The tax owed to the ATO is probably one of the biggest shocks to business owners when they start generating a healthy profit. Without the right strategies in place, you could be left paying way more tax than necessary.
More often than not, business owners will try to minimise tax by maximising deductions. While deductions can be a good way to reduce tax, it’s important to remember that you are sacrificing profit to lower your tax.
Sacrificing profit means sacrificing cash in your hand. As a business owner, your focus should not be on reducing profit to lower your tax, but rather running a successful business and generating a healthy profit.
One of the best ways to reduce tax is by structuring your business and personal assets in the most tax effective manner possible. One way to do this is to utilise a corporate beneficiary, otherwise known as a ‘bucket company’.
We can help you understand all your options, including a bucket company. For more information hear from one of our directors John Liston in the below video or simply read on.
What is a bucket company?
A bucket company is a company that is set up as a beneficiary to a trust. The term ‘bucket’ is used because the company sits below your trust and is used to pour money into it to reduce tax. This allows you to cap your tax payable at a corporate tax rate.
Capped tax rates:
- The corporate tax rate (using bucket company) is 27.5%*
- The individual top marginal tax rate (without a bucket company) is 49%*
*Tax rates accurate as of November 2018.
What is average rate of tax?
This is the overall percentage you have paid in tax. For example, if you earned $100,000 and you paid $26,117 in tax, your average rate of tax would be 26.1%
How can you access the capped tax rate of 27.5%?
The actual set up of this strategy is quite straightforward. You will need to revise the structure of your trust (discretionary trusts are recommended) so it has a bucket company that you can distribute profits to. Once this is set up, it’s a matter of understanding your responsibilities to ensure you are compliant with the ATO.
We will go into these considerations in the latter part of this article, but first, this is an example of how big of an impact this bucket company can have on your financials.
Let’s say your business had a profit of $150,000. If this profit was to be paid to you as an individual, under 2018 tax rates, you would have tax payable of $45,997. This is without a bucket company in place.
If we were to use a bucket company for this business, then the most tax effective way to distribute the $150,000 in profit is to allocate the first $37,000 in profits to you. You will pay $0 tax on the first $18,200 distributed to you, and then 19 cents in every dollar until $37,000.
After you have paid yourself $37,000, it becomes tax effective to distribute the remaining profits to your bucket company. If you distribute to a company, then for every dollar after $37,000, you will pay the tax rate of 27.5 cents of every dollar in tax.
If you chose to receive the income yourself, from $37,000 onwards, you will pay 32.5 cents of tax in every dollar up to $90,000. You would also pay 37 cents for each dollar after $90,000, and 45 cents on each dollar after $180,000 as well as a 2% Medicare levy.
- Tax paid without a bucket company: $45,997
- Tax paid with a bucket company: $34,647
- Total savings: $11,350
Considerations when utilising the bucket company strategy
Commitment to distributions
If you elect to distribute to the bucket company for the Financial Year, then a physical distribution for the same amount needs to be made to the company’s bank account before lodgement of the tax return.
Note: if there aren’t enough funds, the ATO will allow a 7 year repayable loan between the trust and bucket company, with interest charged at benchmark rates. This is called a Div 7A Loan.
Div 7A Loan
A Div 7A loan agreement is a loan between the trust that is distributing the profits and the company that is receiving them.
If the trust doesn’t pay all the distributions in cash before the tax return is lodged, then a Div 7A loan is created.
A Div 7A loan:
- Has a maximum term of 7 years
- Has a minimum annual repayment plan
- Has interest that is payable at a commercial rate prescribed by the government
The minimum repayments need to be met by the trust physically making payment to the bucket company each year. However, it may be possible for the bucket company to declare dividends that can be off-set against the minimum repayment obligation.
How to get money out
To get money out of the company, a dividend can be paid to the shareholders. Because the dividend has already been taxed at the company tax rate, the shareholder receives a franking credit on the tax already paid.
Note: a franking credit allows you to pass on tax paid at a company level to shareholders.
Who should hold the company shares
You need to put some thought into who the shareholders of the company will be.
If they are individuals, then this does not allow much flexibility in how the dividends are distributed. The dividends need to be distributed exactly according to the shareholder percentage.
A smart thing to do is to set up another separate trust to hold the shares of the company. That way the dividends can be distributed by the trust in the most tax effective way.
Holding the shares in a trust is also beneficial from an asset protection perspective. Over time, if a large amount of profit is distributed to the company, the company will have a lot of value. If the shares are held by the individual, this can leave the individual exposed in the event of legal proceedings.
Holding the shares in a separate trust will create another layer of asset protection, whilst also providing extra flexibility of how to tax effectively distribute the dividends.
What to do with money in the company
A bucket company can be a very good structure to hold long-term investments. Effectively, the bucket company can become an investment company that seeks to generate another income source for the owner. As cash is transferred across from a trust into the company, the cash can then be invested.
Examples of investments can be listed shares, investment properties, and private investments.
When investing via a company, you need to be mindful of how companies are taxed. Companies are not eligible for the 50 per cent capital gains tax discount, while trusts and individuals can access a 50% CGT discount if an asset is held for more than 12 months. Also, any profit within a company is taxed at the current corporate tax rate of 27.5 per cent.
However, if you have distributed to a company to save tax, it is likely this will still be under your own personal tax rate. This is where a good accountant can advise you on how to create a tax minimisation strategy best suited to your situation.