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Individual Updates (Most Recent First): Adverse ATO Advice on Super Buy/Sell Cover Partnership and Trust Loan Accounts Effect of Debt Reduction Cover on Buy/Sell Cover Tax Treatment of Self-Ownership Agreements Vested and Indefeasible Interest Simplifying the Valuation Issue Simple or Complete Succession?
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Partnership and Trust Loan Accounts
Different Tax Treatment of Partnerships and Trusts During the life of the Business, the Proprietors would expect it to generate profit from its business activities. Partnerships and Trusts are taxed quite differently from Companies and Individuals. This difference can have a significant impact on the design of a Business Succession Plan for a Partnership or Trust.
Tax Treatment of Companies In the case of a Company, the Profit is taxable in the hands of the Company. The Company will pay the appropriate Income Tax with respect to its Profit (say 30%). This will leave the Company with a Net Profit after Tax of 70%. This amount is an asset of the Company that belongs to the Company and appears in its Balance Sheet. However, the Net Profit after Tax can be:
Purpose of Retention of Profit The Company might wish to retain the Net Profit after Tax as working capital. Alternatively, it might require access to the funds in order to repay Bank Debt or Equipment Finance. Distribution of Profit as Dividend If the Net Profit after Tax is distributed as a Dividend, the Net Asset Value and Balance Sheet of the Company would be reduced by the amount of the Dividend. However, the Net Asset Value and Balance Sheets of the Shareholders would increase by the amount of the Dividends (net of any additional Income Tax payable by the Shareholders). "Retained Profit" If the Net Profit after Tax is retained as working capital, the Retained Profit would normally be reflected in the capital value of the shares or Proprietor's Equity.
Tax Treatment of Partnerships and Trusts In the case of Business Structures like Partnerships and Unit Trusts, Profits retained by the Business have a different accounting and tax treatment. In these cases, the Net Profit of the Business Entity is taxed differently from that of a Company. Distribution of Profit to Partners or Beneficiaries The taxpayers are normally the individual Partners or Unit Holders (or Beneficiaries), which pay tax on their share of the Profit of the Business Entity. For accounting and tax purposes, the Profit is treated as if it has been distributed to the individual Partners or Beneficiaries. The individual Partners or Beneficiaries then pay Income Tax at the appropriate Tax Rate applicable to them on an individual or personal level. Profit Cannot Be Retained by Business Entity This method of taxation requires the Profit to be distributed out of the Business Entity. As a result, it ceases to be an Asset of the Business Entity. Instead, it becomes an Asset of the individual Partners or Beneficiaries. In effect, the Business Entity ceases to have access to the Net Profit as a resource of the Business Entity. Need for Funds One repercussion of this practice is that, if some or all of the Net Profit of the Business Entity is required by the Business as working capital (or to repay External Debt), it must effectively borrow the funds back from the Partners or Beneficiaries. Unlike a Company, the "Retained Profits" do not reflect in the higher value of the Equity owned by the Proprietors. Instead, they are reflected in a Loan Account owing to the Partner or Beneficiary. A Business Entity will often have Loan Accounts where it has used External Debt to fund the Purchase Price of a Business Asset or Property. Often, as the External Debt reduces, the Loan Accounts increase.
Need for Asset and Liability Strategies If a Proprietor of a Business has both Equity and a Loan Account, it is important that their Succession Plan facilitates both:
In effect, their Succession Plan needs both:
The Liability Strategy involves different legal, commercial and insurance considerations to an Asset or Buy/Sell Strategy. A Complete Succession Plan is designed to address these considerations cost- and tax-effectively.
Case Study Each Proprietor in the Business has an Equity worth $400K and a Loan Account of $150K owing to them personally. Informally, the Proprietors believe that their investment in the Business is worth $550K. This belief leads many Clients to state that the value of their Equity is $550K, which results in the Adviser obtaining a Buy/Sell Policy for $550K with respect to each Proprietor. The Buy/Sell transaction is a transaction between the Vendor and the Purchaser. It does not necessarily involve the Business itself. Thus, upon the payment of a claim, the Life Insured (or their Estate) would:
The incorrect analysis of the Proprietors' interest in the Business would deprive the Business of the ability to arrange Key Person Capital or Debt Reduction Cover designed to facilitate the repayment of the Loan Account. It also increases the amount of the Sale Price and therefore the Capital Gain upon which any Capital Gains Tax would be payable.
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Adviser Tip The One Page Strategy is designed to help you simplify Succession Planning. It helps you understand your needs, it helps you quantify them, it helps you cost them, and it helps you prioritise them.
Please contact us to arrange a meeting or teleconference.
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