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Why all the fuss about family trusts?

Affluent Australians usually hold their investments in some combination of superannuation, family trusts and direct ownership of negatively geared property. Over the last year, changes in superannuation rules and more challenging property market conditions have shifted the relative benefits of these arrangements. Family trusts have become comparatively more attractive. Investors should consider whether their 'structuring' and tax planning is still optimal.

The reduction in the income tax rate for small corporations, from 30% to 25%, will make the accumulation of wealth through family trusts more tax effective compared with super and negative gearing.

In the example below, a couple with children can accumulate wealth in their family trust at an effective tax rate of only 13.5% on their investment income. However, when the income tax on small corporations falls from 30% to 25%, as it is legislated to do, the same family trust’s strategy will accumulate wealth at an effective tax rate of only 11.3%.

A family trust with a corporate beneficiary

Mei Li and Jack Houston are a professional couple with high incomes, with three young children aged two, four and six years. They recently sold an apartment that they bought a few years ago, and the couple decides to use the $200,000 net proceeds from the sale to establish a family trust.

The Houston Family Trust will have two purposes. The first and main purpose is to accumulate family wealth in a low tax environment. The second is asset protection (from law suits, creditors in bankruptcy, and some family situations).

After the Trust is 'settled' (brought into existence) the couple makes a gift of the $200,000 to the Trust (or they might instead have loaned the money to the Trust). The $200,000 is then invested in high-income assets, such as high-yielding shares or commercial property. The couple resolves to make further gifts of $20,000 at the beginning of each successive year from their after-tax income.

Six beneficiaries of the Trust are named in the Trust deed: Mei Li, Jack, each of their three children and a corporation (the corporate beneficiary).

Accumulation phase

Assume the pre-tax return on the Trust assets is 6.5% per year after adjusting for inflation, received entirely as income with no capital gain to simplify the example.

At the end of each year, the annual income from the Trust's assets must be distributed to the beneficiaries of the Trust. It will not be distributed to Mei Li or Jack because they already pay income tax at the highest rate. And, it cannot be distributed to the children (without incurring top rate income tax) until the children turn 18 years. So, in the first 12 years of the Trust's existence (until their eldest child turns 18), all of the income is distributed to the corporate beneficiary (CB), sometimes called a 'bucket company'.

The left-hand side of the diagram below shows the role of the corporate beneficiary in accumulating distributions from the Trust until the children are ready to receive distributions. Each year the CB receives the Trust income and pays corporate tax on that income. The payment of corporate tax creates credits for corporate tax paid (or franking credits).

At the end of the first year, there is $200,000 x 0.065 = $13,000 of Trust income, which is distributed to the CB. The CB then pays $13,000 x 0.30 = $3,900 of corporate income tax. The remaining $9,100 is loaned to the Trust. The CB then has assets of $9,100 (the loan) and $3,900 of franking credits.

At the end of the second year, the CB will again receive all the income generated by the assets of the Trust, but this time in two parts. First, as interest on the loan, and then the remainder as a simple distribution of income. The CB will again pay corporate income tax at the 30% rate and again loan its after tax income to the Trust.

And so it goes as 12 summers and 12 winters come and go. The children’s cartwheels on the backyard lawn turn to car wheels in the driveway, and now the eldest child reaches 18 years, and the Family Trust is now ready to move from accumulation to the distribution phase.

The cash flows in the accumulation and distribution phases

Distribution phase

After 11 years the totals are as follows:

  • Gifts to the Trust have amounted to $420,000
  • CB has stored $185,000 from accumulated income
  • Tax paid of about $80,000.

At the end of the 12th year of the Trust's life, distributions to the CB cease and distributions to the children begin. Each child receives a distribution of $37,000 at the end of each year for six years after they turn 18. The children's after-tax income is then gifted back to the Trust. The distribution phase goes on for 10 years, with distributions peaking at $111,000 in the two years that all three children are receiving distributions.

The cash that is distributed to the children has three sources:

  1. Annual income from the Trust's assets, which is now distributed to the children instead of the CB.
  2. Value accumulated in the CB.
  3. Return of the corporate tax paid by the CB.

The diagram above shows on the right-hand side the cash flows in the distribution phase.

During the 10-year distribution phase, all the distributions to the CB that were made during the 12 years of the accumulation phase are returned to the Trust and distributed to the children. The value stored in the CB is paid to the Trust as a series of annual dividends (the Trust owns the shares in the CB). The Trust then passes the dividends, with franking credits attached, to the children who use the franking credits to reclaim the corporate tax that was paid. So, all the money that was ever sent to the CB, including the part that was then sent to the ATO as tax, is returned through the Trust to the children, who then pay personal income tax on that amount.

The Trust's 'effective' tax rate

At the end of the distribution phase the Trust has existed for 22 years. The accumulated value in the Trust is $1.38 million of which $620,000 is the gifts from the couple and $760,000 is the investment returns after tax. The Trust is now reset in the sense that the balance in the CB is zero and the tax credits are zero.

The couple can do whatever they wish with the $1.38 million, including taking it out of the Trust and paying it into their superannuation (at $100000 each per year); gifting it to the children to launch them in the property market; leaving it in the Trust and start accumulating again through the CB; or spending it.

The Family Trust provides some real tax benefits. The $620,000 of gifts compounded into the final value of $1.38 million at an annual rate of 5.62%, which is the after-tax return on the assets. The before-tax return is 6.50% and the after-tax return is 5.62%. Therefore, the effective tax rate of this strategy is 13.5%, which is less than the 15% income tax rate in superannuation during the accumulation phase.

The effective tax rate is so low because the income is stored in the CB until it can be retrieved and cycled through the children's income. When the children receive distributions of $37,000 they only pay $3,867 in income tax, which is an average tax rate of 10.5%.

But if the children pay all the tax (the CB's tax is all retrieved), then why isn't the effective tax rate of the strategy 10.5% instead of 13.5%? All the taxes paid by the CB are retrieved from the ATO and distributed to the children, but while the ATO has the CB's tax the ATO is effectively receiving a zero-interest loan from the Trust. The ATO does not receive a loan in a legal sense, but that is how we should think of it economically. The taxes go to the ATO but are only returned after a period of time, and that raises the effective tax rate of the strategy.

Effect of corporate tax falling from 30% to 25%

The effect of the tax on small corporations (< $10 million in income) slowly falling from 30% to 25% will lead to the Trust having $1.41 million in assets after 22 years and the effective tax rate falls to 11.3%.

The effective Trust tax rate is lower when the corporate tax rate falls, even though all corporate tax is returned because the corporate tax rate determines the size of the zero-interest loan to the ATO. If the corporate tax rate is 30% then the ATO has collected about $79,000 of corporate tax during the accumulation phase (the size of the zero-interest loan). If the tax rate is only 25% then the accumulated tax is $67,000.

If there were no delay in the return of tax paid, through franking credits, then it would not matter to the couple whether the corporate tax rate was 30% or 25%. But once there is a delay in return then the tax becomes a zero-interest loan to the ATO, until it is returned. If that loan goes on forever, then the effective tax rate equals the corporate tax rate of 30%.

A CB meets the ATO's requirement that a corporation is carrying on a business to qualify for the lower tax rate on small businesses, as according to ATO's website, even if the company's activities are relatively passive, and its activities consist of receiving rents or returns on its investments and distributing them to shareholders.

 

Dr. Sam Wylie is a Principal Fellow of the Melbourne Business School and a Director of Windlestone Education. Sam consults and teaches finance programmes for corporate and government clients. Please seek professional advice on structuring and tax planning from a qualified accountant or financial planner. This article is general information and does not consider the circumstances of any individual.

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36 Comments

Dean

August 02, 2019

What is confusing me is why cant the trust simply reinvest the income into more assets? Why go to the trouble to create CB?

Shaun Fishley

September 13, 2017

Great article thanks. It sounds like a large capital gain from a FT could be parked in the bucket as well. If so, could the trust distribute the untaxed 50% of the gain and park the other (taxable) 50% in the bucket?

Alice Weber

August 12, 2017

Thanks for this explanation.

Graham Hand

August 09, 2017

Hi Sam, I've raised this point with some wealthier people, and they say they will simply leave the money there until either they are in a lower tax bracket in later years, or the company will become part of their estate and their children can decide how to use the money. It could be left in there for generations.

Sam Wylie

August 11, 2017

Sam and Graham
If a bucket company accepts the income from the trust and loans out the proceeds to family members for long periods of time, then the effective tax rate on income becomes 30%. But that is a lot better than 47%.

Sam Laser

August 09, 2017

In actual fact bucket companies appear to have restricted use as eventually the money has to come out of the company and make its way to the recipient where the appropriate tax is paid.

Peter Thompson

August 08, 2017

That is about as good a 4-page summary of this complex and nuanced topic as one is likely to find anywhere. Well done and thank you, Sam Wylie.

I am presumably not the only one who opened a spreadsheet to use the article as a guide to hack my way through the maths. But yes, in agreement with some of the other commenters above, in the event that Labour's mooted 30% floor on trust distributions were to be implemented one day, surely the obvious solution after the accumulation phase is to just channel trust distributions to the corporate beneficiary and leave them there, to be distributed ultimately as fully-franked dividends as and when required.

Matt

August 07, 2017

Sounds good in theory, but there are a few concerns:

1) Div 7A on the 'loan' from CB to Trust. There is definitely an issue here and management of that is not explained in the article.

1a) Note: If you leave the cash in CB to void 7A then you introduce a range of other issues, such as losing CGT concessions on growth assets. Could this distort selection of investments , i.e. towards less optimal for the long-term growth towards more income producing?

2) The distribution to the kids is largely hypothetical and may not stack up in real life. For example, are you really assuming the kids have no other income source for 10 years after they reach 18, i.e. by 28? Not sure I'd want my kids to be out of work that long..!!

2b) Note: If they do earn income over that period the efficiency is greatly reduced.

So, a fine theory but does it really work and is it really worth the hassle?

Mike

August 03, 2017

If trusts are to be taxed at company rate and are not compelled to make distributions then you do not need a bucket company

Graham Hand

August 03, 2017

Hi Mike, a trust is an investment structure which holds money but it pays no tax on earnings. Taxable income flows through to beneficiaries, such as a spouse, children or a bucket company. The beneficiaries pay tax on what they've been paid. That is why there is a bucket company in the structure, ensuring that the maximum tax that needs to be paid is the company tax rate of 30%.

AndyB

August 03, 2017

Thanks for the article. A few comments:
- Need to examine Div7A issues on loans between Corp and FT, is not as easy as described here and requires principal and interest to be setup.

- a better result may be, if the couple only has 200k why aren't they putting it in super. tax rate is lower there (not only during accum but much lower in distribution phase). In 12years time they may have reached preservation age

To answer Peter's question - there is a big discussion between ATO and Govt over the ability of passive Inv companies to access the lower tax rate. I believe it's likely passive will be taxed at 30% while active are at 27.5%, i.e. a leaking of div imputation, slightly worsening the net outcome for the FT

Simply having investments in your personal name, FT, super and corp are needed to manage the tax change risk.

Kym Bailey

August 04, 2017

What happened to the gifts from company to trust?
If repaid, the way out of the company is either; a capital return or, a share buyback.
Re the trust owning 100% of the bucket - s100A 1936 Tax Act will put that in the realm of a re-imbursement agreement

Sam Wylie

August 11, 2017

Andy
I agree on all those points. These are short articles in Cuffe Links, so examples have to be simple.

John

August 03, 2017

Why wouldn't you have the trust own the bucket company (with a corporate trustee)
and simply keep the money there? Would be much simpler wouldn't it?

Sam Wylie

August 11, 2017

John
The trust does own the bucket company shares in this example. That arrangement is not necessarily ideal when the bucket company loans the after tax income back to the trust, because it can create Division 7A problems. I put that arrangement in the example to keep it simple.

Peter

August 03, 2017

Will bucket companies such as the one used in this example receive the lower company tax rates - or will the reduction in tax rates only apply to 'small business entities'? i.e.If so and if the company is not a small business will the tax rate simply stay at 30% ?

Sam Wylie

August 11, 2017

Peter
That is the $64k question on which accountants don't agree. The ATO's website is very clear that bucket companies will pay the lower tax rate, but the Federal Government has announced that it will amend legislation to prevent that.

John

August 03, 2017

For my own bucket company, we intend leaving the assets in there (and accumulating income) until such time as my wife and/or I do not have enough personal exertion income to stay above 30% tax rate ....we will then just pay ourselves fully franked dividends coming from the bucket company up to the trust and on to us.

Sam Wylie

August 11, 2017

Gary and John
Those long term accumulations in bucket companies are their main usage, as you point out. I wanted to bring out the fact that the tax paid is a zero interest loan to the ATO. Sometimes money is left in bucket companies for many decades (discretionary trusts can only live 85 years) and loans are made from the trust to family members. But in that case the 'loan' to the ATO is effectively permanent.

Gary M

August 03, 2017

There's also the ability to leave the money in the company indefinitely and take it out when it suits you, perhaps when not earning much income later in life. Or not at all.

Chris

August 03, 2017

Excellent article (from someone who uses one of these family trusts). Only issue I had was that paying dividends from the bucket company back up to the trust then the trust distribution to the children is "theortical" in my view. This is because the children may be earning employment income and on a higher tax rate than 30%. Plus, not every parent wants to gift money to their kids continuously ....including me.

Sam Wylie

August 11, 2017

Chris
I was thinking of children who are still in education, but many are not at 18 years. In any case the cash could be distributed to the children who then make a concessional contribution to their superannuation at a 15% tax rate. Or, it might be distributed to parents, or other beneficiaries on low tax rates.

harry

July 10, 2019

There seems to be a presumption that you have indolent adult children for 6 years from the ages 18 to 24. At the "peak" you distribute $111k to these idle fully dependent children and "saved" at most $40k (assuming you would have had to pay 47% tax). This is the equivalent of $13,333 per fully dependent adult child, this doesn't appear to be a road to riches.

Peter

May 27, 2019

this article metions trust income tax rate lower than super (15%) - in most cases super income is not taxed at 15% as super funds also claim back franking credits which reduce there income tax rate below 15%

Dudley

May 28, 2019

"in most cases super income is not taxed at 15% as super funds also claim back franking credits which reduce there income tax rate below 15%":

In all cases, accumulation super income, other than capital gains (taxed at 10%), less deductions, is taxed at 15%.

Franking credits are credits for tax paid by a company and imputed to a super fund shareholder.

Franking credits exceeding the super fund tax assessment are paid to the super fund, else the super fund pays the difference as tax.

In that way the tax paid on the grossed dividends, less deductions, is always 15%.

Harry

February 16, 2019

I'm perplexed by this.
Nothing here seems to be any different to - put money in bucket company, earn income and pay 30% tax.
Accumulate profits.
When children become adults, pay accumulated profits as dividends with fully franked credits applying.
Why the need for the trust?

Graham Hand

December 16, 2018

Hi Jas Curious, these are specific questions and Cuffelinks is not licensed to provide personal advice. Maybe someone else will respond but we cannot. G

Jas Curious

December 15, 2018

Hi Sam,

Really love your well written article effectively simplifying a complex subject.

To keep things simple, taking living expenses and economics fluctuations out of the equation.

Let's say a couple's income is $400k p.a. combined earned via a Family Trust. The trust also earns $100k in Share dividends p.a. The goal is to retire and survive off share income in the near future.

a) Trust distributes $87k each to a couple each taxed at 34.5%.

b) The remaining $326k is distributed to the CB taxed at ~30%. Generating a $97.8k Franking credit and $228.2k retained earnings for that financial year.

c) The couple then re-invest the after tax income as a gift through the trust. ($67k + $67k = $134k To buy more shares with dividends and 50% CGT exemptions.

d) CB re-invest its retained earnings of $228k into buying shares with 100% franked dividends. (with understanding CGT exemptions do not apply)

Rinse and Repeat until retirement

Retirement
a) CB Pays Accumulated franked dividend to the trust as a stream
b) Trust distributes franked dividends to couple

Does this scenario make much sense instead of loaning the distribution to CB back to the trust with a P&amp;I structure and loan agreement? What are the benefits of creating a loan?

And can the franking credits earned from CB's dividend income offset the Income earned through Trust distribution?

Dane

February 09, 2018

HI Sam,

A little late with this comment. A very useful article. The only bit I don't fully understand is why the CB needs to loan the after-tax distributions back to Family Trust each year during the accumulation phase. The bucket company is there to collect the annual distributions, pay the 30% tax and then eventually distribute back up to the Trust with the franking credits when the children can receive distributions. Is this the way it needs to be structured in order for the CB to be able to pay a dividend back up to the Trust as a way of extinguishing the loan?? Seems illogical.

Amar

January 12, 2018

Thank you for the well explained article.

Philip - Perth

January 11, 2018

Graeme hits the mark perfectly...what lengths will some go to pay as little tax as possible? To me that shows exactly what they are. This obsession with getting away with paying as little tax as possible almost defines what's WRONG with this country (and some others that we seem hog-tied to). I pay taxes so that I can share and use the facilities provided by them, while others avoid taxes but still want to use the facilities. Well, go and live somewhere else. I'd rather have refugees than all this wasted effort and intellect that could be doing something useful.
What happens when those (spoiled) children ask for their "distributions" back?? They can and may well sue you for them, rather than allow you to use them as tax shields. Then you can disinherit them. Sound familiar? Some very wealthy families end up like this!

Chris

January 11, 2018

You can’t ignore Div 7A of the Tax Act unless the after tax cash is actually paid to the BC.

Graeme

January 11, 2018

Just what we need. Another means for "affluent Australians" to pay less tax. Hence more tax for the non-affluent or less money for public education, health etc.

Rahul

January 04, 2018

The article is silent about:-
a) cost of setting up such a trust arrangement
b) cost of operating such a trust arrangement including accounting and tax advisory fees and charges
c) Minimum threshold limit ($ figure) that would make such a structure viable

Jack

October 03, 2017

Very good exposition, but there's a couple of points to add.

- if the children have HELP debt then the ATO will count the distributions they receive as income for the purposes of reaching the income repayment threshold. Not a problem if they are only getting $37K as per the example but most students work part time and it won't take much income from working at Maccas to push their income high enough.

- distributing to parents might not be an option if this mucks up their pension eligibility. If instead they are fairly high income self funded retirees they will be in a fairly high tax bracket.

- distributions to adult children are all very well but don't then fall out with your children. Once it is distributed to them, it is their money. They can ask for the cash any time they want. This does happen.

shaun fishley

September 27, 2017

Sam, could a SMSF be the share holder / major share holder of the "bucket company" enabling the Family Trust to distribute money to the B/C, the B/C pay a dividend to the SMSF, and the members of the SMSF in pension phase benefit from the tax free status of the SMSF?


 

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