Why all the fuss about family trusts?

Share

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.

Share
Print Friendly, PDF & Email

, , , , ,

23 Responses to Why all the fuss about family trusts?

  1. Chris August 3, 2017 at 10:28 AM #

    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 10, 2017 at 11:30 PM #

      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.

  2. Gary M August 3, 2017 at 10:35 AM #

    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.

  3. John August 3, 2017 at 10:38 AM #

    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 10, 2017 at 11:35 PM #

      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.

  4. Peter August 3, 2017 at 1:12 PM #

    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 10, 2017 at 11:37 PM #

      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.

  5. John August 3, 2017 at 1:17 PM #

    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 10, 2017 at 11:41 PM #

      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.

  6. AndyB August 3, 2017 at 2:32 PM #

    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 4, 2017 at 8:54 AM #

      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 10, 2017 at 11:44 PM #

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

  7. Mike August 3, 2017 at 3:24 PM #

    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 3, 2017 at 3:34 PM #

      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%.

  8. Matt August 7, 2017 at 11:06 AM #

    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?

  9. Peter Thompson August 8, 2017 at 11:16 AM #

    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.

  10. Sam Laser August 9, 2017 at 12:47 PM #

    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.

  11. Graham Hand August 9, 2017 at 12:48 PM #

    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 10, 2017 at 11:51 PM #

      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%.

  12. Alice Weber August 12, 2017 at 5:59 PM #

    Thanks for this explanation.

  13. Shaun Fishley September 13, 2017 at 6:53 PM #

    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?

  14. shaun fishley September 27, 2017 at 11:33 AM #

    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?

  15. Jack October 3, 2017 at 3:58 PM #

    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.

Leave a Comment:

*

Register for our free weekly newsletter

New registrations receive a free copy of our ebook, Cuffelinks Showcase 2016.