07 – Start with the end in mind

My old friend

I lunched recently with an old friend. He is a Dover adviser. Our paths first crossed in 1986 when I presented at a National Mutual conference for business insurance experts. He was there.

The Agent Wars were raging. No expense was spared. Interstate advisers were flown business class to Melbourne Airport and by helicopter to Sorrento, on Victoria’s Mornington Peninsula. It was then but a short limo ride to the convention centre…. It was all about getting big. Bigger than the AMP.

I can recall my friend’s skepticism. He saw it for what it was, smoke and mirrors, and stayed focused on the main game of developing a real financial planning practice, that skipped the hype, and aimed for real thirty year relationships with his clients. Where he was their trusted adviser and their first port of call on all matters financial.

He explained his own business and wealth accumulation strategy was to:

  • build up a great CGT free practice in a tax efficient family trust
  • own his own great CGT free practice premises in another family trust
  • invest in a tax-free home in Sydney
  • pay maximum deductible super contributions each year for himself and his wife and
  • invest in tax efficient long term investments owned in tax efficient structures.

The tax efficient long term investments were franked blue chip Australian shares and properties. It was a never sell strategy, which meant he would never pay CGT. Simple.

He was not interested in international shares: they do not generate franking credits and therefore in the long run, ie over the decades, will almost certainly under-perform similar Australian shares.

Now, thirty years on his strategy is complete. He and his wife are worth more than $10,000,000, have a seven digit income and pay a low effective rate of tax. My friend understands the role tax planning has played: minimizing tax has maximized after tax returns and has maximized long term growth. Its as simple as compound interest.

His assets profile and his tax profile

His assets look like this:

  Value Owner CGT status Income tax status
Business $3,000,000 Family trust 1 CGT free Efficient
Business premises $2,000,000 Family trust 2 CGT free Efficient
Home $2,000,000 Spouse CGT free Income tax free
SMSF $3,000,000 Self and spouse CGT free Income tax free
Total $10,000,000      

He started his practice from scratch. It was owned by a family trust from day one, which is the most tax efficient way to own a practice: renewal commissions were distributed to lower tax rate family members. Cash was used to pay off the Manly home as fast as possible, to avoid non-deductible debt. Maximum super contributions were paid each year for both my friend and his wife, usually in equal monthly instalments using the business’ line of credit (to keep cash for the home loan strategy). The SMSF invested in franked shares, and did not sell one share until the tax free pension started at age 60.

His tax profile is very efficient. It looks like this:

  Income Capital gain Total income Income tax CGT Total tax
Business $600,000 $200,000 $800,000 $180,000 Nil $180,000
Business premises $150,000 $100,000 $250,000 $50,000 Nil $50,000
Home Nil $100,000 $100,000 Nil Nil  
SMSF $150,000 $150,000 $300,000 Nil Nil  
  $900,000 $550,000 $1,450,000 $230,000  Nil $230,000

My friend has set up his affairs so he pays the least amount of tax legally possible. He has done it all by the book. His income including unrealized capital gains is $1,450,000 a year and he pays tax of $230,000 or about 16%. This is tax efficient. But it will get even more tax efficient in the future once he sells his practice. Most of the tax is paid by a private company at 30%, and once my friend and his spouse sell the business this company will start to pay franked dividends.

This means he and his spouse will in effect get a refund of the tax they paid in previous years.

The first lesson is

The first lesson is follow the ideas set out in this e-book and you will achieve an efficient tax profile where you pay the least amount of tax possible. This is because you are taking full advantage of the concessions built into our tax system, including:

  • the ability to share business income and investment income between family members and related companies and trusts using trust based structures
  • the small business CGT concessions for businesses and business premises
  • the tax concessions for superannuation
  • the tax concessions for the family home and
  • the fact that unrealized capital gains are not taxed, ie the taxing point is deferred until and if the asset is disposed.

The second lesson is

The second lesson is if you must pay tax pay it in a private company.

The franking credit protocols mean there is a good chance you will be able to claim a credit back in the future, probably triggering a refund of most if not all the tax previously paid by your private company.

This is an important point, and one that is not well understood by many tax advisers. If you pay tax individually or in a SMSF its gone once its paid. Its a once and for all assessment. You do not get any back if you have a lower income in later years. But its different if you pay tax in a company. Its not a once and for all assessment. You get a franking credit. If a shareholder (or in the case of a family trust shareholder, a beneficiary) has a low tax rate in a later year you can pay a fully franked dividend and achieve a refund of all or part of the tax paid previously by the company.

In summary, the franking credit protocols allow you to achieve greater tax efficiency over time.

Further relevant reading

You can read further on tax efficient investing here: The Dover Way. Tax Efficient Investing.

You can read further on tax planning for financial planners here: The Dover Way. Tax Planning for Financial Planners.

The Dover Group