In Part 1 of the Great Australian Nightmare I alluded that those people growing a small business and creating at least $200,000 in family profit should NOT pay off their private home mortgage and instead invest the money into other growth assets. By doing this you can save upwards of 20% per annum via the correct tax structure. This is all smart, legal, structured advice and you need to trust your Tax Advisor.
I will now outline two clients of ours at Paris Financial that show this advice being adhered to and not adhered to. Our first client is Jenny and Craig. They were running a hugely profitable small business that was distributing $800,000 in taxable profit per year. They had a nice house in Doncaster, Melbourne with a decent size mortgage. The business was inherited when Jenny’s father died. Within three years of Jenny’s father passing, they quickly went from earning a reasonable salary each and a small profit distribution to earning $800,000 and owning the business themselves. My advice to Jenny and Craig was to setup an investment trust and pour all their free cash into that trust. I outlined the tax savings to the couple and how the cash flow would work. All very manageable. However, it required them to NOT pay off their private Mortgage in Doncaster. They listened to the advice, but the “Great Australian Dream” in their minds was far too strong.
So, Jenny and Craig paid themselves $400,000 each per year, sent huge amounts of tax to the ATO and quickly paid off their private mortgage in Doncaster. After that was paid off, their business continued to thrive and they set their sights on a large piece of land in Lysterfield. Their next goal was to build their dream home with a pool and tennis court. They took out another big loan with the bank, built their dream home, moved in and aggressively paid back this next loan. There they were in their dream home, with a pool, tennis court, their brood of kids and Mortgage free. What a dream!!!. I kid you not, the year after they settled in Lysterfield was 2008, the Global Financial Crisis hit and their business profits were cut in half. Jenny and Craig started receiving $400,000 per year rather than $800,000 and so they were hardly on the breadline but their belts were just starting to tighten. From there, their business started to suffer due to the advancement of technology and their income kept dropping progressively each year. Jenny and Craig then needed to sell Lysterfield to keep the business afloat and then moved the family back to their house in Doncaster that they had kept as an investment property. The business continued to get overridden by a combination of new players in the market and technology. Eventually the business needed to be put into voluntary liquidation and the couple had to go back to being salaried employees.
By chasing the Great Australian Dream this couple cost themselves over $900,000 in extra tax by paying back private mortgages! When their business faced tough times and eventually went under they had no assets left. If they had taken some complex but smart tax advice all those years ago their business would still have gone under but they would not have lost everything. Jenny and Craig would have had significant investments in an investment trust and a “paper gold” franking account. Jenny and Craig, or dumb and dumber, as I like to affectionately call them lived the Great Australian Nightmare.
In contrast, our other example client Gloria and Marshall listened to complex tax advice, understanding it to a point but then trusting their tax advisor. Gloria was the business driver in their relationship and Marshall was the silent partner doing the bookwork for Gloria’s business. Gloria went into business on her 48th birthday, a superb time to open your own business. This is a time when you have learnt all your industry lessons, have long standing contacts and relationships; we find people of this age do exceptionally well in small business. Gloria was no exception. She opened a real estate agency and smashed it. For the next 6 years she grew the business from nothing to three branches and a value of $1million. During those 5 years she still had a private mortgage but under our instruction she did not pay it off. Instead, she put her free cash into other investments and built the business. Then, at the age of 54 Marshall was diagnosed with a terminal illness. The business was sold for $1million while Gloria and Marshall moved to a warmer climate to help Marshall with his relaxation and health management strategy.
The couple paid $0 tax on the sale of the business, then extinguished their private mortgage of $290,000. The remaining $710,000 left from the sale of their business together with the proceeds from the sale of their house and their other investments, were kept for their new life in Queensland – relaxing in early retirement and looking after Marshall. For the next few years Gloria and Marshall lived off their investments and also took advantage of their “paper gold” franking account. They would not have access to that franking account if they paid off their private mortgage. Marshall lived for another 5 years in relative tranquillity and Gloria continues to benefit from the most tax effective strategy for a growing small business.
So, DO NOT live the Great Australian Dream if you are in business because it can turn out to be a nightmare and you pay far too much tax.
P.S. Names of those in this article are not their real names to protect their identities and their body weight.
Pat Mannix, Partner, Paris Financial