As a business owner, one of your key duties is to ensure your enterprise remains profitable. When your business starts generating substantial profits, it’s crucial to have a strategic plan in place.
While maximising deductions is an important aspect of any tax planning approach, depending solely on deductions for tax minimisation can lead to sacrificing profit when other alternatives exist. Since you and your family depend on the profits from your business to support your lifestyle, it’s vital to understand the most tax-efficient ways of distributing income and the optimal business structures to achieve that.
Think about the role a bucket company could play in your overall tax strategy.
Understanding Bucket Companies
A bucket company, also referred to as a corporate beneficiary, is a company that functions as a beneficiary of a trust. This setup allows any income distributed from the trust to the bucket company to be taxed at the corporate tax rate, which currently stands at 25% (if it qualifies as a base-rate entity), compared to the individual’s marginal tax rate (the proposed highest tax rate for individuals for 2023-2024 is 47%, including the Medicare levy).
Bucket companies are named so because they operate beneath a trust, like a bucket, and are utilised to distribute income. It’s essential to keep in mind that specific rules pertain to family trusts and organisational structures within a family unit. Failure to adhere to these rules may result in family trust distribution tax implications.
How Bucket Companies Operate
Typically, a bucket company encompasses three main components:
- A trust with excess income available for distribution.
- The corporate beneficiary must meet the definition of ‘beneficiary’ as per the trust deed.
- Consideration of whether the bucket company is included in a family group.
Determining Shareholders of the Company
One key reason for utilising bucket companies is to leverage their tax advantages, which should be taken into account when deciding who holds the shares of the company.
If an individual holds the shares, there is limited flexibility in how dividends can be allocated; they must be distributed based on the shareholder’s proportional ownership. Alternatively, if a different type of trust holds the shares, surplus profits can be distributed, allowing for a lower overall tax burden.
Corporate Tax Rates for Bucket Companies
Bucket companies are subject to corporate tax rates, which depend on the type of company and may be either 25% or 30%. A tax rate of 25% applies if the company qualifies as a base-rate entity; otherwise, the tax rate may likely be 30%.
Taxation of Trust Income
Generally, the net income of a trust is taxed in the hands of its beneficiaries; both individual and corporate beneficiaries are taxed on their respective shares of the trust’s income at applicable rates.
As of this article’s writing, the highest marginal tax rate for individuals (excluding the Medicare levy) is 45% for those with a taxable income of $180,000 or above. In contrast, non-base rate entity companies are taxed at a flat rate of 30%. The difference between the highest individual marginal tax rate and the company tax rate implies a potential tax savings of at least 15%. For instance, on a $100,000 income distribution, a corporate beneficiary could save at least $15,000 in taxes.
Ensuring Proper Distributions
When distributing to the bucket company for the financial year, it is crucial to ensure that the same amount is also transferred to the company’s bank account before filing the tax return. In particular, trusts are required to distribute to corporate beneficiaries; otherwise, the Unpaid Present Entitlement (UPE) regulations may be triggered.
Utilising Funds in the Bucket Company
This discussion has highlighted how bucket companies can aid individuals in tax savings by disbursing dividends at company tax rates. However, there are other strategies available with bucket companies.
A bucket company can also serve as a vehicle for holding long-term investments, such as shares, real estate, or assets, effectively functioning as an investment company that produces an additional income stream for its owner. Although companies cannot access the 50% Capital Gains Tax discount, there are compelling reasons to consider a corporate structure.
Extracting Funds from the Bucket Company
As noted, the trust allocates income to the bucket company, raising the question: How can one draw money from a bucket company?
There are three primary methods for extracting money from a bucket company:
- Distributing dividends to the shareholders. Since the dividends are taxed at the company rate, shareholders receive franking credits that reflect the tax already paid. Individuals need to report the dividend income as taxable income, and any unused franking credits can be refunded, or top-up tax obligations may arise depending on the shareholder’s marginal tax rate.
- Obtaining a loan from the bucket company. Similar to any loan, the principal and interest must be repaid. This is a specific loan type called a Division 7a Loan, which has particular rules that require attention.
- Utilising a distinct discretionary trust structure to receive dividends. While the first method requires profit distribution to align with ownership, and the second incurs interest, this last method allows for profit distribution according to the Trust deed. For example, designating a discretionary trust as a shareholder in the bucket company facilitates larger distributions to individuals with lower marginal tax rates. Note that additional regulatory conditions, such as Section 100A, may also need consideration.
Can a Family Trust Structure Contain a Bucket Company?
To function effectively, a bucket company must be a qualifying beneficiary of a family trust. Therefore, it’s essential to examine the trust deed to confirm that the bucket company falls within the general category of beneficiaries.
Depending on the structure, a Family Trust Election may also be necessary. Consider the family group, which could define or influence who the beneficiaries are.
Identifying the Right Bucket Company Strategy
While bucket companies can be advantageous for investors and business owners and represent potentially tax-efficient strategies, they might not be suitable for every situation.
A bucket company strategy could benefit you if you are:
- A business owner looking to create a financial reserve for your family.
- A business owner experiencing significant income fluctuations from year to year.
- A business owner approaching retirement or planning to sell your business who anticipates lower business income moving forward.
However, if you are subject to the Personal Services Income (PSI) regulations, a bucket company strategy may not apply. These rules prevent individuals from reducing or deferring income tax by redirecting income derived from their personal services through companies, partnerships, or trusts. We recommend seeking professional guidance to determine whether a bucket company aligns with your needs.