One of the key responsibilities of a business owner is to ensure the business remains profitable. Therefore, when the business begins to yield substantial profits, a strategy is necessary.
While maximising deductions is an important aspect of any tax planning approach, relying solely on deductions for tax minimisation can lead to sacrificing potential profits to reduce tax obligations, even when there are alternative options available. As you and your family depend on the profits from your business to support your lifestyle, it’s crucial to grasp the most tax-effective ways of distributing income along with the ideal business structures to achieve this.
Consider incorporating a bucket company into your overall tax planning strategy.
Uses of Bucket Companies
A bucket company, also known as a corporate beneficiary, is a company established as a beneficiary of a trust. This structure allows any income distributed by the trust to the bucket company to be taxed at the company rate, currently set at 25% (if classified as a base-rate entity), rather than the individual marginal tax rate (the proposed top tax rate for individuals for the 2023-2024 fiscal year is 47%, including the Medicare levy).
The term “bucket company” derives from their position beneath a trust – similar to a bucket – from which income is distributed. It is essential to be aware of the regulations governing family trusts and the structures within a family group, as family trust distribution tax may apply.
How do Bucket Companies work?
Typically, there are three components involved in a bucket company:
- A trust that has surplus income to distribute.
- The corporate beneficiary must meet the definition of ‘beneficiary’ as outlined in the trust deed.
- Consider whether the bucket company is part of a family group.
Who should hold the company’s shares?
A primary reason for utilising bucket companies is to take advantage of their tax benefits, which should be a consideration when determining who holds the company’s shares.
If an individual holds the shares, there is limited flexibility in how dividends can be allocated, as they must be distributed in accordance with the percentage ownership. Conversely, if another type of trust holds the shares, surplus profits can be distributed, leading to a lower overall tax payment.
Tax rates of bucket companies
The bucket company is subject to corporate tax rates, which can be either 25% or 30%, depending on the company’s classification. If the company qualifies as a base-rate entity, a tax rate of 25% will apply; otherwise, the tax rate is likely to be 30%.
Taxing trust income
The general rule is that a trust’s net income is taxed at the hands of its beneficiaries; both individuals and corporate beneficiaries are liable for tax on their share of the trust’s income at applicable rates.
As of the time of this writing, the highest marginal tax rate for individuals (excluding the Medicare levy) is 45% for those with a taxable income of $180,000 or more. For non-base rate entity companies, a flat tax rate of 30% applies. Given the difference between the maximum individual tax rate and the corporate tax rate, there exists a potential saving of at least 15%. For example, on an income distribution of $100,000, a corporate beneficiary could pay a minimum of $15,000 less in tax.
Commit to distributions
It’s crucial to ensure that when income is distributed to the bucket company for the financial year, an equivalent amount is also allocated to the company’s bank account before filing the tax return. Specifically, trusts must distribute to corporate beneficiaries; failure to do so could trigger the Unpaid Present Entitlement (UPE) rules.
What can be done with the money in the Bucket Company?
This article has explored how bucket companies can help individuals save on tax by paying dividends at corporate tax rates. However, this is not the only strategy associated with bucket companies.
A bucket company can also hold long-term investments, such as shares, property, or assets. In this way, it acts as an investment company that can generate an additional income stream for its owner. While companies cannot take advantage of the 50% Capital Gains Tax discount, there are other compelling reasons to utilise a company structure.
Getting money out of the Bucket Company
As previously mentioned, the income from the trust is distributed to the bucket company, leading to the question: How can one withdraw money from a bucket company?
There are three methods to extract funds from a bucket company:
- Pay dividends to the shareholders. Since the dividend has already been taxed at the corporate rate, the shareholder will receive a franking credit corresponding to the tax that has been paid. The individual will then consider the dividend income as taxable income. Any excess franking credits may be refunded or require a top-up tax based on the shareholder’s marginal tax rate.
- A loan from the bucket company. Similar to any other loan, the principal and interest must be repaid. This type of loan is known as a Division 7a Loan, and there are specific requirements to keep in mind.
- A separate discretionary trust structure can receive the dividends. Unlike the first method, which mandates distribution based on shareholding, and the second method, which incurs interest obligations, this last approach allows for profit distributions according to the Trust deed. For instance, using a discretionary trust as a shareholder of the bucket company permits the largest distribution to an individual with the lowest marginal tax rate. Be aware that there may be additional rules to satisfy, such as Section 100A.
Will a family trust structure allow a Bucket Company?
For a bucket company to operate as intended, it must be an eligible beneficiary of a family trust. Thus, it is necessary to review the trust deed to ensure the bucket company is included within the general class of beneficiaries.
Furthermore, a Family Trust Election may be necessary, based on the structure. Take into account the family group, as this may define or influence who the beneficiaries are.
Appropriate bucket Company strategy
While bucket companies can be beneficial for investors and business owners and represent one of the most tax-efficient strategies, they may not be the best fit for your particular circumstances.
A bucket company strategy could be advantageous if you fall into any of the following categories:
- A business owner seeking to create a financial cushion for their family.
- A business owner experiencing significant income fluctuations from one financial year to the next.
- A business owner approaching retirement or planning to sell their business and anticipating lower income levels moving forward.
However, the bucket company approach may not be effective if you are affected by the Personal Services Income (PSI) rules. These regulations prevent individuals from minimising or deferring their income tax by diverting personal service income through companies, partnerships, or trusts. Professional advice is recommended to assess whether a bucket company aligns with your needs.
