Ensuring your business remains profitable is one of your most important responsibilities as a business owner. But do you have a plan for what to do when your business starts to generate a healthy profit? How can you avoid being blind-sided by the tax owing when the ATO comes calling?
While methods such as maximising deductions have their place in any tax planning strategy, a tax minimisation strategy that solely relies on deductions can leave you sacrificing profit in order to lower your tax when there may be other options available to you.
With you and your family relying on the profits generated by your business to fund your lifestyle, it's important you understand the most tax effective manner for distributing income and the best business structures that allow you to do so.
You may want to consider how a bucket company might fit in your overall tax planning strategy.
What are Bucket Companies used for?
A bucket company (otherwise known as a corporate beneficiary) is a company that is set up as a beneficiary of a trust with the purpose of allowing any income the trust distributes to the bucket company to be payable at the company tax rate, currently 25% (only if it is a base rate entity), as opposed to the individual marginal tax rate (the top tax rate for individuals is currently 49% including Medicare levy).
They're called bucket companies because they sit below a trust like a bucket and are used to distribute income to it.
It is important to keep in mind there are rules around Family Trusts and in those structures distributing within a family group, otherwise family trust distributions tax may apply.
How do Bucket Companies work?
There are generally three elements present for a bucket company:
There is usually a trust with surplus income to distribute
The corporate beneficiary must fall within the definition ‘beneficiary’ under the trust deed
Consideration as to whether the bucket company is a part of a family group
Who should hold the Company's shares?
One of the main reasons bucket companies are used is to access the tax benefits they provide, and you should keep this in mind when you're making a decision around who holds the company's shares.
If an individual holds the shares, there is not as much flexibility in how the dividends can be distributed; they will need to be distributed exactly according to the shareholder percentage, however, if another kind of trust holds the shares the excess profits may be distributed in a way that allows for less total tax paid. For more on this see below (how to get money out of a bucket company).
What tax rate does a Bucket Company pay?
The bucket company pays the corporate tax rate, which could be 25% or 30% depending on the type of company. If the company is a base rate entity a company tax rate of 25% will apply, however, if it is not the company tax rate will likely be 30%. The corporate tax rate was higher in recent years at 27.5% from the 2017–18 to 2019–20 income years and 26% in the 2020–21 income year.
Taxing trust income
The general principle is that the net income of a trust is taxed at the hands of the beneficiaries; individuals and company beneficiaries pay tax on their portion of the trust’s income at the rates that apply to them.
The highest marginal tax rate for individuals (not including the Medicare levy) at the time of writing this article is 45% for people with taxable income of $180,000 or more. There is a flat tax rate of 30% for non base rate entity companies. Due to the current discrepancy between the highest marginal tax rate for individuals and the company tax rate, there is currently at least 15% savings potential. To illustrate, on an income distribution of $100,000, a corporate beneficiary would pay at least $15,000 less tax.
Commit to distributions
It is important that you ensure that when you distribute to the bucket company for the financial year, you also distribute the same amount to the company's bank account prior to lodging the tax return.
In particular, trusts must distribute to corporate beneficiaries otherwise the Unpaid Present Entitlement (UPE) rules may be triggered.
What can you do with money in a Bucket Company?
So far in this article we have looked at how bucket companies can help individuals to save tax by paying out dividends at company tax rates. This is not the only bucket company strategy available.
A bucket company can also be used for holding long-term investments, such as shares, properties, or investments. In this regard, the bucket company becomes an investment company that can generate another source of income for the owner. However, companies do not have access to the 50% Capital Gains Tax discount, but there may be other compelling reasons to use a company structure.
How do you get money out of the Bucket Company?
As has been already established, the trust distributes the income to the bucket company, which begs the question, how do you get money out of a bucket company?
There are three ways to extract money from a bucket company:
pay dividendsto theshareholders. Due to the fact that the dividend has been taxed at the company rate, the shareholder will receive a franking credit to the extent that tax has already been paid. To learn more about franking credits, see our article here (insert backlink to franked dividends article). An individual will include the dividend income as taxable income. Any excess franking credits are refundable or top up tax may be required depending on the shareholder's marginal tax rate.
a loan from the bucket company. As with any other loan, you will have to pay back the principal and interest to the bucket company. The loan is a special type of loan which is called a Division 7a Loan, and it has its own requirements you will need to be mindful of. More on that below (provide jump link).
the dividends can be received by a separate discretionary trust structure. Whereas the first method requires profits to be distributed according to shareholding and the second method incurs interest, this last method distributes profits according to the Trust deed. For example, using a discretionary trust as a shareholder of the bucket company allows you to make the largest distribution to an individual with the lowest marginal tax rate. Note there may be other rules to satisfy or consider such as Section 100A.
Division 7A loan
Div 7A loans can be complicated and warrant an entire article, but for now three points are relevant to bucket companies:
the interest rate for the repayments to your Div 7a loan is set by the ATO. The benchmark interest rate for the 2022 financial year is 4.52% and for the 2023 financial year it is currently 4.77%. You must comply with the minimum principal and interest repayments each year.
If your loan is unsecured it must be repaid within seven years.
If it is secured to a property, for example, the repayment period can extend to 30 years.
If you are looking to calculate the minimum annual repayment plan, you can use the Div 7A calculator on the ATO's website, which you can find here.
Will my family trust structure allow a Bucket Company?
In order to function as intended a bucket company must be an eligible beneficiary of a family trust. As a result, it is important that you read the trust deed of the trust to ensure the bucket company falls within the general class of beneficiaries.
Additionally, depending on the structure there may be a need to make a Family Trust Election. Consider to the Family Group may define or impact who the beneficiaries are.
How do I know if a Bucket Company strategy is right for me?
While they are generally useful for investors and business owners and there is no doubt that a bucket company can be one of the most tax-effective strategies, it may not be ideal for your unique situation.
A bucket company strategy may be of benefit if you are any of the following:
a business owner who wants to build a nest egg for their family
a business owner who experiences large fluctuations in income from one financial year to the next
for business owners coming up to retirement or looking to sell their business, and who won't be earning as much business income moving forward as a result
Using a bucket company will not work for you if you are caught under the Personal Services Income (PSI) rules, which exist in order to prevent individuals from reducing or deferring their income tax by diverting income they receive from their personal services through companies, partnerships, or trusts.
We encourage you to seek professional advice when trying to ascertain whether or not a bucket company is right for you.
Bucket companies can work well as part of a tax savings strategy for business owners and investors alike, however, they are not for everyone. What's more, the Australian Taxation Office is actively engaged in discouraging tax avoidance and the general trend seems to be increasing crack downs as evidenced by the recent guidance from the ATO regarding Section 100A trust distributions.
A good accountant can guide you through the pitfalls and advantages of various tax savings strategies and help you work out a boutique plan that suits your unique financial situation. For the best tax advice seek expert help.
Causbrooks gives you a client manager supported by a team of knowledgeable small business experts. We’re here to take the guesswork out of running your own business.
Get in touch with us to set up a consultation or use the contact form on this page to inquire whether our services are right for you.
Any advice contained in this document is general advice only and does not take into consideration the reader’s personal circumstances. Any reference to the reader’s actual circumstances is coincidental. To avoid making a decision not appropriate to you, the content should not be relied upon or act as a substitute for receiving financial advice suitable to your circumstances.