Don’t risk it for a biscuit

Friday, 1 April, 2011

Most people go into business knowing they will face risks. Many of these will be within their control but others will be outside.

Most people go into business knowing they will face risks.  Many of these will be within their control but others will be outside their control, as so tragically experienced recently by those affected by natural disasters.

Prudent business owners establish risk mitigation measures to protect their business, such as; internal controls to guard against fraud, retention of title clauses on sale of products, insurance policies, careful budgeting and forecasting and timely management reports.

Prudent business owners also establish risk mitigation measures to protect themselves and their family's assets, such as; directors and officers insurance, a limited liability legal structure, shareholders agreements and alienation of personal assets.

Prudent people going into business seek professional advice in regard to their exposures and how to protect themselves.  The following is based on a true story about what can happen if you don't seek or heed professional advice and how you can find yourself exposed to business risks without even realising you are conducting a business.

Jenny and Joe are a married couple.  Joe works as a marketing manager for an international company.  Joe and Jenny had saved some money and sought advice on how to invest it.  Their accountant suggested they set up a family discretionary trust and invest the funds through that structure.  Joe was reluctant to spend a lot of money on the structure and his accountant agreed that it was not necessary to establish a corporate trustee for the trust.  Accordingly the trust was established with Joe and Jenny as trustees and it acquired some listed shares and term deposits.

Jenny has a brother Harry and sister Celia who owned and operated a restaurant.  On the advice of their accountant they had each established a discretionary trust, with companies as trustees, which formed a partnership to operate the business.  Their accountant explained that this structure allowed them to take advantage of all the capital gains tax concessions.  Harry and Celia invested all the funds they had, and could personally borrow, in their restaurant, spending large amounts on a lavish fitout.

Despite having reasonable patronage the restaurant could not generate sufficient income to cover the overheads and service the debts to the bank.  As a result, the business fell behind in payment of its rent and PAYG withholding remittances.  Harry and Celia asked Joe and Jenny if they would be interested in becoming investors in the business.  Joe and Jenny loved the restaurant and were happy to invest some of their funds.  Harry and Celia explained that they operated the business as a partnership of discretionary trusts because it provided the maximum tax benefits.  Joe and Jenny were happy for their trust to become the third partner.  (You can probably now see where this is going.)

The restaurant's debts continued to grow until ultimately the bank took action.  Harry and Celia became bankrupt and the taxation office and landlord sued the partners of the business for the unpaid PAYG withholding and rent.

As partners, the trustees of the three discretionary trusts were jointly and severally liable for the debts of the business.  Harry's and Celia's trusts had company trustees which had no assets other than $12 of issued capital.  However Joe and Jenny were still the individual trustees of their trust and were therefore personally liable for the debts of the trust.  As a result, the full burden of the business debts fell on them as the only partner with assets.

In order to avoid bankruptcy Joe and Jenny had to sell the trust's investments, which partially covered the debts, and the Taxation Office garnisheed Joe's salary to discharge the remaining PAYG withholding debt.

Joe and Jenny were supposed to be just silent partners, simply investors, but because of careless structuring they virtually lost everything.

This could have so easily have been avoided if:-

they had sought professional advice when they decided to invest some of their trust money in the family business;
they had formed a new trust to invest in the restaurant, rather than the trust that held all their savings;
their accountant had made it clear that an individual trustee was only ever appropriate when investing in passive investments;
they had understood that joining a partnership was not a passive investment; and
Harry and Celia had been less deluded by the glamour of having their own restaurant and more focussed on the banal but critical aspects of their business plan, like budgeting.

Basically, risk mitigation is about having strategies to deal with the "what if's" - thinking about the worst that can happen and protecting yourself against it.  Not assuming that ‘she'll be right' but rather making sure you understand what could possibly go wrong even if that means you have to pay for some advice.

For Joe and Jenny, saving a few hundred dollars on some professional advice and a trustee company ended up costing them their life's savings and a large part of Joe's income.

Time to have fun

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