Tax Tip 372: The Extra Compounding that can Occur with Bucket Companies

A company that is not trading will generally pay a maximum tax rate of 30% whereas an individual will generally pay a maximum of 47%.

That means that on an equivalent income a company can pay 17% tax less than an individual.

Imagine an extreme case where there is $100,000 investment income generated.

If this was taxed in the hands of an individual already on the top marginal tax rate it would result in $47,000 in tax.

If it were taxed in the hands of a company it would result in $30,000 in tax payable.

That is $17,000 in tax saved – per year.

Imagine how much extra capital there would be if this went on for 10 years.

In the first year there would be $17,000 extra capital to invest, then that $17,000 would be reinvested and be compounding so in the second year there would be $17,000 plus the extra return on $17,000 plus another $17,000 saved as well. It would snowball.


Example

Nelson has inherited $1mil. He is working as an aid worker helping a charity set up with the sole aim to help the poor with him being on a $400,000 salary. So he is on the top marginal tax rate and any extra earnings would be taxed at 47%.

Nelson sets up a discretionary trust to do the investing. He ummed and aahed about it for ages as he is a loner with no family and no friends – even the poor don’t like him. So he would effectively be the only beneficiary the trust would ever distribute to, other than a company.

He is a good investor and causes the trust to earn $100,000 in income in year 1. He causes the trust to distribute to a bucket company he sets up with a second trust as the shareholder.

$100,000 goes to the company and $70,000 is left over after $30,000 tax.

The company invests this itself rather than lending it back to the trust.

So in year 2 the company generated $7,000 income on this $70,000 and pays $2,100 in tax so it has $4,900 after tax, plus it receives $100,000 from the trust again and pays $30,000 tax on that. At the end of year 2 it would have $70,000 plus $4,900 plus $70,000 = $144,900

Had Nelson caused the trust to distribute to himself he would have paid $47,000 in tax and be left with $53,000 to reinvest. He might still generate a 10% return but that would mean only $5,300 in income before tax or $2,809 after. At the end of year 2 he would have $53,000 plus $2,809 plus $53,000 or $108,809


You should be able to see that by using a bucket company there is more capital left over and this allows greater compounding.

Next, I will show how this can still benefit people like Nelson when eventually it all comes out of the company and extra top up tax is payable.

 

Companies can indefinately DEFER final tax payable provided Division 7A isnt impacted. If the profits are retained until the persons cease income earning it may even be possible to get a partial or full REFUND of the company tax already paid. This limited to low income persons as once the marginal tax rate of the individual exeeds 30% shortfal tax may apply. Under that value (eg property losses etc) this can mean smaller dividends can allow shareholders refund of all the franking.

Div7A is a Part of tax law which taxes funds "taken" from a company as if they were a dividend and it can lead to lost franking as a penalty.