Live off capital and pay less tax

By BRUCE SHEPPARD

Taxpayers can choose whether to live off income or capital. From a tax point of view, living off capital is obviously preferable.

There are several mechanisms for creating capital. Trusts, qualifying companies (QCs) and companies can create capital on which a shareholder can live while excess profits are retained in such structures at a 33 per cent tax cost.

Changing business structures involves commercial as well as tax risk. If taxpayers change their commercial structures, they should do so for a commercial reason, not for tax mitigation. If tax is the main reason for any change, avoidance can be alleged. If it is proven, the new structures can be set aside and the income reassessed.

From 2001 company and trust structures will enjoy a tax advantage. If a business is conducted either personally or in a partnership, there has never been a better time to consider incorporation. Commercial advantages include:

* Limited liability: In most circumstances, companies will enjoy the protection of a limitation on liability. But directors may well be liable for company debts if a company trades recklessly while insolvent. In addition, if directors provide guarantees to support trading and/or financing arrangements, limited liability is less of an advantage.

For most enterprises, the real issue is unforeseen liability. A limited liability company will in most circumstances provide protection from these.

* Separate legal entity: If an individual dies or is rendered legally incapable, a partnership is determined which can have adverse tax consequences. A company is unaffected.

Other advantages companies have over individual ownership include:

* Companies can employ owners' spouses without obtaining Inland Revenue consent, provided they do not pay excessive remuneration to a shareholder or a shareholder's associate.

* You can become your own employer and provide yourself with fringe benefits, if cost effective, or with superannuation benefits. Super funds are also taxed at 33 per cent.

* If you transfer your business to a company structure, you need to ensure you transfer it for fair value. If you inflate the price the company has to pay you, any excess above fair value will be considered a dividend.

Once you have established the fair value of your business, and the company has entered into a sale and purchase agreement, the resulting debt for purchase is money owed to you by your company. Thus, you have created capital you can either live off in lieu of income or use to refinance other debt.

It is also worth considering if it is time to establish a trust. Advantages include:

* Trusts protect assets from creditors arising as a result of business activities.

* Trusts provide a mechanism for regulating succession between generations more flexibly than a will.

If you already own shares in a company, it may be appropriate to form a trust to acquire them from you. It is important to ensure the trust agrees to pay you their market value - a formal valuation should be completed and a sale and purchase agreement should follow, creating another loan account which you can draw instead of income. After the trust's formation, all company dividends will belong to the trust. To the extent that the dividends are fully imputed, no further tax liability will arise. The cashflow from dividends can then be used to repay the loan.

Trusts also have advantages for income splitting with others.

Qualifying companies are another interesting structure. Effectively, dividends from QCs are either fully imputed (taxed at 33 per cent) with credits available, or exempt.

Before March 31, it would be useful to ensure that QCs maximise the dividends they pay their shareholders on the basis that any dividends paid will effectively be exempt. All issues regarding dividends in earlier articles need to be considered.

To the extent that assets are owned individually, the use of QCs to hold assets should be considered. If those assets are sold for capital gains at some point, the capital gains can be distributed tax free.

In reviewing your structures for 2000 on, careful consideration is needed because transferring business enterprises to such structures will result in additional taxable income in the year of transfer. An example would be depreciation recovered on fixed assets.

Again, if these changes are contemplated before March 31, 2000, you will need to critically review your provisional tax payments and accept that there may be some exposure to use-of-money interest levied by IRD.

In some instances, it may be appropriate to bring forward tax payments and pay tax early. If your business has consistent profitability and cash flow, and you know you are paying provisional tax next year, it may be worth paying your taxes early to support further payments of tax-free dividends in the current year. Paying tax at 33 per cent to save an imminent tax liability at 39 per cent yields 18 per cent on your tax investment!

To wrap up on matters needing consideration before March 31:

* All companies should consider paying out dividends before March 31, and large companies planning to pay dividends in April or May should consider bringing them forward.

* Tax-deferral strategies need to be reviewed thoroughly, and the cashflow consequences of reversing them must be dealt with.

* To the extent that changes in your business structures are appropriate for sound commercial reasons, company incorporations and trust formations should be completed and, in conjunction with such changes, formal valuations should be obtained on all assets and proper employment contract arrangements put in place on appropriate commercial terms.

With the opportunities available for small businesses to plan their affairs effectively, the year 2000 can appropriately be described as Y2Pay.

* Bruce Sheppard is a partner in Gilligan Sheppard, an Auckland accounting firm.