Look through companies
Many property investors hold their properties in look through companies (LTCs). An LTC can be useful if the property investment runs at a loss as it allows the losses to flow through to the shareholders personally where it can be offset against their other income in order to reduce tax payable. There are however disadvantages with LTCs which need to be carefully considered:
- If an LTC makes a profit this will be passed through to the shareholders and they will need to pay tax on that profit. In profit making situations it is often better to hold the investment via another structure. An ordinary company is one alternative. If profits were generated via an ordinary company the profits could accumulate within the company at a reduced marginal tax rate of 28%. Any tax liability would also belong to the company, rather than being imposed on the individual shareholders.
- Before setting up in business, or before buying an investment property, you need to carefully consider the future profit forecasts. This will help guide you in choosing the right structure from the start. If, for example, you started off with an LTC and then later you found that this was not appropriate, because profits started to be generated, changing to another structure can be costly in terms of the professional costs and the significant tax implications. If you elected into the LTC regime (because previously you had an LAQC), careful consideration should have been given to the issues prior to making the election.
- The ability to pay shareholder salaries is limited in comparison to other structures – for example, trusts and ordinary limited liability companies.
- Tax due in relation to profits generated by the LTC may need to be funded by the shareholders from their personal resources. Although it may be possible to distribute funds from the LTC to pay tax, shareholders cannot assume that such funds will be available to assist. The shareholders may need to pay provisional tax. In an ordinary company, it is usually the company that has the sole liability to pay tax.
- In some circumstances not all of the losses of an LTC are able to be passed through to the shareholders and the means of calculation is complicated.
- A LTC must have 5 or fewer shareholders. If shareholders increase beyond 5, the LTC company loses its status and a large taxable gain may result. The shareholders will be directly liable to pay tax on that gain. It is possible for the number of shareholders to increase beyond 5 without shareholders being aware of the change, for example, assuming there are 5 original shareholders, 1 shareholder could sell his shareholding to 2 unassociated people. This would cause a loss of the company’s status without the other shareholders’ knowledge or consent. If one of the shareholders is a trust, sometimes the underlying beneficiaries of the trust are counted as shareholders of the company and sometimes they are not. Changes in the trust’s income payment practices can lead to a change that affects the company’s status. For example, instead of the trust shareholder being counted as 1 shareholder, the underlying beneficiaries are counted, leading to the maximum number of 5 being breached – possibly without any of the shareholders being aware of the change.
- An LTC is vulnerable to abuse. Although all shareholders must give permission to elect for the company to become an LTC, only 1 shareholder’s permission is needed for the entire company to lose its LTC status. There is nothing to stop a disgruntled ex spouse or former business partner from writing to the IRD and causing a revocation of the LTC status. The revocation will affect all shareholders and it will potentially lead to large and unexpected taxable gains.
- Some, but not all, of the issues can be prevented with a shareholders’ agreement.