08 – The small business capital gains tax concessions

Step 1 in creating a tax efficient profile for your practice is to understand that almost all capital gains on the sale of a small to medium sized financial planning practice are CGT free.

This is not a tax loophole. Its deliberate tax policy, and is designed to encourage small and medium sized business people. Small businesses as a group are the largest employers in Australia, and a vital part of the Australian economy.

This is one of the reasons why building up a business is the best investment that will present to both you and your clients.

You can read the ATO materials on the small business capital gains tax concessions here: ATO Guide to the small business capital gains tax concessions.

An interesting example: the sale of Kathy’s practice

Kathy started a solo risk insurance practice with a $100,000 investment in 2005. Its gross income was $218,000 in 2015, including trailer commissions. Kathy enjoys a pristine reputation for professional propriety, compliance and good service with both her AFSL and her clients. It’s a great practice.

Kathy attributes this greatness to Dover’s support and in particular its requirement for all SOAs to be reviewed by MLA Lawyers before they go to clients. This is particularly helpful for solo practitioners without convenient peer support. It’s a free second opinion. To be frank Kathy cannot believe that every AFSL does not read and check every SOA before it is sent to the client, but that’s another story.

Kathy’s practice is owned by a family trust. She has been distributing the net income connected to first year commissions to herself in accordance with income tax rulings IT 2369 and the net income connected to renewal commissions has been distributed to lower tax rate family members in line with common industry practice, as exemplified by the ATO in Private binding ruling 34668 2004.

Kathy’s practice is valued at 2.75 times gross income, ie about $600,000.

(You can read an erudite paper by Wes McMaster on financial planning practice valuations here: Valuing your financial planning business. It’s fair to say that a multiple of between two and three times gross income is a rule of thumb for valuing financial planning practices. This is a  favorable valuation base compared to other business sectors, which would usually be valued at less than three times maintainable future earnings. There is some evidence that practice values are falling as a result of the 2015 LIF commission reforms.)

Kathy was concerned about the 2015 LIF commission cuts and reforms and the future of solo risk insurance specialized financial planning practices. She had read Dover’s Fifty ideas to take your risk insurance practice from good to great and understood that the net cash flow, profitability and goodwill value of her practice would fall from 1 July 2016 and would plummet from 1 July 2018.

She decided that she would be better off selling her practice, investing the sale proceeds in a mix of Australian shares and property, and starting a new general fee for service financial planning practice that would be less damaged by the LIF commission cuts and reforms.

Kathy’s cost base is $100,000 so her capital gain is $500,000.

The three CGT concessions

Kathy’s $500,000 capital gain is subject to three separate capital gains tax concessions, being the 50% discount that applies to all assets, the active asset exemption and the rollover exemption. Their combined effect is cumulative, and in summary, this means no CGT is payable on Kathy’s capital gain.

Kathy’s CGT computation is tabulated here:

Sale price

$600,000

Cost base

$100,000

Capital gain

$500,000

Other capital gains and losses

Nil

Net capital gain

$500,000

50% discount

$250,000

 

$250,00

Active asset discount (50%)

$125,000

 

$125,000

Rollover to super fund

$125,000

Net capital gain

Nil

Kathy invested her CGT free $500,000 in a mix of Australian shares and property trusts ($125,000 in her SMSF after the rollover).  

She expects to earn a long term (ie 20 year average) of about 9% a year, or $540,000, as reported over the last 20 years in the Russell ASX Long Term Investment Report. Kathy knows she is in for a bumpy and chaotic ride in any one year, but expects in the long term her investment returns will revert to their 20 year averages, as predicted by the Morningstar charts reviewed and explained in our Friday Reflection Smell the Serenity published in mid-December 2015.

Kathy’s day-to-day efforts are now focussed on starting a new multi-service and fee for service financial planning practice.

How much is $500,000 CGT free?

The average Australian was worth about $330,000 in 2015[1], and this is the third highest average wealth level in the world.

$500,000 CGT-free is a lot of money.

This explains why we believe buying or starting a small business with a view to selling it at a CGT free capital gain is one of the best investment strategies available to you both you and your clients.

Starting or buying a small business should be on the checklist for discussion with every client, and you should regularly remind your clients of this option.

What other CGT free or concessional CGT assets are available?

The Dover Group