Legal Tip 308: How can a Company or Trust pay for Loans with Negative Income?

When a newly set up trust or company invests in property there is often a negative income. The expenses are more than the rents, especially in the early years.

When this happens the person behind the trust or company should not just be using their money to pay the loan or chip in the short fall. This will have 4 issues

a) Reduces asset protection as it develops a resulting trust relationship

b) Creates an estate planning mess

c) Will result in debt recycling in reverse – it diverts income from the payment of the persons’ personal debt, which in turn creates

d) Adverse tax issues


What should be done is that a loan is made to the trustee or the company. Where the person has other debt legal advice should be sought on the rate of interest to be charged. All loans should be under a written loan agreement with extra care taken on the terms of that agreement where the person will be borrowing and onlending to the trustee or company (debt recycling!).

Where the individual is fearful of bankruptcy they might even want to make a gift to the trust rather than loaning the money. But this has a lot of legal implications so legal advice should be sought.


Example

Homer sets up a company to buy property. He lends it the deposit and it borrows the rest from a bank. The company still has a $500 per month shortfall.

Homer just chucks in $500 from his home loan offset per month.

This means Homer is debt recycling in reverse – the interest on his home loan is increasing and this is not deductible. When Homer wants to get the money back in the future he will be taxed on the money as it would be deemed income if it is not a loan.

When Homer dies he will have less assets to leave to his kids plus it would be complicated with the executor legally bound to sue the company to try to recover the money.

If Homer became bankrupt the trustee in bankruptcy would also likely sue the company to try to recover the money.

 

Cheers Terry, just came from the discussion on the tax tip 89 thread.

In your above quote,
what are some options Homer has if he borrowed from the bank on a 30yr loan term with his house as security, and on lent the funds to the trust/company,

1. Is Homer able to charge the trust the same amount of interest as the bank is charging him even though the homer-trust loan is not secured by property?

2. Can the Homer-trust loan term be 30yrs?

Apologies if these questions were already answered, there are some similar threads with lots of good info.

 

Homer would have a lot of options.
If he wants to claim the interest on his loan and wants the trust to claim interest on its loan then a proper writing loan contract is needed on commercial terms. I have done a private ruling for someone and for them the ATO allowed the same interest rate with no security for the loan.

 

Yes where they are no schemey elements the ATO accept that a personal borrowing capacity refinanced as a loan to a entity is a commonplace arrangement to assist things like investment. So things like one leg being unsecured arent subect to a arms length exclusion. But fatal where there is no loan documentation or evident transactions paid by the entity. ie substance and form of the loan must be maintained. Compounding, deferral and loan back arrangements etc and similiar all best avoided.

Wise to confirm arrangements with a binding ruling. The ATO process is pretty simple and for a savvy taxpayer they can DIY or invest extra and have a legal or tax adviser assist.

 

Thank you Paul and Terry, I will explore private ruling but looking like I could at least get started with a correct agreement in place, also found this on the ATO community forum, and they pretty much confirmed the same thing about it being at arm's length.

Answered: Re-loaning from individual to a trustee of discret... - ATO Community

 

wow what a terrible response from the ATO.

There is a fundamental legal error in that example - which is not for the ATO to point out - but their answer in regards to the tax side is pretty off too. I had a private ruling done for a client lending to the corporate trustee at the same rate as their loan from the bank, under a written loan agreement, prepared by another lawyer, not be, and the ATO come back and said the interest on that would not be deductible to either the persons or the trust.

 

If Homer decided he wanted the corporate trustee to use the trust's earned income to pay some extra amounts towards the trust's debt, rather than make distributions for a few years, who pays the tax on these extra amounts, they would get treated the same as the principal portion, but would it be taxed at the C/trustee rate?

And how would that look like in the trust's tax return?

 

Are you saying the trust will repay some of this debts?
Where does the trust get the money to pay this?

If income then the income will still be taxed. If no beneficiary is presently entitled to the income the trustee would be taxed at the top marginal tax rate.

 

If it was a DT with corp trustee, there would be no beneficiary entitled to income unless trustee decides to distribute correct?

In above example, let's say the trust had a standard homeloan for property it purchased and rents out. it generates positive cashflow and the trustee decides to put those earnings on the homeloan as extra repayments rather than to distribute.
1. if trustee puts an extra $10k on the loan, he would then owe the tax man 3k?

2. Would this 3k just come from trust earnings?

3. Would this cause the corporate trustee the need to now do its own tax return in addition to the trust return?

Hope that all makes sense.

 

If it was a DT with corp trustee, there would be no beneficiary entitled to income unless trustee decides to distribute correct?
That would depend on the terms of the deed.

1. The trustee would owe $4500 extra tax as they would be taxed at 45% on the $10k if it was not made presently entitled to a beneficiary. Assuming the $10k comes from the positive rent.

2. It would have to come from the corpus of the trust

3. no, the trust's tax return.

This seems to confuse people but its very much the same as if you owned a property and generated $10k positive income. If you paid this into the loan to reduce your debt the $10k is still income.

 

See
Tax Tip 308: Trusts, Profits used to reduce debt and Tax

 

But for a corporate trustee it would be 30%, not 45%?

Haven't heard that one, will read up on it though, so basically that $10 you start a trust with would be considered corpus and doesn't need to be distributed?

Thank you for explaining those other points Terry.

 

No. You are confusing company tax and trustee tax.

 

Yes and any other gifts or even depreciation amounts.

 

Yep, I think I'm understanding now, would it be correct to say that if the trust was making repayments on a P&I loan, - the accounting would generally reflect the interest portion coming from the trust's earned income, and the principal portion coming from the corpus?

If there is not enough funds in Corpus, the trust could use the earned income, granted it distributes the same amount on paper to the beneficiary, that beneficiary could then 'gift' the trust the same amount on paper to settle the matter. Otherwise a UPE is recorded, which I take it kind of like an IOU from the trust, and subject to creditors etc as you mentioned in your new tax tip.

 

I don't know anything about accounting, but that would probably be how it would be recorded.

If a trust pays the principal with income it would have a debt to the person who missed out on that income. This would be a UPE in the first instance but could be converted into a loan or forgiven etc