure that people will need to carefully consider when weighing up an investment company versus a trust structure. The main one is an investment company doesn’t attract a 50 per cent discount on capital gains crystallised like individual beneficiaries of a trust would.

Why a private company structure?

People can establish private companies for various purposes, including to hold their investments, and they subsequently become shareholders and directors of the company.

Importantly, it can be problematic to borrow money from your company as it can be seen as being a dividend paid from the company, which is then required to be recorded in the tax returns of shareholders as unfranked dividends and so is not tax effective. Alternatively, interest may need to be charged.

However, there is no such problem if you lend money to your company. There is no need for interest to be charged to it by you. So, for those who have money to invest, they could lend it to their investment company and have the company invest the money. The benefit of this is that the company then generates investment income, but only pays tax at the 30 per cent company tax rate. This may be a lower rate than individuals would pay on that same investment income.

The money loaned to the company can also be recalled at any time, either as a lump sum or in instalments.

The loan account can be topped up by having the company declare a regular dividend to the shareholders, which is then credited to their loan account. Sometimes no tax is payable by the shareholders on this dividend, as the dividend comes with tax credits, or franking credits, that may cover the tax otherwise payable.

This structure might be used where there is a substantial amount to be invested, more than can be contributed to a super fund.

Another benefit of private investment companies is they can be an appropriate and effective means for estate planning. The company survives the death of the shareholders and their shares are simply passed on through their estate to the beneficiaries. Arrangements can be left intact, if that is the family’s wish.

Why not a family trust?

A family trust can be used in a similar way, but the tax situation is likely to be different, depending on particular circumstances. Trusts are a popular choice for families and their advisers because they inherently provide asset protection, allow income to be distributed flexibly in line with the family’s wishes and enjoy a range of tax concessions (see breakout).

Because none of the trust assets are owned by the beneficiaries, these assets can potentially remain relatively safe even if, for example, a beneficiary becomes bankrupt or owes money to someone under a court order.

However, to achieve the maximum level of asset protection, the trustee must also consider any debts the trust owes to members of the family. For instance, a common situation occurs when a mum and dad lend money to their family trust so the trustee can use it to make investments, with the money being recorded as a liability of the trust. In this case, creditors of the mum and dad may still be able to access the assets in the trust in a debt recovery procedure.

Further, trust taxation is a complex area. Over the years, various governments have introduced more tax legislation to tighten the tax-effectiveness of the trust structure and there will likely be further reform in the future. While a trust structure still has many benefits, it’s a complicated arrangement. Trustees should consult the trust deed and consider seeking professional legal and tax advice in order to properly discharge their responsibilities.

So, for families looking for ways to manage their money in a tax-effective way and to pass that wealth on to their children and grandchildren, what are the options? Superannuation may not be the most effective way to pass on wealth to your children as, upon death of the member, the asset balance must be paid out, with the exception of where the benefits revert to a spouse. Some of the most popular structures have been family trusts and investment companies. They each have pros and cons and, in some cases, it makes sense to use both. They are more flexible and accessible than super, and certainly worth considering when large sums, say amounts in excess of $1 million, are to be invested.

It is worthwhile getting the structure correct upfront as reorganising investments later can be costly in terms of fees and tax.

Ultimately, the choice to establish a private investment company vehicle in which to channel non-super-directed balances will be based on the individual needs and circumstances of an individual and their family. Inadequate planning can have dire consequences on family members, however, knowing the benefits achieved through a private company structure will assist with making more informed investment decisions for Australian families.

PRIVATE INVESTMENT COMPANIES V TRUSTS: THE PROS AND CONS

Tax: Family trusts are typically not taxed themselves; instead, taxable income is allocated among family members and can be decided on year by year. This is useful for using up lower tax thresholds of family members, but may be problematic for large portfolios that generate a lot of income, which may end up being taxed at the highest individual marginal tax rate.

Investment companies, on the other hand, pay their own tax, usually at a flat 30 per cent. However, they can have different share categories, which means dividends can be paid tax effectively to recipients on lower tax rates. In addition, investment companies don’t have to distribute income each year and can instead accumulate and reinvest wealth. When it comes to capital gains, they don’t qualify for a discount and the full company tax rate needs to be paid, but it is only incurred when an asset is actually sold. As a result, assets can be held for many years and grow in value without capital gains tax being payable until eventually sold. Access: A key issue with superannuation is the funds can only be accessed on retirement or meeting another condition of release. Both family trusts and investment companies offer much greater access, but there are still some issues to consider.

Distributions can be loaned back to a family trust by beneficiaries for reinvestment. However, this does create a liability for the trust to pay that individual at some point. In addition, loans to the trust can be recalled.

Similarly, with investment companies, dividends paid out can be loaned back to the company, or not declared in the first place and, like family trusts, loans to the company can be recalled. However, loans from the company are problematic as they can be treated as unfranked dividends or subject to interest and repayment rules. Estate planning: Both family trusts and investment companies are much more suited to estate planning than superannuation.

With family trusts, when a trustee dies, a new trustee will need to be appointed, but otherwise the trust can continue uninterrupted, although family trusts typically have a lifespan of 80 years.

Likewise, new directors of an investment company will need to be appointed upon death of an existing director, and the shares in the company can be simply passed on or bequeathed to beneficiaries, including to their testamentary trusts, if established. It’s also a very tax-effective vehicle as there is no tax payable at this point and the company can continue indefinitely.

Asset protection: This is one area where superannuation is very effective as a complying fund is treated as exempt property when it comes to the bankruptcy of a member. The terms of the deed of the family trust will be important in dictating the level of asset protection provided, but there is the opportunity to provide some degree of protection.

Investment companies also offer some asset protection through their status as a limited liability company. Compliance costs: Both family trusts and investment companies need to have tax returns and accounts prepared each year. But there is no need for an audit as there is with SMSFs.