Can You Better Protect Yourself?
1 May 2017
Can You Better Protect Yourself?
Case Study 1
Jo and Jack have a personal house in Mayfair St worth $1.5 million, no debt, and in JJ Trust.
They decide to get into property trading and development, operating through a Company. Their banker suggests it is easiest to borrow funds in the Trust name secured over Mayfair St, so the Company buys Kent St for $400,000, plus has a $300,000 overdraft facility, all secured over Mayfair St and the Debt in the Trust.
A). The development goes horribly wrong. The property market has crashed and there are leaky complications with the property and development. The Company now owes $600k on a partially renovated property, plus $100k to subcontractors. The Company decides to sell the property in a rush, to minimise potential loss. Unfortunately it is only worth $500k. Plus GST is owing on the sale of $65k.
I'm not a solvency or liquidation expert, but most likely the $65k GST debt would have first priority, so IRD would get paid first. Only $435k left now. Then there are two unsecured creditors, the $600k the Trust has loaned, plus the $100k creditors. But only $435k to pay $700k. Most likely a liquidation would be forced, then liquidator fees would be taken that can easily amount to $50k. The remaining $385k would most likely be paid out, with each unsecured creditor getting 55 cents in the dollar back.
So overall the Trust would get $330,000 of its $600,000 back, thus still owing the bank $270,000!
B). What if the Company takes out the loan, but it is secured solely over the personal, Mayfair St property? This would most likely give the same outcome as A)
So what could be done to improve this?
- If the bank took security of the trading property at Kent St. From the sale, the bank would then get the $500,000 (presuming not mortgagee sale). This means the Trust would only owe $100,000 to the bank, which is a $170,000 improvement on A)!
- If the Trust had done a formal loan agreement and General Security Agreement (GSA) before the money was advanced to the Company, then the Trust would most likely have priority and get its loan back before GST or any other unsecured creditors. Again, this would mean the Trust would only owe $100,000 to the bank.
It is ESSENTIAL that you get legal advice before loaning between entities, and that you protect for the worst case. Unfortunately, business and property development does go bad, so it is worth spending $500 to $1,000 to set it up correctly. It is also ESSENTIAL that this is done before any money changes hands! Sometimes the structures that banks suggest, and is easier from a finance perspective, are not in your best long term interests.
Case Study 2
Mike and Kelly have done well in life. They have a personal home worth $1 million with $50,000 debt. They have a rental portfolio in a company with $750,000 equity.
Their lawyer has recently suggested a family Trust be set up to protect their family home. The Trust has been set up and the family home transferred into the Trust.
So everything is now safe and protected in the Trust? Right?
This is just a step in the process and you need to look further:
- Should Mike and Kelly gift any amounts the Trust owe them? In the past you could gift $27,000 per year each without paying Gift Duty. Gift Duty has been abolished a number of years ago, so now you can gift the full amount in one go. But, this can affect future rest home subsidies! To have asset protection, the full amount really needs to be gifted. If you choose not to gift the whole amount, lawyers can add some clever clauses into your loan documents to help give some protection.
- Should the shares in the rental property be transferred to the Trust, and then this value gifted too? This would provide further asset protection, but ensure you receive tax advice around any transfer of shares, as this can be complicated and there are many tax catches.
- If Mike and Kelly have a current account with the Company (very likely), this could be assigned to the Trust, and then gifted.
- If Mike and Kelly have life insurance policies, should these be owned by the Trust, so that any proceeds go directly to the Trust?
It is important to consider all major current and future assets. Are there any other major assets that are worth protecting?
Case Study 3
Lisa and Jordan have a business operated through a company and a rental property business operated through a different company. The business makes good profit. The Rental Company breaks even, but they aim to pay down loans over the next two years.
Money is transferred from the Business Company to the Rental Company to pay down the loans - What is the major issue here?
Well, if the business goes bust, then the Rental Company would have to repay the advances. This can amount to hundreds of thousands over a long period.
How can it be improved?
Generally it is better for the profits and therefore money, to flow down to the owner and then be advanced to the Rental Company. These advances could be from a Trust long term, with formal loan agreements and General Security Agreements in place. It is also important to make sure the profits have flown currently to the owner and this may require the need for dividends to move retained profits to the owner legitimately.
Kind regards
Ross Barnett
