45 – Financing your practice

Its common for an adviser to be servicing a large non-deductible debt such as a home loan.

Here, with careful management of the business’s cash flow, the adviser can accelerate the re-payment of expensive non-deductible debt. The idea is to borrow to pay all deductible business outgoings so  the cash flow from the practice increases.

The adviser then uses the increased cash flow to repay the home loan.

This process is particularly rapid in the two years following a change from an employment to a practice trust, if applicable, as the financial planner switches from the PAYGW system to the PAYGI system, and enjoys a tax payment holiday for up to 22 months.

Once the non-deductible debt is paid off, the deductible debt should be paid off too.  

Interest should not be capitalized. That is, it should be paid as and when it is due.

A diagram may help illustrate how this idea works. The blue lines show the movement of cash through the practice and the red line shows the movement of debt through the practice.

recommended-debt-cashflow-structure-for-one-owner-practice-business

How much does this save?

If, for example, the  home loan started off at, say, $200,000, and the interest rate is 5%, then at a marginal tax rate of 47% this strategy saves the adviser $4,700 (ie $200,000 times 5% times 47%) cash each year. 

If the $4,700 cash saving is used to pay back the loan then, ignoring the other scheduled principal repayments, the loan will be paid off in about 20 years. Such is the power of compound interest.

Limits on deductibility

The amount of the deductible debt should be limited to the reasonable working capital needs of the practice, and clearly connected to to the business’s deductible outgoings. 

Interest on debt that exceeds the reasonable working capital needs of the practice will not be tax deductible.

A practical example: coffee and banana cake

I was chatting with an adviser over a coffee. I was impressed to hear how he had grown his fee for service practice. Spooked by the LIF, he widened the range of services, engaged with his existing clients and was marketed actively to new clients. It was working. He knew it had to: the LIF commission cuts were going to smash his profitability and practice value if he did not do something quick.

You can read about the LIF commission cuts and their effect on practice profits and values here: Fifty Ideas To Take Your Risk Practice From Good to Great.

He commented that he was building up $200,000 cash to buy a small risk practice. Buying an insurance register can be a good move, because you get what you pay for, and you can offer a wider range of services to the new clients. It can be two for the price of one. A great return on investment.

I asked why? I mean, why pay cash? Why not borrow to buy the risk practice and use the cash to pay off his home loan?

He agreed immediately. It was a good idea. We kept talking. The good idea got better.

Could he borrow to buy new plant and equipment? And to maximise cash drawings so he can pay even more off his home loan? Yes, he can.

Could he borrow $60,000 to pay two lots of maximal super contributions as 30 June comes closer? One for himself and one for his employee wife. And use his cash to pay off even more home loan? Yes, he can, provided he is an employee, which he was. (The position is different for personal contributions.)

This was a particularly good strategy as the contributions generated an immediate tax benefit of $15,000 cash, ie $60,000 times (40% less 15%).

This is a great way to start any new investment: a virtually nil after tax interest rate on the borrowing side of the card, and a concessionally taxed income stream on the investment side of the card.

Borrowing to pay deductible employee super contributions is a great investment strategy. You can read about it here: Borrowing to pay super contributions.

Happily the practice was owned by a trust, not a company. This is one of the great advantages of a trust over a company. It meant cash could be taken out without triggering a tax charge. He could easily move the cash out to his wife who would then pay off the home loan. The home and the home loan were in her name for asset protection purposes.

I ordered banana cake and another coffee, and left the tab for adviser to pay.

Further reading

The Dover Way includes extensive materials on managing debt and you can read it here: Debt management and borrowing to invest.

The Dover Way also includes extensive materials explaining simple gearing strategies and more advanced gearing strategies. You can read about these here: Tax effective strategies.

The Dover Group