Business structures for the family farm
Author: Brian David Wibberley | Date: 16 Sep 2014
Brian David Wibberley,
Active Ag Consulting Pty Ltd & Wibberleys Chartered Accountants.
business structures, business cash flows, risk management, self-managed superannuation funds, succession, retirement and estate planning.
Take home messages
- To successfully manage and run a family farm business you need to establish a solid foundation. This foundation is composed of various structures and strategies, what we call “tools in the shed” along with a sound understanding of how these tools should be used for the betterment of the business and the family.
- The stronger the foundation, the better the business and the more likely it is the family will achieve their life long goals.
The information contained in this presentation is educational information for general circulation and is not specific professional advice. Prior to contemplating the use of any of these concepts or strategies readers need to discuss their personal circumstances with their professional advisers and tax agents.
Wibberleys Pty Ltd or Active Ag Consulting Pty Ltd accepts no liability of any kind and provides no guarantee or warrantee to any person or organisation who relies on the information contained in this presentation.
In the event that anyone wants to discuss the application of these concepts and strategies in relation to their personal and business affairs they will need to make a separate appointment with one of our professional advisers to discuss their circumstances.
ITAA - Refers to the Income Tax Assessment Act either 1936 or 1997.
SIS Act – Refers to the Superannuation Industry (Supervisory) Act 1993 & Regulations.
CGT – Capital Gain Tax.
MBT – Small Business Taxpayer
Introduction – the family farm business game
As this topic suggests there are various aspects involved when it comes to managing a family farm. These include:
- the human aspects
- the science, technology and production aspects, and
- the business and economic aspects.
Failure to adequately address all of these areas may result in the eventual failure of the family business.
No matter what form of primary production you engage in:
- Broad acre cropping
- Intensive livestock farming
- Fishing, and
If you engage in the business as a family farming unit you are faced with similar issues and demands.
Bill Malcolm and Jack Makeham “The Farming Game” publication 1981 reprint 1993 stated: “One feature of managing farms that distinguish them from managing many non-farm businesses is the close relationship between the household (consumption unit) and the business production unit. As a result – non-productive issues have a larger role in how the business is managed than with non-farm businesses.”
Given this fact it’s impossible to manage a successful business without taking into account the people and how they feel. It’s my view successful farming is about 60% emotion and 40% doing the job.
Well many of the management, production and marketing decisions people make , have financial ramifications for years to come e.g. failure to spray radish weeds in a crop, failure to feed the ewes and rams before mating , failure to sell grain at the top of the market, etc. Often these decisions are made in isolation and if the person making these decisions is stressed or worried and they make the wrong decision on the day, the poor decision can affect their bottom line for years to come.
These stresses and worries can arise from health, finance, family, marriage and succession issues. In practice we often see successful businesses suddenly performing poorly from a production and financial aspect, due to a marital dispute or financial pressure. The effect of these issues on the successful performance of a farm business cannot be underestimated.
Further to these human issues, farming families are faced with uncertainties in relation to production.
Farmers are in the business of manufacturing food. Like most manufacturers they take various inputs, apply certain processes, utilise a work place or equipment to come up with a product for sale at a gain.
Unlike most manufacturers farmers are faced with a wide range of fluctuating production factors driven largely by the climate. Rainfall and sunlight can play havoc on the production process. Too little rain, too much rain, too much humidity, no sunlight, too much sunlight can have a dramatic effect on production. Further to this farmers have to deal with living organisms, crops, pastures, livestock, pests and diseases in an every changing world and climate.
Over the last twenty years we have seen a large emphasis on the science of agriculture. The focus has been on maximising physical production per unit e.g. per hectare as opposed to focusing on the net profit or financial sustainability of the farm business. To do this you need to consider the ‘whole business’.
We understand science is important and coming from an agricultural science background I know this as much as anyone, however experience as a financial adviser to family farming businesses has emphasized the fact that successful farm business is more than just the top line. It’s about a whole range of complex issues, ranging from the family through to scientific, technology production issues through to the business and economic aspects of the profession. Unfortunately like the human aspects of farming one area that is in urgent need of attention is the economic and business aspects of managing the family farm.
Business aspects of managing the farm
In an age where we have seen significant advancements in science and technology in relation to agriculture we have seen little development in business management.
Other than the introduction of the personal computer and laptop and the introduction of the GST, which has forced farmers to process their transactions in a timely manner, many farm businesses are managing their farm financial affairs the same way as their parents did 30 years ago.
One area that some development has occurred is in produce marketing. However given that our produce marketing systems and procedures are still in their infancy the farming community is littered with unfortunate marketing disasters like contract wash outs etc. In fact when it comes to grain marketing the removal of the single desk system has catapulted most grain growers back to where their grandparents were some 50 years ago.
So what does the modern family farming unit need to do to survive these challenges?
It’s our view that it is essential that the farming family unit develop a strong foundation upon which to build their business.
We have all heard the story about the importance of building a house on a solid stone foundation as opposed to building a house on sand. The same applies to a family farming business. It doesn’t matter how much a family invests in technical advice, financial and legal advice, family succession, counselling, etc, it’s all a waste of time unless you have the right foundations.
What we are talking about here is structures, processes and strategies that the farm business is built upon. How are you going to handle the transfer of the management and ownership of the business to the next generation? How do you protect the farm business and assets in a family dispute between siblings or an impending divorce? What about your retirement and security in old age? What can you do if faced by financial pressure of a drought, or in good years the potential of a large income tax assessment?
We have always said that to do a job e.g. build a house, repair a tractor, etc, you need the right tools. Not only do you need these tools you need to know how to use them. Another analogy we can use is the game of chess. You can have all the game pieces but if you don’t know where to move the pieces at the right time then you can’t win the game. It’s these tools and strategies that are important in establishing the foundation, to then establish a successful family farming business.
Building the foundations for a successful business
In this paper I want to brush over ten key financial management tools and strategies that we believe are essential for any farm business.
Hopefully if we have time I intend to provide simple demonstrations on how these tools and strategies can be used to address the wide range of human, production, marketing and financial issues outlined above. My intention is that at the end of this talk that you have some idea of what you need to do.
At the end of the day all of these ideas are complex and require considerably more time to fully outline their operation and the benefits they can provide to your family. However we have to start somewhere.
The tools in the shed
All successful family farming businesses need:
- Appropriate trading and operating structures
- Appropriate finance facilities
- Financial risk management strategies - FMD’s
- Business analysis - an understanding of flow of business funds
- Equipment replacement policy
- Establishment of a Self Managed Superannuation Fund- SMSFs
- Accumulation of off-farm assets
- Succession plans for
- unplanned succession
- planned succession
- Estate plans, and
- Access professional advice.
All of these tools are essential, to be able to handle the complex nature of your family business along with all of the production, marketing and financial risks. Every farm business should aspire to building their business foundations on these key concepts.
Note: This list is not in priority order and it is not exhaustive. Further to this, how and when a family addresses each of these structures and strategies will differ depending upon their personal requirements.
Flexible operating structure and separate asset owning structures
There are a number of ways to trade and own assets:
- sole trader or sole ownership
- partnerships or jointly held assets
- company, or;
- trust structures.
We recommend family discretionary trusts with corporate trustees.
Why we believe that partnerships of individuals are limited?
Partnerships are excellent structures that have served many farming families well in the past. There comes a time however, when the family evolves, that the benefits provided by a partnership structure of individuals, or assets held jointly, or as tenants in common, begin to decline.
At this stage the family need to consider what other options are available that suit their needs.
(a) Partnership legal structure
Partnerships are fixed structures in which each partner shares in their share of the business income or asset ownership in a set proportion e.g. 25% each, in a four person partnership.
With a fixed structure like this it provides little opportunity for each partner to share their share of the income and capital of the business with their partner, children or other entities e.g. companies, etc.
As a result partnerships are very inflexible when it comes to the management of income tax and the transfer of asset value to the next generation.
(b) Alterations to the partnership structure
Another issue that arises with partnerships and their fixed nature relates to any alteration to the make-up of the partnership.
When people exit partnerships, by death or retirement, or enter partnerships, by the addition of new partners such as wives and children, the old partnership dissolves and a new partnership is created.
This event can create both income tax and stamp duty liabilities.
Further to this, the Income Tax Assessment Act (ITAA) stipulates various market value rules. What these rules specify, is that any assets or interests in assets e.g. partnership fractional interests or a share in business real property transferred from one person or entity, to another person or entity, has to be transferred at current market value; even if no consideration is paid.
This creates two issues.
One with capital assets:
e.g. Dad owns some BHP shares acquired for $10 in 1990, current market value of $32. If Dad gives Mum half of his shares for no consideration he will pay tax on 50% of the $22 capital gain.
The other issue that arises for people who are classified as large tax payers (not under the Simplified Small Business system), is with depreciable assets and trading stock:
e.g. Market Value of a Tractor $80 000
Tax written down value (10 000)
Assessable income on transfer $70 000
e.g. Merino Ewe Market Value $120
Tax value in financials (10)
Assessable income on transfer $110
An important issue here is that at some stage someone will die, retire or the family will want to separate, in which case there will be a transfer of assets that will involve the market value rules and may trigger either a capital gain or assessable income on transfer.
When it comes to the re-organisation of family partnerships there is relief offered under Div 40 ITAA, Subdivision 328-D ITAA (both in relation to Depreciable Plant), and Division 70 ITAA (Trading Stock) that can be utilised to overcome these issues.
Finally to add insult to injury each State Government may raise stamp duty under their respective Stamp Duty Acts on the conveyance of asset value e.g. depending upon the State this may include interests in partnerships, or asset conveyance from one person or entity to another person or entity.
The net result is that any alteration to partnership capital e.g. departing partners or addition of new partners or conveyance of capital assets may result in a stamp duty assessment.
Each State’s ‘Duty Acts’ of parliament provide various reliefs in regards to farming assets and family farm re-organizations. You will need to consult with an appropriately qualified professional to determine the respective law for your State.
(c) Asset protection
In addition to the above issues, partnerships and direct ownership of assets provide little asset protection in the event of legal, financial or marital disputes.
With partnerships, each partner is seen to personally own a fractional interest in the partnership and as such their share of their assets can become embroiled in their personal dispute. This can be exceptionally disturbing to the other members of the partnership. Further to this all partners are jointly and severally liable to the activities and actions of the other partners in the partnership.
Although not really a major concern for small family partnerships of Mum and Dad and their children it can be of considerable concern when “in-laws” join the business. These outsiders come with a whole different range of what we call life values that may or may not correlate with the rest of the family e.g. different education levels, religions, beliefs etc.
We strongly advise our clients not to expose their personal assets to these new comers until such a time that they either retire from the business or are happy that their children’s relationships are stable. This may seem a little hard, at the start for new wives and husbands, however it is generally not long before they themselves, are faced with these issues with their own children.
Another issue of concern with people trading personally or in partnerships relates to personal liability. Farming is a risky commercial business. In the event the business suffers an accident (e.g. creates a road accident, spray drift), or is subject to a legal dispute, all of the partners are personally liable. If the partnership assets and insurance cover is insufficient to cover the claim, each partners personal assets e.g. houses etc. can be liable to satisfy these claims.
The moral of the story is that you should ensure that the business is conducted in a structure separate and independent from yourself and that your assets are held in a structure(s) that provide control and ownership rights however are held separately from you as an individual.
Why not trade via a company?
Often you hear people talk about farming businesses being conducted in a company.
Companies are very poor structures in which to conduct farming business as they are not eligible for a range of primary production concessions:
- They can’t use FMDs , and are;
- ineligible for primary production averaging.
Further to this, companies are faced with a range of income tax issues such as:
- You can’t stream income,
- companies pay tax at a rate of 30 cents in the dollar,
- they are subject to a range of Capital Gains tax issues,
- there are restrictions on loans to shareholders and their associates, and;
- there are tax issues on eventual wind up.
Companies can be useful to cap your tax rate at 30% however you need to explore all of the other options that are available to you before trading through a company.
Despite the down falls of trading companies we do recommend that people use companies as trustees of various trusts. As trustee the company does not trade in its own right. It trades on behalf of the trust structure and trust beneficiaries.
So what do we recommend as an appropriate asset owning trading structure?
Where there is a single family e.g. Mum and Dad and maybe a son or daughter we would suggest that the business be conducted in single family discretionary trust with a separate corporate trustee.
Family Discretionary Trust
A trust estate is a way in which to own an asset e.g. equity. This asset can be a business, an investment or a property.
In a trust structure the assets of the family are held by the trustee on behalf of the trust beneficiaries or family members. The trustee is responsible for the day to day activities of the trust. This involves making decisions about the assets and the undertakings of the trust’s business or investments. The trustee does this on behalf of the trust beneficiaries who are the people or family members that benefit from the income and assets of the trust estate.
We recommend that our clients use a Proprietary Limited Company to act as trustee for both trading and land owning trusts. The reason for this stems from limited liability and when it comes to family farms, the shareholding nature of the company along with directorships, etc, provides greater flexibility with controlled intergenerational succession.
A typical family discretionary trust structure appears as follows:
All trusts have a ‘trust deed’ or book of rules like a company constitution that determines what the trustee can and can’t do and how the various participants e.g. the trustee and the beneficiaries should behave.
There are different types of trust estates determined by their deed. Some are fixed in regards to income and capital entitlements. These are called unit trusts. Some are discretionary where the trustee determines what happens to income and capital and others can be part fixed and part discretionary. We generally use family discretionary trusts and when we refer to trusts we are talking about this type of trusts.
In a family discretionary trust the trust deed nominates a person called the ‘appointor’ whose role is to ensure that the trustee acts in the best interests of the beneficiaries. This person is the ultimate controller of the trust as they can remove the trustee and appoint a new trustee in the event that the old trustee is not acting in the best interests of the beneficiaries.
This feature of discretionary trusts is very useful and powerful when it comes to succession, asset protection and estate planning.
Operation of a Family Trust
Unlike individuals, joint ownership and companies; where the assets are owned directly by the person or entity, trusts are different.
In a trust structure the assets are owned by a third party (e.g. a person or entity) independent from the beneficial owners. This feature of an independent trustee provides a range of advantages to families in that the assets can be owned on behalf of the whole family as opposed to specific individuals. In a family discretionary trust individual beneficiaries only end up owning assets directly when the trustee of the trust exercises their discretion to distribute income or assets to a specified beneficiary.
In most discretionary trust deeds there is a wide range of potential beneficiaries.
The first class of beneficiaries are called Primary Beneficiaries – usually Mum and Dad or the principals of the business.
The second class of beneficiaries are called secondary beneficiaries which include – Mum and Dad’s children, their spouses, their grandchildren, etc.
However, it can also include parents, brothers, sisters, nieces, nephews, eligible companies and trusts. All trust deeds are different and you need to review each deed to identify eligible beneficiaries. None of these potential beneficiaries are entitled to any assets or income of the trust estate until the trustee exercises their discretion, as specified in the deed, to a nominated beneficiary.
This provides great flexibility in relation to asset ownership, dealing with trust income and asset protection.
For instance, a son and daughter in law can join the family business and enjoy a share of business profits without actually owning anything directly. This is very different when compared with a partnership where a new partner obtains direct access and a share of the family assets, or a company where the new partner ends up owning a direct share in the family company.
In a trust structure, family members can come and go as they wish.
Another important feature of a trust structure, when it comes to succession planning, is the ability to commence handing over day to day running of the farm to the next generation without losing control.
For instance Mum and Dad can hand over the trustee powers to their daughter and son in law and still remain as the trust’s appointors. The daughter and son in law run the farm and distribute the annual profits to themselves.
In the event of a marriage break down Mum and Dad can exercise their discretion as appointors and remove the current trustees (the children) and appoint a replacement trustee. By doing this they can protect the underlying business assets of the family.
Care needs to be exercised in this process as the family law court has wide powers in relation to trusts. From our experience however, provided the assets belong to the wider family and not to specific individuals, this form of asset protection works well.
If the daughter and or son in law are sole appointors, then they would potentially be deemed as controllers of the trust and the assets would be considered to be marital assets. Loan accounts or unpaid present entitlements in the trust always belong to the specific beneficiary and will be a personal asset of these people.
Trusts also provide a very valuable form of asset protection. In the event that someone has a business that is subject to a degree of risk or financial exposure, it is best the business is conducted via their family trust.
In the event that the business fails, it is the trustee that is liable for the loss. The trustee can sell the trust’s assets to pay the liability, however the shortfall is payable by the trustee personally. If the trustee is a $2 company then there are no more assets.
The beneficiaries of the trusts are in no way liable for any of the trust’s liabilities and their individual separate assets are protected. The same applies to the directors and shareholders of the trustee company who are protected by limited liability.
Hence the reason why we don’t recommend that people be individual trustees of their trusts. For example, in the event the individuals operate a farm business with themselves as individual trustees of a trust or as a partnership of individuals, their other personal assets can be financially exposed.
Family discretionary trusts are essential when it comes to estate planning.
When a person dies any assets or equity that they own personally passes into what is called a deceased estate. (Refer Estate Planning section). Family trusts are called ‘in vivo trust estates’ or an estate created before you die. By structuring your assets in a family trust you are in effect creating an estate plan before you die.
Once the assets transfer into the trust you no longer directly own them. What you own is the control, in your capacity as trustee and appointor, over those assets.
When it comes to succession and estate planning you can determine either in your ‘will’ or in the trust deed who this power of control (and in effect ownership) is to pass to on your death. In effect by structuring your estate into trusts you are preparing your ‘will’ before you die. If your directions as to whom this power is to pass to are contained in the trust deed then these directions over ride whatever directions there are in the will. As a result these directions are far more binding and certain, than your ‘will’ and cannot be contested like wills.
This is very important in a farming context where the land can be worth millions of dollars and there may be the possibility of dispute in regards to people’s estates.
It can protect those beneficiaries that are actively engaged in the farm business and provide them with certainty that the land will eventually be controlled by them with no risk of dispute.
Structuring your estate into a number of family trusts can also be advantageous when it comes to dividing up your estate. You can direct in each trust deed, who the power of appointor is to pass to.
We strongly recommend that people use as many trusts as they can to provide not only the next generation with flexibility but also generations into the future.
In situations where there is no trading and the trust simply owns an asset, say farm land, there is no need for the trust to apply for a tax file number, ABN or lodge a tax return. The trust remains dormant until such a time as there is a change of ownership or control.
Finally family discretionary trusts are fantastic for tax planning through the ability of the trustee to stream various types of income e.g. revenue income, capital gains tax income, primary production income, dividend income to various beneficiaries in varying amounts. Care needs to be taken to ensure the deed is well drafted; to empower the trustee to do this effectively, as the tax legislation and ATO are very specific in regards to the requirements for effective distributions of trust entitlements.
Trusts can own specific assets or conduct a business.
Where there is a business such as a farm that can be subject to business and financial risk, we recommend that the business is conducted in a trust with a separate corporate trustee from the other asset owning trusts with a second separate corporate trustee.
You will note that often we recommend more than one asset owning trust. In fact each separate asset, provided they are not closely connected, should be owned in a separate trust to assist with succession and estate planning. The main reason is the flexibility of being able to hand over the control of these asset owning trusts to various family members as a part of the family succession at various times, and at death.
Partnership of trusts
In a situation where you have a multi sibling family of say two or three children and their families, and if it is likely that the business will eventually divide into two or more separate units, we would recommend a partnership of two or more discretionary family trusts as follows:
Alternatively if you believe a division in the family business is going to occur sooner rather than later you may create your new partnership with two new Corporate Trustees: -
Control over trusts
In normal circumstances we would suggest that the parents be the appointors of these new trusts along with each respective son or daughter e.g. the appointors for Trust (1) would be – Mum, Dad and child 1 and the same for the other trust with child 2, with the appointors to act jointly in each respective trust. This provides both generations with a degree of control.
Alternatively the family may be happy for some other arrangement. We leave these decisions up to the family.
In some cases for asset protection, the power of appointment and ultimate control remains with Mum and Dad until they are ready to hand over the control. This is important in the event that one of the family marriages is unstable or the parents need time to ensure they are adequately provided for in their retirement.
So how, given the market value rules in the Income Tax Assessment Act and the State Stamp Duty provisions can you restructure from your existing entity, say a partnership of four individuals, into a new structure?
This is done via the establishment of what we call an interim partnership between the old entity the partnership entity of Mum and Dad and the new entity the partnership of the children. Division 40-340(3) and Subdivision 328-D of the ITAA (1997) state that, provided the transferor and the transferee elect for rollover relief to apply and the restructure involves family members with no consideration, the depreciating assets can be transferred from one entity to another via an interim partnership at tax written down value.
Division 70-100 of the ITAA (1997) follows along a similar line where it states provided the original owner of the livestock owns at least 25% or more of the asset after the transfer then trading stock can be transferred at tax written down value. In the 1997 rewrite of the Tax Act trading stock includes operating assets such as growing crops.
Note the real key to this type of restructuring, whether it is from a single entity to another single entity, is the creation of a partnership. It is only with the creation of a partnership that these provisions work.
Care needs to be taken with Stamp Duty to ensure that your transactions do not attract unwanted tax liabilities. You will need to consult with an appropriately qualified professional in this regard.
So what Benefits will you achieve by restructuring in this fashion?
The family will be eligible for a wide range of benefits that they currently don’t enjoy in their current partnership of individuals.
(1) Solutions to their current and future succession issues
As the family will be farming in a partnership of family trusts when they decide to split, they need to decide on who is going to take what assets and what cash adjustment needs to be made. Then they simply sign Income tax elections for plant, equipment and stock and go their separate ways.
(2) The use of a corporate trustee and the two trusts operating separately from the family individuals and other asset owning structures in the family will provide valuable asset protection.
(3) As each family will have their own trust and eventually their own trustee company, they will also benefit from a succession and asset protection point of view when it comes to handing over control and ownership of the farm business to their children in an orderly controlled and protected fashion.
(4) As each family’s trust will effectively be a clone of each other the family will have complete legal ability to stream income throughout the family group.
(5) The use of a corporate trustee provides for an opportunity for family members to have an employer. This can provide a range of benefits if needed. Individual partners cannot employ themselves.
(6) A little known benefit of trading in primary production trusts is the ability of older members of the family to own farm management deposits. Currently to be an FMD depositor you need to be engaged in primary production.
In the event that you implement a Farm Management Deposit Strategy (and we would strongly recommend that the family does) and the parents retire from a partnership of individuals they would need to withdraw their FMDs as they are no longer primary producers.
If however they are eligible beneficiaries of a primary production trust, they can retain the FMDs until they die. As a result this can provide excellent tax planning opportunities for the family.
What’s more, by progressively drawing the FMDs down in their retirement, they can redeem the FMDs without paying excessive tax. This is possible by utilising the increased tax free threshold (despite them being on averaging) and utilising a range of retiree tax offsets.
The net result is the family gets to keep the original tax benefit enjoyed at the time the initial deposits were made.
(7) In addition to this the ability of streaming primary production to other family members provides the opportunity of distributing income to wives, partners and children who in turn, provided they are over age of 18 can also use FMDs, etc.
Note: Their non-primary production has to be less than $100,000 in the year of deposit.
We trust you can see that trust structures go a long way to assisting farmers in addressing a range of their succession issues.
Trusts as asset owning structures
Where land is held in peoples own names or as joint tenants there are issues that need to be addressed if the family wishes to transfer land to the next generation. There are two issues involved with transferring parcels of land between individuals and entities e.g. trusts and SMSF’s, when it comes to family succession.
The first is stamp duty and the second is capital gains tax.
From a stamp duty point of view each State provides certain relief for the transfer of farming land within family groups. These provisions, especially in relation to trusts and companies, are complex and considerable care needs to be taken when interpreting how these provisions apply to your family. Seek professional advice.
From a capital gains tax (CGT) point of view all land acquired after the 19th of September 1985 will be subject to the effects of capital gains tax on any increase in value of that land.
e.g. Capital Gain is the difference between: -
Current Market Value $XXXX
Less: Original purchase or transfer value ($XX)
Gross Capital Gain $XX
Provided the asset is not owned by a company this gross gain can be reduced by the 50% general discount, to half - $X. Tax is payable on this amount at the tax payers marginal rate or average rate of tax, despite no consideration being paid.
In the event that you qualify as a Small Business Taxpayers then you may be able to apply a number of further CGT concessions such as:
- 15 year exemption – where the land has been owned and farmed in excess of 15 years - 100% of the capital gain is exempt provided the tax payer retires,
- further 50%, capital gain discount,
- rollover to a new active asset with a two year period – delaying the capital gain, or;
- rollover to an eligible superannuation fund where 100% of the capital gain is exempt.
Obviously these concessions are very valuable if you qualify. To qualify as a small business tax payer your:
- Net combined asset value needs to be less than $6,000,000, or;
- gross farm income needs to be less than $2 000 000.
Note: Complex rules apply to family trusts and companies.
In the event that you don’t initially qualify as a small business taxpayer there is always the option of exploring restructuring to see if you can comply in the future.
If you think you are in this position we suggest you discuss your circumstances with one of our professional advisers. Call us on: (08) 8682 5222.
Summary of trust structures
Well drafted discretionary family trusts are essential structures for any family farming business as they provide the following benefits: -
- Flexibility with regard to inter-generational controlled succession,
- asset protection,
- flexibility with estate planning,
- flexibility with profit sharing, and;
- tax planning.
Appropriate finance facilities
Finance facilities need to be flexible so you can pay off the debt and redraw the balance at any time.
- Provide flexible financing for operations,
- provide flexible funding for FMDs,
- provide flexible funding for retirement and succession,
- provide flexibility when required to acquire assets at short notice, and;
- 30th June tax planning cash flow.
Build-up of farm management deposits as a risk management strategy
Let’s stop here for a moment? There is a real problem in Australia in that a vast majority of the farming population and accountants don’t really understand what these products are or how you can use them in a family farming business!
So what are they?
Schedule 2G – Division 393 of the Income Tax assessment act states, FMDs are:
(1) A term deposit – which pays interest.
(2) For which for a primary producer e.g. Farmer or Fisherman, gets a tax deduction up to a maximum of $400 000 per person, for 100% of the amount deposited provided the deposit if left on deposit for a period of 12 months and that their non-primary production income does not exceed $100 000 in the year of deposit.
(3) Thereafter when the deposit is redeemed the funds come back into the individual’s personal tax return as assessable income.
(4) The maximum deposit per person is $400 000.
(5) You can have FMDs in different bank institutions.
(6) You are actively engaged in primary production or an entity that engages in primary production.
So why do people use farm management deposits?
In the first instance they are useful in managing individual’s income tax and this is where a lot of farmers and their advisors leave this strategy. This is unfortunate! I always hear people say:
“We don’t like using FMDs. They save us tax in high income years and all that happens is that we pay the tax in a later year when we withdraw them.”
This is a very one dimensional view and I can understand why these people don’t favour FMDs. Unfortunately their experience and understanding is limited to tax. Our view of FMDs is much broader.
The opportunities that these deposits can provide and the benefits of utilising these tools strategically in your business can be incredible and are really only limited by imagination. We see FMDs as much more than just a means of reducing tax in high income years. We see them as an essential wealth creation and risk management tool absolutely essential in any farm business.
Once we introduced this strategy to our clients, not only did it save them tax initially, we noticed another interesting phenomenon and this was: -
What benefits are there on introducing an FMD strategy
(1) Positive cash flow strategy
Provided your FMDs have been on deposit in excess of 12 months you can withdraw your FMDs in multiples of $1 000. If you are in a drought declared area you can withdraw them earlier.
They become assessable income to the individual depositor in the financial year of withdrawal.
In the event that the FMD is redeposited before the end of the final year, the redeposit offsets the initial withdrawal and the net result is nil income and nil tax.
The advantage of this is that the equity you have tied up in your FMDs that have been on deposit in excess of 12 months can be used to assist with annual cash flow financing during the year e.g. reducing your overdraft. Care needs to be taken when doing this as any new deposits have to remain on deposit for a further 12 month period. As a result we recommend that people only withdraw 50% of their balance so they have access to other 50% for additional funding if required. Other issues that need to be considered can include PAYG instalments on withdrawal amounts etc. This can be overcome by proactive planning.
(2) This leads us on to our next strategy and that is obtaining further tax benefits over time.
By doing this people can maintain their reduced tax status for years to come.
Now we have we put some of the issues to bed in relation to “establishing an FMD strategy” how can these tools be used in addition to just saving tax.
(3) Little risk and less tax to pay
The first significant benefit of an FMD is that it provides financial insurance.
It can always be withdrawn and used to repay the loan finance used to fund it originally. The money is always there so there is little risk.
All that happens is:
- You end up paying the tax you would have anyway. Furthermore due to the loss of purchasing power of money over time e.g. inflation, the value of this delayed tax is less, and
- As a result of utilising your FMD Strategy your primary production average is less, so you enjoy a greater averaging rebate on withdrawal. Primary production averaging is another form of tax reduction provided to primary producers that is rarely used to its full potential especially in large family groups.
(4) Financial risk management
The next major benefit of FMDs financial insurance is that it can assist and take the heat out of future financial decisions.
For instance if you have $1 000 000 in FMDs, your overdraft is still $500 000 and a property purchase comes up. You can borrow $1 500 000 to purchase the property with the knowledge that you always have your $1 000 000 of FMDs up your sleeve to assist you with paying interest and if need be principal payments in the event the business is unable to meet these commitments, at any time in the future. This is very powerful and can apply to the acquisition of all sorts of assets e.g. off farm property, more farms etc.
(5) Provision for commitment in the future
Another benefit of FMDs is they can act as what we call a sinking fund or provision for an outlay at some time in the future. For instance the family want to start providing over time for the eventual retirement of Mum and Dad.
To do this they would like to deposit cash into a superannuation fund. However, once the money is in the superannuation fund it is unavailable to the business.
The first step is to use a FMD.
e.g. Step 1
Once the family is happy with the level of FMDs and they feel they are sustainable, they can then transfer the excess over to the SMSF. The initial withdrawal amount is subject to tax in the individuals name and is offset as a concessional member contribution to the superannuation fund which is taxed as 15% contributions tax or less in the superannuation fund.
The same principles can apply to building up a cash provision for the acquisition of plant and equipment
(6) Retirement funding
Another concept people are unaware of is the ability to assist with funding on individual’s retirement outside of super.
The Income Tax Assessment Act (ITAA) states for people to maintain FMDs that they have to be engaged in the business of primary production or be eligible beneficiaries of a trust engaged in primary production. Refer Section 393-25 of the ITAA.
Provided Mum and Dad are eligible beneficiaries of the farm business trust and receive some primary production income from time to time then they are eligible to retain FMDs. Further to this, due to their age, the increase in the tax free threshold, the mature age worker tax rebate and the low income rebate etc they can earn up to $35 000 each and pay little to no tax. This enables them to wind down their primary production average and withdraw their FMD’s each year tax free to assist in funding their retirement.
The net result is the tax benefit that was saved in their original deposit is always maintained.
(7) Financial insurance with plant and Equipment Replacement
The next strategy relates to using FMDs to assist with acquiring replacement and upgrade Plant and Equipment: -
Let’s look at an example:
A farmer decides that they are going to spend $150 000 on a tractor. If they were to pay cash for this acquisition, at an average tax rate of 25% they would need to earn $200 000 pay tax of $50 000 to leave them with the $150 000 to acquire the tractor.
In this scenario they would be up for the $50 000 tax about nine months after the acquisition.
After the tractor purchase they are be able to use the tractor in their business and claim tax depreciation on the original cost of the tractor at say 20% per annum.
Alternatively the farmer, provided they are eligible, could deposit $150 000 into a farm management deposit. No tax is payable on the $150 000 which now is treated as a full tax deduction. At a tax rate of 25% this would reduce the annual tax bill by $37 500.
The farmer would then take out a chattel mortgage loan to acquire the tractor. Payments on this item of equipment over a 5 year period payment in advance at a rate of 8% would be
$34 785 per annum. In each payment the farmer claims interest and depreciation on the payment.
At any point of time in the future when the farmer encounters a poor year $35 000 of the FMDs could be redeemed to meet the annual payment. Tax is payable on these redemptions however in the event that it’s a poor year this tax would be less than in the year of initial acquisition.
The overall outcome of this strategy as opposed to a straight out acquisition is obvious.
In the first scenario the farm has incurred a tax liability of $50 000 along with acquiring a depreciating asset.
In the second scenario the farm has still acquired the machine, there has been an immediate reduction in annual tax liability of $37 500. This is an excellent turn around in tax and money has been put aside to ensure the machinery payments can always be met in the future. A low risk strategy.
Furthermore the interest earned on the $150 000 deposit say $6 000 can be used to offset the chattle mortgage interest on the equipment loan.
(8) Unforeseen events
What’s more the FMDs can be used as a form of financial insurance in relation to other unforeseen events on the farm. It’s always good to be able to access finance without having to borrow it from a bank.
The take home message is that farmers need to understand that cash is very important when it comes to risk management and income tax planning. Do not waste that cash on investing in assets that depreciate in value. Use other people’s money and match the cost, with the value that the asset provides to your business. At the same time do not spend the cash, place it aside as a provision for poor years.
FMDs provide this opportunity.
Furthermore when it comes to acquiring and funding the purchase of replacement and upgrade plant and equipment, FMDs are essential. None of our farmers have equipment finance without first ensuring they have back up FMD strategy in place.
One of the issues we don’t understand is that there are a lot of primary producers out there that do not have maximum FMDs, they pay excessive amounts of tax and have huge exposures to equipment finance.
These people need to rethink their strategy and take advantage of these low risk opportunities.
Purpose of an FMD strategy
- Delay tax on income to future years,
- valuable form of financial insurance to cover equipment purchases,
- provide flexible funding for operations,
- to act as a sinking fund to provide emergency funding for unforeseen events and planned events e.g. retirement funding, succession etc , and;
- an essential risk management tool.
Traditionally farm management has concentrated on the trading activity of farming to derive a profit. Farm managers and their advisers prepare budgets, balance sheets, enterprise gross margins and profit and losses.
We use all of these concepts and processes however one of the fundamental failings in this area of management is obtaining accurate meaningful reporting. Understanding how your business is performing and monitoring key financial performance indicators (KPI’s) is essential for informed decision making in any business.
In the world of finance, manufacturing, retail, hospitality, entertainment, mining, health in fact in every commercial and human sector in society, reporting and monitoring (KPI’s) have become the norm except for farming.
The question we need to ask as an industry is why?
Surely if there was ever an industry that needs accurate reporting and monitoring it should be primary production. We have pondered on this failing for many years. Maybe it relates to the ever changing environment in which the farm manufacturing operation takes place? No two seasons are the same? Unlike a hospital, hotel or a factory where the environment is relatively stable and controlled, farming involves dealing with the climate and living things. These factors are constantly changing.
The fact that you outlay large sums of money to achieve a result does not necessarily mean you are going to get the result that you expect. There is no doubt farmers can budget accurately for their expenditure but due to yield and commodity prices it is difficult to determine the net result or evaluate results over time.
Our view, on failure of the farm sector to accurately report performance and monitor KPI’s, is as a result of a fundamental breakdown in the role of the accountant coupled with the fact that farmers do not perceive that there is any value in the reports that accountants prepare in regards to management decision making.
Historically the accounting profession evolved to count things and to create meaningful informative reports, out of chaotic data, for informed decision making by business managers.
Unfortunately in more recent times the role of the rural accountant has been to prepare historical financial statements to arrive at a net assessable income to determine how much tax a farmer needs to pay.
These financial statements are usually accurate, being reconciled to underlying source documents such as bank and loan statements, tax invoices, finance contracts etc and have been prepared using generally accepted accounting principals.
Unfortunately due to their primary purpose being for tax, the financial statements (July to June) span two farm years (March to February) including the income of one farm year and the expenses of the next farm year.
Further to this there are all sorts of entries such as accelerated depreciation of plant and equipment, profit on sale, capital write offs etc all designed for tax that distort the true performance of the business. When it comes to the balance sheet or statement of affairs these are prepared on an historical cost basis and not a current market value basis.
The net result is that the financial reports are used for tax purposes and by financial institutions such as banks and equipment finance companies as a guide to the financial capacity of the business to service their borrowings.
When it comes to farmers, once the tax has been prepared and financial statements have been given to the bank, the financial reports go into the filing cabinet until the accountant says they can be destroyed.
Such a waste! As we all know the financial statements are accurate and that farmers pay a considerable amount to have them prepared.
So what reports do farmers commonly use?
(1) Cash flow budgets are common however they only provide an indication of future cash flow movements and do not take into account movements in asset and liability values.
(2) An annual balance sheet or statement of assets and liabilities is useful provided it is prepared at the same time each year say 1st March. This will provide an indication of the movement in net wealth from one year to the next however this statement fails to take into account cash flow movements and liquidity.
(3) Enterprise gross margins can be useful as an indicator of enterprise performance however they also fail to take into account other expenditures on business overheads, finance costs and movements of capital.
To further compound the issue normal tax accounting financial statements are designed for commercial accounting purposes and they fail to report key financial performance information in a format suitable for primary producers.
As we stated earlier financially managing a farm today involves a lot more than just decisions that relate to trading income and expenditure. There are a whole range of other receipts and expenditures such as accessing borrowed funds, expenditure on land and equipment acquisitions that are critical in the financial success of a farm business.
This information is often difficult to identify, determine and analyse using traditional financial statements.
The net result of all of this is that as an industry, farmers need a reporting system that provides them with the information they can, easily interpret and analyse, to assist them with informed decision making.
This is what we have developed with Active Ag Consulting Pty Ltd. A cloud based system to reconstitute traditional financial statements along with incorporating production data to produce visual information to assist farm management decision making into the 21st century. Visit our website www.activeagconsulting.com.au.
So what information do farmers need?
In developing our analysis reporting system we wanted to concentrate on the information that farmers really wanted to know and not what other people think they should know. Further to this we wanted the information to be accurate, visual and easy to interpret without too many words or complex tables.
The aim of our report is to outline to Farm Business Managers:
- The true trading surplus the business generates on a year in year out basis and how much is left over after:
a) Paying for non-negotiable payments or payment the business is committed to pay?
b) Paying for family drawings and personal expenditure?, and;
c) Paying for replacement and upgrade of equipment?
The final balance is the true net trading surplus that the farm business manager can use to expand the business, acquire other assets and reduce debt.
- Is the business spending too much or not enough on equipment replacement and upgrade?
Is the business over capitalised for its level of production? Are repairs and maintenance payments to high?
- Are equipment finance payments too high?
Is this placing the business at financial risk?
- Is the business value going up or down over time?
Are we achieving our goals?
- What is happening to debt levels?
Is our financial risk increasing or decreasing over time? Should we be considering an exit strategy?
- What other risks is the business exposed to: -
- e.g. Production Risk?
- Market Risk? etc
- How are our business enterprises performing in comparison with broad based regional averages?
Although we don’t encourage the use of benchmarks it is often good to have some idea as to how your business enterprises are performing in comparison with other producers. If you are well down on the average it may identify problems that can be addressed.
While developing our analysis and reporting program we recognised one essential feature of running a business and that is that the performance of the business is not always just about the trading performance of the business.
Business revolves around making financial decisions. Sourcing other forms of capital by way of borrowing, funds introduced, sale of assets etc and expenditure decisions on capital items, debt reduction etc.
Concentrating only on the trading side of the business e.g. trading income and expenditure can be misleading. Although essential for the growth and development of the business this area is not the only part of the business that mangers need information about.
Further to this is the true reason why we are all in business. Most people are in business to make money to spend on themselves and their family. This is their primary purpose, so having information on issues such as - How much are we spending in this area? Or how much can we spend? Are of vital importance to most business managers.
As a result our analysis expands in these areas. How are people using their natural, capital and labour resources? What is really going on?
There have been many times over the years where we have seen very successful farmers achieving great productive performance however their businesses fail. Alternatively we have seen other primary producers that have never returned a profit become very successful.
‘Why is this so?’
The modern farm business manager needs to know what is happening in their business and what the results are of various farm financial management decisions that they make in this process. It is unfortunate that there is a time delay between the decisions and the reporting however any report up to six months after the end of the financial year is better than no report at all.
Care also needs to be taken when it comes to focussing too much on the past. As one commentator says – “You can’t drive a car forward, if you are always looking in the rear vision mirror.” Never a truer statement however there is another saying – “It is difficult to know where you want to go to, if you don’t know where you are, or where you have come from.”
Our experience and research has indicated - when it comes to modern farm financial reporting very few mangers have any idea as to what is, and what has, actually gone on. On this basis it is our opinion that all farmers need to analyse and reflect on what has been going on for at least the last five years as a starting point to develop a forward plan.
Once they have some concept of how their business is really working and where they are currently positioned they can then make informed management decisions for the future and take corrective action where required.
It is going to be essential as we move into the 21st century for farmers to monitor their Key Performance Indicators and our program is designed to do this so farm business managers can monitor key trends and developments.
Armed with this information they can commence planning for the future. To this end we have developed a simple planning program to assist with all decisions required in running a business such as trading performance, sourcing additional capital, capital expenditure decisions, debt reduction, decisions in relation to plant & equipment acquisitions and decisions on family drawings etc.
Once managers have reviewed various options they can then drill down and prepare more detailed plans and budgets as required.
It’s our view when it comes to planning you need make a decision on the basic overall direction you want the business to go in prior to spending too much time on detailed plans and budgets.
Developing a planned equipment replacement and upgrade policy - Equifin
Replacing equipment is essential and inevitable. Size, scale, make and model is all important, however whether you can afford what you want, how you pay for it and the issues as to whether you make a profit or not determine whether you are going to survive in the long run. Other issues include production risk and efficiency. Both are absolutely critical in reducing overall farm risk and improving your bottom line.
So how do you know whether you can afford it or not and how much really should you be spending on this critical decision?
The first step is assessing your current position:
- What do you own and what’s it worth?
- Is it suitable for your scale of operations and level of production?
- How do you assess this?
- How old is it and when do you think it will need replacing?
- How much will this cost and when?
- How do you think you will pay for it and how will you finance it?
These are all critical financial decisions.
Well we see financial decisions in relation to farm equipment replacement and upgrade as often being ad hoc and poorly formulated.
Few people have an adequate replacement and upgrade policy despite the fact that these decisions are make or break decisions of significant financial impact.
We hear comments such as:
“We replace gear when it is worn out or we replace gear after good seasons because cash is available? Surely people have a better use for their cash than investing in depreciable plant?”
Some people have rules of thumb, harvesters get replace when the tyres wear out etc or we have to replace the tractor duals.
As financial advisers we see that outlays on equipment fluctuate over a period of years.
This cycle increases both financial risk and production risk.
What’s more the cycle today looks more like this: -
The question people have to ask: -“As the price of replacing equipment becomes higher are your profits increasing at the same rate?”
Answer is no.
So how do you get around this?:
(1) Firstly assessing where you are now, and secondly;
(2) by capital budgeting replacements:
- What needs to be replaced and when?
- How much is it likely to cost? and;
- How will you fund the purchase?
To do this you need software to enable calculations and to model scenarios – You need Equifin.
Equifin is an online software program developed by our firm to enable farmers to develop their own equipment replacement and upgrade capital budget and to evaluate various financing options. Visit: www.activeagconsulting.com.au.
What you are aiming to achieve by evaluating various finance options and planning for the future replacement of your equipment, is a regular consistent cash outlay comesurate with the scale of your operation and your level of production.
Experience has shown us that approaching your equipment purchasing decisions using software like this leads to:
(1) Improved Equipment – on a regular basis
- Replaced and upgraded in regards to technology
- Reduced production risk and increased efficiency, and
(2) Reduced financial risk with no peaks in outlay, efficient use of money and greater profitability.
(3) Coupled with FMD’s there should be no risk and reduced tax.
Self-managed superannuation funds
Although called Self Managed Superannuation Funds (SMSFs) they are rarely ‘self managed’ due to the complexity of their administration. You need an accountant, an independent auditor and a financial planner to assist you in their annual administration.
This comes at a cost. Cost for annual financial statements and tax return preparation, cost for compliance documentation and minutes, cost for audit and cost for financial advice. As a result of these annual expenses it is generally not worth setting one of these up until there is at least $200 000 in the fund. As the fund grows the costs decrease in proportion to level of investments under management.
What are family superannuation funds?
Contrary to belief SMSFs are not investments. They are structures in which to hold assets to fund your retirement, provide for a death benefit on your death and provide insurance benefits in the event that you suffer an accident, illness or death.
As a structure they appear very much like a family trust or deceased estate.
It is what the Trustee of the Superannuation fund invests its money in, that are the investments.
The Trustees, who are the same people as the members (a requirement for SMSF’s), have a wide discretion as to what they can invest in and this is why they are called Self Managed.
Trustees are required to draw up an investment strategy to take into account:
- Goals of the fund,
- investment diversification,
- planned investment earnings, and;
- risk Management etc.
In effect Trustees can invest in a wide range of assets e.g.:
- equities – Australian & International,
- business real property,
- residential rental property, and;
- other eligible assets.
When it comes to the administration of the fund the Superannuation Industry (Supervisory) Act 1993 the “SIS Act” and regulations and the Income Tax Assessment Act “ITAA” (1936 & 1997) and regulations stipulate specific rules for what Trustees and members can and can’t do.
Some of the main rules and regulations include:
- The sole purpose test.
- The in-house asset test.
- Prohibition on loans to members or associates.
Along with a range of other requirements. In reality what the Trustees and their members can do is generally fairly wide and provided the main aim is to provide for the retirement, insurance and death benefits of its members then you are ok.
The key to a good flexible Family Superannuation fund is its “trust deed.” Like family discretionary trusts the trust deed is the governing rules of the fund and it is this document that determines in line with the ITAA Act and SIS Act what can and can’t happen.
We recommend that people purchase a good deed with a separate Corporate Trustee and they ensure the deed is regularly updated. We also recommend that people obtain appropriate advice from qualified advisers. SMSF qualified strategists and financial planners.
What are the advantages of setting up a family superannuation fund?
A well-constructed SMSF can: -
(1) Provide a separate pool of investments or assets to independently fund retirement, provide insurance benefits and to provide for a benefit on the death of the member.
(2) They can also provide valuable tax concessions as follows: -
(a) People can obtain a tax deduction for making an eligible contribution to the fund. These are limited by contribution caps as follows: -
$ 30 000 p.a.
Subject to 15% Contributions Tax
Over age 49
30th June 2014
$ 35 000
Subject to 15% Contributions Tax
Non Concessional Contributions
(No Tax Benefit)
$ 180 000 p.a.
Or for people under Age 65
$ 540 000
For a 3 year period – No tax
In the event the taxpayer qualifies as a small business tax payer the following additional contributions can be made: -
15 Year SMB CGT Rollover
$1 355 000 per person
Life Time Limit – No Tax
SMB Retirement CGT Rollover
$ 500 000 per person
Life Time Limit – No Tax
(b) The income in the fund is concessionally taxed at a rate of 15% or less.
(c) When a member elects to take a pension the income on the assets funding the pension payments becomes tax free 0%.
(d) If the member is aged between ages 55 – 59 the pension is taxed at their marginal rate however they obtain a 15% pension rebate.
(e) Once you are over age 60 the pension is tax free and is not included in your assessable income. It is now is included in the pensioner’s adjusted taxable income for Centrelink purposes and eligibility for the Self Funded retiree’s health care card. This cuts out at $80 000 per couple.
(3) Superannuation funds can be used effectively in the process of business succession.
When an agreement is made that the family will contribute $xx amount of dollars to the fund and once an amount is arrived at, Mum & Dad sign over the farm to the next generation.
Alternatively we use the superannuation fund as a tax effective structure in which to accumulate wealth for the provision of non-farming children in the overall estate planning and business succession point of view.
(4) Superannuation funds can be used to pay income replacement stream and insurance benefits.
These can either be self-funded by the superannuation fund or the Trustee can own separate insurance policies in the super fund to fund member’s benefits. This is particularly important for people with young children or people who are conducting business.
The advantage of this is that the premium for the Life, TPD & income replacement insurance cover can become tax deductible.
(5) Superannuation funds are also very useful as a funding mechanism for the farm. Families can use the superannuation fund to replace the bank and we have a good example of how this can work shortly.
(6) Superannuation funds are also very important when it comes to estate planning.
The use of binding and non-binding death benefit nominations and SMSF wills is a great way for people to structure and manage their estate.
As a SMSF is a trust, it falls outside the Estate law provisions and as a result cannot be contested, if the trust deed and compliance documentation are correct.
Some examples of how Family Superannuation Funds can be used in a primary production setting include:
Build-up of off farm savings to pay for retirement of the older members of the family.
Build-up of Retirement Funds
The cash and investments can be used to fund retirement or acquire further assets such as business real property.
Acquiring and leasing business real property
Where business real property is acquired by the fund section 66 of the SIS Act allows the business to lease the asset.
As a result additional tax deductible contributions can be paid to the fund over and above the contribution caps.
If a member of the fund is drawing a pension the lease income in the fund is not subject to tax. Furthermore if the member is over age 60 their pension payment is tax free.
In effect this strategy has the ability to convert assessable farm income into tax free income.
Limited recourse borrowing arrangement (LRBA)
An LBRA is an arrangement where an SMSF borrows money to buy an asset (e.g. a property).
Sec 67A of the Superannuation Industry Supervision Act (SIS) stipulates that the asset that is acquired has to be a single acquirable asset. What this means is that there can only be one asset or class of assets.
The loan to the superannuation fund to acquire the asset can be from an independent party like a bank or can be from a related party e.g. the family trust. We usually use a combination of both. The loan security is limited to the amount borrowed with no other risk to superannuation assets hence the term limited recourse loan.
Sec 66 of the SIS Act allows trustees and members of an SMSF to acquire business real property from themselves, a related party or an independent party and it also allows the SMSF to lease this land to the member or related party. The aim is to speed up the acquisition process very much like when a young person borrows to acquire their first home.
Sec 67A also specifies the asset has to be held in what is termed a Security Holding Trust while the loan remains outstanding. There needs to be a separate security trust and loan for each asset e.g. title. Holding Trusts are also termed bare trusts because they have only one beneficiary and that is the SMSF.
Once the loan is repaid, the asset is automatically transferred from the holding trust to the SMSF.
The structure appears as follows: -
Obtaining a tax deduction by contributing assets in specie
Contributions in Specie
A contribution inspecie is where eligible property e.g. business real estate like a farm, listed equities or widely held trusts, to a specific market value, are transferred to the fund instead of cash.
The value can be claimed as a tax deduction up to the concessional contribution caps.
Accessing cash from the fund
In this situation the SMSF in effect pays cash for the assets. The assets are transferred to the fund and the cash is paid out to the business.
These funds can be used to acquire further assets or retire debt.
Example of acquiring business real Property
Step 1 – The Business Buys the Farm first using bank borrowings
Step 2 Super fund then buys the farm by creeping acquisition (overtime) or outright. Cash released repays the bank.
Step 3 – Business Pays Rent to Superannuation Fund
The benefits of these steps are outstanding
You can increase the level of contributions to the fund
They are now not only limited to:
(a) Contributions subject to caps, but also
(b) Lease rentals
This is great for young people wanting to increase their super contributions
The rent is tax deductible to the farm business and is concessionally taxed in the superannuation fund, and this is a great way to fund retiring members of the family
- The farm gets the tax deduction.
- The family superannuation fund receives the rent income.
- As Mum and Dad are on a pension and the fund pays no tax on the lease income.
- Finally Mum and Dad pay no tax on the pension they receive.
They can keep all of rent to pay their pension and daily living expenses. They can keep some money in the fund to accumulate funds to provide for other non-farming family members in the future – e.g. even up the estate.
They can draw the full amount tax free – live on some of the money and give some of the money back to the farm.
- By doing this Mum & Dad and the family superannuation fund in effect step in the shoes of the bank.
- The family becomes Self funding.
- Why pay interest to the bank. Isn’t it better to pay the interest into the family superannuation fund?
- The downside of course of putting a farm into the superannuation fund is that it can’t be used a security for borrowings.
- The upside of course is that it is protected.
Development to off farm assets
These can be:
(c) Cash – FMD’s , or
(d) Other assets
Research has shown that the most successful 5% of primary producers all have a disproportionally high level of off farm assets when compared with the average Australian farmer.
Let’s look at some examples of how these assets can benefit a farm operation.
- We have had clients in the past that buy shares – Blue Chip – BHP, Wesfarmers, Bank shares etc
- Over a period of years by making regular contributions they can build these portfolios up let’s say $250 000.
- A bad year comes along or they wish to acquire a tractor for $100 000.
(1) They sell the shares to buy the asset, and pay capital gains tax (CGT) if the shares have gone up in value, or
(2) They lend against the shares borrowing $100 000 against the $250 000 in equity at a gearing ratio of 40%.
The benefits of option (2) is that:
(1) They get to keep the shares, the dividend income, the tax credits and the future capital growth.
(2) They avoid the CGT on the sale of the shares, and
(3) They get to use the equity in cash to buy their tractor.
I have seen people run farm overdrafts against a share portfolio. What could be better than to make money, knowing that your shares are earning tax effective income and capital, while you are using the equity in your farm business to grow crops. At the end of the year you repay the margin loan out of crop proceeds. If the year fails just sell the shares and pay out the debt. What have you got to lose?
Alternatively after building up your share portfolio you can transfer some of the shares as a contribution inspecie to your family superannuation fund as a tax deduction.
In doing this you:
(1) Wash out the CGT with a super deduction,
(2) Claim the balance of the equity as a tax deduction against current year income, and
(3) You get to keep the shares in a concessionally taxed environment.
One of the main issues facing many farm families that wish to hand their farm over to the next generation is retirement housing. It always seems that retirement housing is left to the last minute. Why?
All farming businesses should go out and secure a housing loan and buy a rental property. The rent on the house will assist with repaying the debt and the negative cash flow can be used as a valuable tax deduction. When the retiring people decide to leave the farm they can move into the property, or sell it and build a new home.
By buying the asset early they have a stake in the housing market, which if house values go up and it always seems to go up, their asset value will go up, so that the changeover figure is less in the future.
Surely this is only common sense for people who know their children will take over running and owning the farm business in the future.
Purpose of developing off farm assets?
(1) Like FMD’s they are a valuable form of financial insurance,
(2) They provide choice and flexibility in the future with regard to succession, retirement funding and housing , and estate planning
(3) They can be structured to reduce tax via negative gearing ,and
(4) It’s another way to use the equity in your property to diversify your income streams and investments to reduce the family farm’s financial risk.
A succession plan
When does succession occur?
The transfer of a person’s control and ownership over business assets can occur in two circumstances:
(1) Planned succession as a result of the gradual or complete retirement of one of the main principals or key family members from the family business, and
(2) Unplanned succession as a result of illness, injury, accident or death of one of the main principals or key family members.
Every family has to have a contingency plan for unplanned succession along with a flexible forward plan for planned succession.
This plan should cover:
- How you intend to hand over control
- When is this likely and what’s going to trigger this
- To what extent is control handed over
- To whom is the asset going to be handed to.
- How are you going to protect the family wealth?
- How is this going to affect your Estate Plans? And
- In the event of unplanned succession in regards to one of the key family members as a result of injury, illness, accident and death how is the plan going to be funded.
The Relationship between succession planning and estate planning
There is a very close relationship between succession planning and estate planning. Often when people are developing their succession plans they are also organising their estate plans at the same time. Both involve the transfer of equity or control over equity from one person to another. The only difference really is that succession planning occurs while you are alive and estate planning involves dealing with your assets and control over those assets when you die. A good succession plan will incorporate your estate plans.
To implement a successful succession plan for the family you need: -
(1) Family trusts to operate the business and to hold assets,
(2) A family superannuation fund,
(3) Insurance, to fund debt reduction and equity payouts and
(4) A carefully structured family succession agreement
A family succession agreement is essential for all multigenerational and multi-sibling families especially where there are young wives, husbands and children.
The main reason is because of the use of family trusts and superannuation funds. When you use these structures no one owns anything other than control over the assets. This can leave the partners and the children of family members in a vulnerable position as their partner does not own any specific assets. The assets are owned by the family collectively.
The family succession agreement should acknowledge this and provide guidance to the family, in the event of death or permanent and total disability in regards to:
(a) What the family wants to achieve if this were to occur e.g. repayment of debt, payout of equity etc.
(b) How the financial interests of the party involved are going to be determined.
(c) How the family intend to meet these commitments. This may be by transfer of property, insurance or cash payment.
Purpose of this strategy
- Protect all of the family in the event of a major trauma, accident or death,
- provide for debt reduction to reduce financial risk,
- provide a process and funding mechanism for equity payouts,
- provide for the insured’s personal family, and;
- provide certainty for the family in the future.
Everyone needs to have an estate plan to ensure that their wishes are adhered to when they die or they lose mental capacity and that their beneficiaries are looked after as they desire. A good estate plan incorporates a range of different estate documents to cover situations where you lose mental capacity and when you die.
Estate documents that are important when you lose mental capacity are called “Living Wills.”
These documents are important because once a person loses their mental capacity they can no longer make decisions or execute documents on their own. Further to this they cannot act as a company director or trustee.
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