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How 'bucket companies' work in family trusts

There is a common belief that family trusts have limited uses unless there are beneficiaries on lower rates of tax to distribute income to. In fact, some argue their purpose is lost.

This view is simplistic because there are other benefits of trusts beyond distributing to individuals on lower incomes. This article focusses on the use of 'bucket companies' in family trusts.

The use of bucket companies 

A bucket company is a corporation and a beneficiary of a trust whose job it is to hold on to distributions. In other words, it is a corporate beneficiary. The advantages of distributing trust income to corporate beneficiaries lie in the facts that:

(a) companies, as opposed to individuals, pay a flat rate of tax on income which is often less than the applicable individual tax rate, and

(b) whilst a trustee is compelled to distribute the income of the trust, thereby incurring a tax liability for those individuals who receive a distribution (at whatever rate), a corporate beneficiary can hold those distributions. If there are franking credits available, there might also not be a ‘tax differential’ to pay on those distributions.

There are tax rulings which require care when structuring these arrangements so as not to fall foul of the provisions of Division 7A of the Income Tax Assessment Act 1936, which deems certain payments to shareholders or their associates as dividends.

Please also note that this article considers trust income, rather than distributions of capital gains through trusts, which are taxed differently. Furthermore, the examples used here only apply to private companies and not listed companies.

Prerequisites for a bucket company structure

Three preconditions must exist for a bucket company to function:

  • There needs to be a trust with income to distribute.
  • The trust deed of the trust must allow for corporations to be beneficiaries.
  • The corporate beneficiary must fall within the definition ‘beneficiary’ under the trust deed.

Taxing of 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.

Currently, the highest marginal tax rate for individuals (not including the Medicare levy) is 45% for people with a taxable income of $180,000 or more. For passive income companies, there is a flat tax rate of 30% (or 27.5% if the small business tax rates apply).

So, other things being equal, the current difference between these two tax rates is at least 15%. On the same income distribution, say $100,000, a corporate beneficiary would pay at least $15,000 less tax. While corporations do not have a minimum tax threshold due to the flat rate of tax, most individuals have a marginal tax rate over 30%. The 32.5% marginal tax rate currently kicks in at $37,001.

Number of individuals and net tax by tax bracket, 2016/2017 income year

 

Source: ATO Taxation Statistics

Corporations as beneficiaries

The beneficiaries of a trust can be specifically named or they otherwise fall within the broader definition of being within a “class of beneficiary” under the trust deed. For instance, where a corporation is not specified as a beneficiary, a typical trust deed should have a definition creating beneficiary classes which includes corporations that are wholly or partly owned by individual beneficiaries.

For example, Joanna is a beneficiary named in a trust deed. Most trust deeds should include a clause which allows for distributions to a corporation that Joanna controls, even though that corporation is not specifically named in the trust deed.

What to do with the distributions in the company

Once it is established that the corporation may be classified as eligible for a distribution, it will receive the distribution and be liable to the ATO for the tax payable at the corporate tax rate.

As the distribution and (usually) cash now sits in the corporation, there arises a practical question about what to do with it. This depends on the strategy in place. For some, the purpose of a bucket company (having paid tax on it at a lower rate) is to hold the distribution until some point in the future when it can be distributed to individuals.

Another strategy involves loaning the cash. If the loan is to a related entity, a Division 7A-compliant loan arrangement is needed. Always be cautious when loaning funds from corporations to related entities because they can run foul of tax rules.

Consider this example: John has set up a trust to be the shareholder of his company. He also has a corporation he can nominate as a bucket company to be a beneficiary of this trust. John is on the highest marginal tax rate and has no one else who he can distribute to. The company declares fully franked dividends, and John uses the bucket company to take the distribution, and after that then loans that money to himself so he can purchase an asset. John would have to enter into a Division 7A loan arrangement with the company and repay the loan in accordance with those terms. The benefit here is that John can realise the benefit of the dividends (via the corporate beneficiary) without incurring the obligation to pay the highest marginal tax rate on those funds upfront. The tax obligation is spread over a longer term.

It may also be possible for the corporate beneficiary to deduct expenses from the income it receives from the trust. A possible scenario might be to distribute to a corporation that has carried-over tax losses from previous financial years, but watch for carried-forward tests. The value in this could be considerable because, in the case of dormant companies with carried-over losses, it may not need to go back into trading to realise the benefit of those losses from a tax perspective.

Sometimes it makes commercial sense to move only the retained earnings out of a company. This is a ‘balance sheet exercise’ which involves moving profit out of a company without transferring cash right away. Examples include where the company has been using its profits to aggressively pay off debt. In these situations, the company will accumulate valuable franking credits and retained earnings and it can make sense in some circumstances to move these out of a company rather than leaving them there exposed to commercial and legal risk. The franking credits can be used up thereby creating a channel for the distribution of income in the future.

Approach with caution and professional advice

It is not possible to cover all aspects of this subject in a short article.

This article has summarised the potential benefits of using bucket companies such as:

  • To take advantage of lower rates of tax paid by corporations.
  • To hold retained earnings and franking credits until needed.
  • To offset expenses and carried over losses incurred by corporate beneficiaries against distributions.
  • To use loans to related (and unrelated) entities to purchase assets without paying upfront tax at the highest tax rates.

A note of caution and technical qualification.

Although the use of bucket companies in family trusts in particular is common, simply taking advantage of the lower rates of tax applicable to corporate beneficiaries is not without consequence or risk. For instance, the ATO considers that Division 7A may apply to an unpaid present entitlement of a corporate beneficiary where the trust and the beneficiary are related entities. This position is found in TR 2010/3: Income tax: Division 7A loans: trust entitlements, which is not without its critics. Practice Statement PS LA 2010/4 sets out the procedure and requirements for the establishment of a sub-trust to take advantage of exemptions from Division 7A.

 

Jacob Carswell-Doherty is Solicitor Director at Foulsham & Geddes law firm. This article is general information and does not consider the circumstances of any individual. Personal advice should be taken before acting on any information.

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13 Comments

Harry

July 09, 2019

The debate wasn't as simplistic as the opening paragraph made out. The claim was made that using bucket companies in a trust would allow zero taxation of trust income. What this article clearly establishes is that you would be paying the company tax rate on distributions, making the trust no better than just corporatising your investments. No magic zero taxation has been exposed.

Jacob Carswell-Doherty

July 10, 2019

Harry - I agree that there is no magic formula for zero taxation - nor should there be. I firmly believe in paying tax. However, I disagree with your statement that the trust is no better than just corporatising your investments. As the article points out, there are various benefits which would not otherwise be available in a standard corporate structure. The degree to which a trust will provide benefits depends on the individual circumstances. Some people might not be looking for zero tax, they might want protection from risk. Some people will be able to reduce their tax to zero using bucket companies, others will get a marginal benefit and a lot will get zero benefits. It's about having options.

Harry

August 14, 2019

My statement regarding trusts being no better than corporatising your investments was in relation to taxation.

As for zero taxation with trusts, this has a genesis from a claim made during the last election that the use of trusts and bucket companies allow the rich to pay no taxes.

I said this claim was untrue, and Graham said he’d seek a column on the topic, which seems to be this one.

Reading this article it seems that a reasonable summary is that you can use a trust and a bucket company to limit your tax on investment income to the company tax rate.

Any ability to lower your tax rate below that level requires:
1) dependent adult children who can utilise there lower marginal tax rates, but this is limited to the first $37k per indolent child, and of course, means you are maintaining a fully dependent adult
2) any ability withdraw accumulated capital (ie earnings, not the initial capital) at a lower tax rate is dependent on your income falling to zero, i.e. after retirement, which is nice, but you are hardly classifiable as wealthy at that stage, and the “discount” is just your normal marginal tax rates making any large returns less tax effective.

I like the simplicity and convenience of trusts for asset protection and allocation, and am a very keen supporter of their continued role, hence it is important to point out the repeated claim of a magical pathway for the very rich to pay no tax is untrue.

You don’t become a billionaire by avoiding tax, the hard part is getting the billion dollars of income in tbe first place.

Jacob Carswell-Doherty

July 11, 2019

Let's keep the discussion to taxation then.

With the use of franking credits, it would be very easy for an individual to use a bucket company to pay zero tax, or a very reduced rate of tax, in one or more financial years.

The bucket company receives franking credits, might pay a small differential of 2.5% on the distribution - if there are expenses which can be deducted the tax payable may very well be zero. The funds are then available to be used by way of a Div7A loan. Done the individual has paid zero or very little tax in that year. In later years, it is possible to continue this.

If there are no franking credits available then you'd have to rely on deductions and distributions to beneficiaries on lower rates.

Harry

July 12, 2019

I don't quite understand your logic here, the bucket company needs to pay tax, the franking credits are that tax.
Not counting that tax against the individual doesn't mean no tax wax paid.

The claim of zero taxation was agoinst gross income.

Albert

July 09, 2019

Another use is for the bucket company to hold on to the retained earnings and use the funds to invest in its own name. This could allow the more rapid accumulation of assets and a large franking credit for future distribution.
The bucket company could be owned by a second discretionary trust which could allow fully franked dividends to be distributed to future generations in a lower tax bracket.

Jacob Carswell-Doherty

July 06, 2019

Great point Kym!

Wayne

July 05, 2019

I'd be interested to hear the response to Richard's question. I too thought certain conditions must be met to qualify for the reduced company tax rates - namely not more than 80% of income must be from passive sources.

Another question I have is, assuming the majority of individuals are on the 30% tax rate by 2024, how useful will bucket companies be from a tax minimisation perspective?

Graham Hand

July 06, 2019

Hi Wayne and Richard, thanks for the clarification, the bucket company will most likely be taxed at 30% as it is not a 'base rate entity' to qualify for the 27.5% rate. We have made this clearer in the article.

Tom

August 14, 2019

I have seen balance sheets with equity reported under the net asset figure as unpaid present entitlement to individual beneficaries. Is that UPE for an individual as reported in the equity/corpus a loan owing to the beneficiary? Or does it represent a share of the capital/assets of the trust, like propriertorship for a partnership. The UPE is the same amount as the net assets in the balance sheet. It is a discretionary trust and not a deceased estate/testamentry trust. Cheers

Jacob Carswell-Doherty

July 06, 2019

Thanks Wayne. Bucket companies work best when the individuals are taxed above 30%. There needs to be an overall benefit before setting up something like this. But, as the article highlights, the benefits are not just about tax, sometimes they are used to hold cash or retained earnings for other purposes.

Richard

July 04, 2019

Great article, wouldn’t the 30% company tax rate apply to a bucket company not the small business tax rate of 27.5?

Kym Bailey

July 04, 2019

Companies carrying forward tax losses from a prior year must satisfy the ATO’s “continuity of ownership test” (COT) or, if unable to do so, the “same business test” (SBT) for losses to be deductible against assessable income of future years.


 

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