Look Through Companies (LTC) - Do you want to be One?

Two weeks ago we talked about the formula used to calculate shareholders interest in a LTC.  This week we are going to work through an example of how the formula works.  The formula was:

Investment - distributions + income - deductions - disallowed amount

So let's assume the following: Chris and Sally decided to buy a rental property in the hills of Havelock North in 2000.  The cost of this property was $1.2 million. The rental proprty is owned by an LAQC called Easy Rent Limited.  Chris and Sally decide to convert this company to an LTC. Easy Rent Limited has share capital of $100 which is fully paid up with Sally owning 75% worth of $1.00 shares and Chris owning 25% worth of shares. The market value of the property is now $2.0 million and the mortgage outstanding as at 31 March 2011 is $906,707 (keep this date in your mind) Easy Rent Limited purchased the property with a 100% mortgage and the losses have been split in accordance with the shareholders interests. To be able to borrow from the bank, Chris provides additional collateral in the form of a home which had a value of $400,000.  Sally did not have any ownership interest in this home.  The banks mortgage on this property was for $400,000.  Both Chris and Sally have made contributions through their current accounts in order to make sure interest payments are covered. In addition, Chris borrowed $20,000 from Easy Rent Limited to buy a SS Holden Commodore. All parties that have an owners interest in a LTC must chose one of the following methods for the basis of their loss limitation: The market or accounting book value; or The method, as if the LAQC had always been an LTC

The first method, incluces loans that the shareholder owed the company as at 31 March 2011, and the intent is that the outcome of the calculation will reflect a snapshot of the economic risk that each shareholder bears at the time that the company is converted into an LTC.  It does not reflect distributions made in prior years.

Method A Investment

Current Value of Shares  Sally - 75%  Chris - 25%  Total 100%  Value of Property  1,500,000  500,000  2,000,000  Less Mortgage  680,030  226,667  906,707  Net Value of Shares  819,970  273,323  1,093,293  Plus Current Account  601,685  200,562  802,247  Security 0  400,000  400,000  Sub Total 601,685  600,562  1,202,247   Gross Value of Shares 1,421,655  873,885  2,295,540   Less Distributions        Loans to Shareholders 0  20,000  20,000   Initial Basis Method A 1,421,655  853,885  2,275,540

The second method looks at a company as if it had been an LTC since its inception.  So from Easy Rent Limited, this will involve an aggregation of the investment, distributions, income, deductions and any disallowed expenditure since 2000 when Easy Rent Limited was formed.

Method B

Investment   Sally - 75%  Chris - 25%  Total 100%  Shares (cost) 75 25  100  Current Account Security* 601,685 200,562  802,247  Security (Chris's house)    400,000  400,000  Sub Total  601,760 600,587  1,202,347  Less Distributions  20,000  20,000  Plus Rental Income 273,000   91,000  364,000  Sub Total 874,760 671,587 1,546,347  Less Deductions        Prior years 874,685 291,562 1,166,247  Less Disallowed amount 0 0    Owners Basis  75  380,025  380,100 *  The amount that Sally and Chris paid to their current account matches the shortfall of the rental income after deducted the expenses.

In summary, Sally and Chris would be better off using Method A because: they do not need to obtain prior period information it may be possible for them to claim losses in subsequent years which would not be possible if they were using Method B

Next week we will look at the election rules for new companies, taxing of LTCs and disposal of Look Through Interests