Contents
- What is a Bucket Company?
- How Does a Bucket Company Work?
- Tax Efficiency Through Trust Profits
- Base Rate Entity
- How to Set Up a Bucket Company?
- Determining Share Ownership for the Company
- What Possibilities Exist for Funds Held in a Bucket Company?
- How Can Funds be Withdrawn from a Bucket Company?
- Division 7A Loan
- How to Determine If a Bucket Company Strategy Fits Your Needs
- Key Challenges of a Bucket Company
What is a Bucket Company?
A bucket company is a type of company established as a beneficiary to a trust. The term bucket signifies its position beneath the trust, serving as a conduit for funneling funds into the trust to minimise tax liabilities.
The strategy involving a bucket company enables individuals to limit the tax on profits distributed by a trust to either 30% or 25%, which is significantly lower than the individual top marginal tax rate of 47%.
In essence, the corporate tax rates applicable to bucket companies are 25% for Base Rate Entities and 30% for other companies. This structure offers tax advantages compared to distributing income directly without utilising a bucket company.
It’s crucial to note that while a bucket company is associated with the trust, it is not owned by the trust itself but may be owned by a trustee. Moreover, there are specific regulations concerning Family Trusts, particularly regarding intra family distributions, which may affect the tax implications.
How Does a Bucket Company Work?
Typically, a bucket company comprises three key components:
- Presence of a trust holding surplus income available for distribution.
- The corporate beneficiary must be designated as a beneficiary according to the terms outlined in the trust deed.
- Evaluation of whether the bucket company is integrated into a family group structure, considering potential implications related to family trust distributions tax.
Tax Efficiency Through Trust Profits
For those with a Discretionary or Family Trust generating profits, employing a bucket company strategy can be advantageous. This approach allows for a reduction in tax on distributed trust profits to either 30% or 25%, which is considerably lower than individual top marginal tax rates, which may reach up to 45%.
Here’s how this strategy works:
Consider a scenario where a trust earns profits from its business activities or investments.
Option 1: These profits could be evenly distributed between Individuals 1 and 2, who may face marginal tax rates ranging from 32.5% to 45%.
Option 2: Alternatively, profits could be distributed to Individuals 1 and 2 up to the 32.5% tax bracket, with the remainder allocated to the bucket company. This allows for the benefit of the company’s capped tax rate of either 25% or 30%. Depending on individual circumstances, option 2 could result in significant tax savings for the current financial year.
The funds retained after tax in a bucket company can then be utilised for various purposes, including investment in shares, property, or providing loans to other entities at predetermined interest rates.
Base Rate Entity
For a company to qualify as a base rate entity in Australia, it must meet two main criteria. Firstly, its annual aggregated turnover, calculated at the end of the financial year, should be below $50 million.
Secondly, the company’s assessable income should not consist of more than 80% base rate entity passive income. This implies that at least 20% of the company’s income must originate from active sources, such as business operations or trading activities. Meeting these conditions allows the company to be classified as a base rate entity, which can have implications for its tax treatment.
How to Set Up a Bucket Company?
Setting up a bucket company involves several key steps:
Establish a Trust
Initially, there must be a trust with income available for distribution. Additionally, the trust deed must explicitly allow for a corporation to be listed as a beneficiary.
Incorporate the Company
The next step is to incorporate the bucket company as it is done with any other company, following the legal procedures and requirements for company formation.
Determine Company Officers and Shareholders
Consideration should be given to appointing directors and determining the shareholders of the company. It‘s essential to discuss these decisions with both the company’s accountant and legal advisor to ensure compliance with regulations and alignment with the overall financial strategy.
Consultation and Advisory
Seeking guidance from financial and legal professionals is crucial throughout the setup process to ensure that all legal and regulatory requirements are met and that the chosen structure aligns with set financial objectives.
Determining Share Ownership for the Company
When considering who should hold shares in a bucket company, it’s crucial to prioritise the tax benefits they offer. If shares are held by an individual, dividend distribution flexibility is limited, as dividends must align precisely with the shareholder percentage.
However, if shares are held by a different type of trust, excess profits can be distributed in a manner that minimises overall tax liabilities.
What Possibilities Exist for Funds Held in a Bucket Company?
Another valuable function of a bucket company lies in its ability to serve as a repository for long term investments. These investments may include holdings in shares, properties, or other financial assets. By assuming this role, the bucket company transforms into an investment entity, capable of generating additional income streams for its owner.
However, it’s essential to note that companies don’t benefit from the 50% Capital Gains Tax discount available to individuals. Despite this limitation, there could be other compelling reasons to adopt a company structure for managing investments within a bucket company framework.
How Can Funds be Withdrawn from a Bucket Company?
Once income is funneled from the trust to the bucket company, the question arises: how can one withdraw funds from a bucket company? There are three primary methods for extracting money from a bucket company:
Dividend Payments to Shareholders
Dividend Payments to Shareholders
Loans from the Bucket Company
- Another option involves borrowing money from the bucket company. Similar to any other loan, borrowers must repay the principal and interest. However, these loans are categorised as Division 7a Loans and entail specific requirements that must be adhered to.
Dividends Received by a Discretionary Trust
Alternatively, dividends can be channelled to a separate discretionary trust structure. Unlike the first method, which distributes profits based on shareholding, and the second method, which incurs interest, this approach distributes profits according to the terms outlined in the Trust deed.
For instance, utilising a discretionary trust as a shareholder of the bucket company enables the largest distribution to an individual with the lowest marginal tax rate. It’s important to consider and satisfy any additional rules, such as those outlined in Section 100A.
Division 7A Loan
Division 7A loans can be intricate, deserving a comprehensive examination, but for now, three key points are pertinent regarding bucket companies:
- The interest rate for repayments on the Division 7A loan is determined by the tax authorities. As of the 2022 financial year, the benchmark interest rate stands at 4.52%, while for the 2023 financial year, it currently sits at 4.77%. Adherence to the minimum principal and interest repayments each year is imperative.
- If the loan lacks security, it must be repaid within a span of seven years.
- Conversely, if the loan is secured against an asset like property, the repayment period may extend up to 30 years.
While bucket companies are generally advantageous for investors and business proprietors, it’s essential to assess whether such a strategy aligns with the individual’s specific circumstances.
How to Determine If a Bucket Company Strategy Fits Your Needs
A bucket company approach might be suitable for individuals in the following scenerios:
- A business owner aiming to establish a financial cushion for their family’s future.
- A business owner encountering substantial fluctuations in income from one fiscal year to another.
- Business owners nearing retirement or planning to divest their business, anticipating reduced business income in the future.
However, utilising a bucket company may not be suitable for individuals subject to the Personal Services Income (PSI) rules. These rules are designed to prevent individuals from minimising or deferring their income tax by channeling income earned from personal services through companies, partnerships, or trusts.
Key Challenges of a Bucket Company
Transfer of Trust Income
For a bucket company to receive income from a trust, the trust must physically transfer the funds into the company’s bank account before filing its tax return. This initial challenge requires having the necessary funds available without negatively impacting cash flow.
Alternatively, if direct transfer isn’t feasible, establishing a Division 7A loan between the distributing trust and the bucket company becomes necessary, subject to specific terms including a maximum 7 year term, minimum annual repayments, and interest rates set annually.
Withdrawal of Funds
Taking money out of a bucket company isn’t straightforward. Funds can be extracted through dividend payments to shareholders. As dividends are taxed at the company rate, shareholders receive franking credits equivalent to the tax already paid by the company.
Depending on individual tax rates, this can result in potential tax savings. Retired individuals with lower incomes may strategically receive dividends over time to potentially qualify for tax refunds on franking credits.
Investment Strategy
Once funds are transferred to a bucket company, they need to be invested wisely. While the company can invest in various assets such as businesses, properties, and shares, holding appreciating assets within the company may not be optimal.
This is because the company doesn’t benefit from the 50% Capital Gains Discount available to individuals and trusts. To minimise risk, bucket companies should focus on passive investments rather than actively running businesses, which could jeopardise accumulated assets.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.