Legal Tip 126: Structuring a development Part I

Structuring a development


When developing land and building there are many things to consider when structuring. There is no one answer to how best set things up as there will be too many variables.


Developing tends to be very risky. Risks can come from several areas some of which are:

- Cash flow crisis, often caused by delays
- Falling values
- Poor workmanship
- Injury

Having a company own the land can provide a barrier between the development and the persons behind it. Companies limit liability. For example, there may be a dispute with the builder. If it ends up in court it would be far better for the company to be suing the builder than yourself.

Structuring the company is important too. Banks, and others want personal guarantees, usually from all directors and sometimes from shareholders as well. To limit the risk of your personal assets being exposes you would want to limit the number of directors and who the director(s) will be – hopefully, you had previously structuring your personal affairs so you own little personally.

Should the company own as Trustee or in its own right? This also depends on a few things. Are you planning to sell or keep? Which state is the land located in?

If you intend to keep then you will need to worry about land tax issues. Land tax law varies from state to state.

If you will sell, land tax is less of an issue because it may only be a one-off event.

Developing is usually taxed as revenue rather than capital gains. So there will be no 50% CGT discount available. The biggest drawback of a company is the lack of the 50% CGT discount, but that won’t apply here anyway. Companies have another advantage of being able to retain income, pay 30% tax and then pay the tax out as a dividend at a later date. This could be timed to when the beneficiaries are on a low income so there could be tax savings or even tax refunds from the franking credits.

The shares of the company should be owned by the trustee of a discretionary trust for both asset protection and tax minimisation.

If a trust owns the development then the profits can be distributed to a bucket company and retained in a similar fashion. For this reason, a trust is generally preferred as it adds the additional possibility that it can bypass the company and pay a beneficiary directly. The advantage of a trust is that income retains its character. So income comes out as income to the beneficiaries, capital gains as capital gains (if there were any). But a company transforms income into dividends – which have different tax consequences sometimes. An example would be if there was a capital gain in a trust this could be distributed to a beneficiary who had a capital loss so that the loss could offset the gain. However when a company has a capital gain it would come out as a dividend, and not a capital gain, so it could not be offset by the loss. This is not such an issue with developing, but it could be if the property is retained and held onto.

Either way, you might have a large profit which may end up, in part at least, into a company. Getting it out can be a problem as it will mean tax is payable. Borrowing it from the company can also cause it to be deemed as a dividend and tax to be payable – or a high rate of interest would need to be charged by the company.

One way around this is for the next development to be done using the cash in the company.

The same company that holds the cash should not do the next development because of asset protection reasons. A new company should be set up and company A should lend company B the money to get started. A written loan agreement should be entered into and ideally a mortgage be taken over the land of the second project (behind the bank). This way if the second project fails company A would be a secured creditor and would take priority over unsecured creditors.

Similar to the first project. Funds will be needed to kick it off. These funds can be lent by a related party family member who can take security behind the bank.

Where there are more than 1 group of people doing the development then there are other issues to consider. A discretionary trust would not work because there would be no guarantee the profits would be split evenly (being at the trustee’s discretion).

Two groups could structure in the following ways:
- Company with 2 separate discretionary trusts owning shares,
- 2 discretionary trusts with company trustees owning the land as tenants in common,
- A unit trust with company as trustee and 2 separate discretionary trusts owning the units,
- One group just lending money and not taking an ownership interest.

The unit trust can work better than a company in some instances as it is a private arrangement and can keep the unit holders secret. A company’s shareholders are publically searchable. Units of the trust may also be able to be transferred to an SMSF at a later date, whereas shares of a company cannot because of tax issues this creates.

Where some homes want to be kept by the parties then they will probably want to end up owning one or more in their own names/entity rather than jointly like the project. This will involve the transfer of titles and will result in a taxable event being triggered and stamp duty being triggered. This may be able to be avoided, or minimised with careful planning up front though.

All the above has assumed that the land is to be purchased in the future. Where the land is already owned then it may not be possible to implement the ideal structure because of the stamp duty and the CGT consequences of changing ownership midway.

Planning the control of trusts and companies is also very important, especially bucket companies with large sums of cash and also, trust property with large amounts of equity. When you die or lose capacity you want to make sure the right people take over these entities. A trust falling into the hands of a relative could mean your direct family misses out as the trustee will have full discretion on how to distribute income and capital (subject to the deed) and the relative will likely be a beneficiary and so could appoint to himself or to his family at the expense of your family.

 

See Part II here Legal Tip 127: Structuring a Development Part II

 

Can you please explain this a bit further?
Let's say,
- group A is doing the actual development
- group B is just lending the money

How should they set up the structure?

 

I don't know how they 'should' set up the structure. There would be about 10 ways

Here is one.
Company with discretionary trust holding the shares of the company owning the land. Group A could control the trust and the company, group B might be discretionary objects of the trust though, hidden from plain sight.
Group A might set up a corporate trustee of a trust which lends money, under a written agreement with mortgage, to the company at a specified interest rate.

 

See this one Devan

Legal Tip 363: Asset Protection Strategy when Lending Money

 

Hi all – Terry’s post above answers a lot of questions I’m pondering recently, keen to hear everyone on the forum thinks of our situation:

We plan to buy, develop and sell 2-lot subdivision/townhouse projects alongside PAYG jobs. Current set up for this is:

Family Trust 1 with a corporate trustee and family members as beneficiaries.

1st development has now finished and we will set up another Beneficiary – Bucket Pty Ltd to distribute the profits.

Option 1: For 2nd development, Bucket Pty Ltd lends money back to Family Trust 1 (I understand this needs to be a complying Div 7a loan), so the trust has working capital to buy, develop and sell.

Option 2: Changing to a company structure. Bucket Pty Ltd now has $$, use this to buy next site.
1. Can shareholder of Bucket Pty Ltd be Family Trust 1 or do we need to set up a new Family Trust 2?

Option 3: As above, but Bucket Pty Ltd lends money to newly created Project 2 Pty Ltd, who will buy, develop, sell.

2. Does Option 2a get complicated as money in both companies Bucket and Project 2 Pty Ltd eventually has to be distributed as dividends, so two companies needing two lots of shareholders (can they both be Family Trust 1?)

3. For Development 3, should we set up Project 3 Pty Ltd, or keep doing in Project 2 Pty Ltd?

Any thoughts on which option may be best would be greatly appreciated. We are in talks with our accountant + lawyer but keen to hear from others who have developed in a similar way.

 

1. this is possible but keep in mind the loan would be PI over 7 years so high repayments
2. This is possible
the shareholder of a bucket company should not be the trustee of a trust that distirbutes to that bucket company
3. This is safer than the bucket company developing itseld
what is 2a?
3.3. should is a strong word, but you would generally not want to reuse a company due to risk.

What about all the things you haven't considered?

 

Thanks for the reply Terry

Sorry that 2a should read Option 3. I can see Option 3 would create distance, with Bucket Company being a 'bank' lending money out to Project 2 Pty Ltd to carry out the business. However, would we run into same issue again once Project 2 finishes and profits are in excess of what shareholders need at the time? The profit needs to be kept in the company, so Project 2 is sitting there holding cash?

From a risk perspective, do you think main risk sits with Builder and Architect/Draftsperson and not the Developer?

Our focus has been trying to keep companies/trusts manageable - which makes us lean towards Option 2 - company with Family Trust 2 as shareholder, get rid of Family Trust 1.

What other key things should we consider?

 

no

You need to get some specific legal and tax advice. You could have profits diverted into a bucket company which could be a beneficiary of several trusts doing separate projects, or it could be a holding company of several companies doing different projects.