About 450,000 affluent Australian families hold their investments in some combination of superannuation, family trusts and direct ownership of negatively geared property. But over the last year, changes in tax rules and changes in property market conditions have shifted the relative benefits of these arrangements. Family trusts have been made comparatively more attractive. Investors should consider whether their ‘structuring’ and tax planning is still optimal.
A lot has changed recently in terms of the relative merits of super v family trusts v negative gearing. This article uses an example to focus on just one part of the overall picture: how the reduction in the income tax for small corporations from 30% to 25%, will make the accumulation of wealth through family trusts more tax effective.
In the example a couple with children are able to 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 strategy will accumulate wealth at effective tax rate of only 11.3%.
The example follows. But first, a reminder that this newsletter is commentary and education, and not financial advice. Proper ‘structuring’ of the ownership of assets and streaming of the cash flows from those assets through trusts, corporations, partnerships or direct ownership is a crucial part of wealth management. You need advice on structuring and tax planning and your accountant is the person to speak to. This article helps you have that conversation at a higher level.
A family trust with a corporate beneficiary
Mei Li and Jack Houston are a professional couple with high incomes, who have young children, aged 2, 4 and 6 years. They recently sold an apartment that they bought a few years ago, and now the couple decide to use the $200,000 net proceeds from the sale to establish a family trust.
The Houston Family Trust will has 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 make a gift of the $200k to the Trust. They might instead have loaned the money to the Trust. The $200k is then invested in high income assets, such as high yielding shares or commercial property. The couple resolve to make further gifts of $20k, 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).
Let’s imagine that the pre-tax return on the trust assets is 6.5% per year after adjusting for inflation. Obviously, income will fluctuate from year to year, and equally obviously there will be capital gains or losses on the assets, but I want to keep our example simple to bring out a few points. So, a 6.5% real return before tax, received entirely as income, with no capital gain.
At the end of each year the annual income from the trust’s assets must be distibuted to the beneficiaries of the trust. It won’t be distributed to Mei Li or Jack because they already pay income tax at the highest rate. And, it can’t 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.
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 corporate beneficiary (CB) receives the trust income and pays corporate tax on that income. The payment of corporate tax creates credits for corporate tax paid (called 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 (corporate beneficiary). 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 of 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. 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 is 18 years (borrowing from Joni Mitchell’s song The Circle Game). The Family Trust is now ready to move from accumulation to the distribution phase.
Figure 2: The cash flows in the accumulation and distribution phases
After 11 years the totals are as follows. The couple’s gifts to the Trust have amounted to $420k. The CB has stored $185k from accumulated income and tax of about $80k has been paid by the CB.
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 $37k at the end of each year for 6 years after they turn 18. The children’s after tax income is then gifted back to the Trust (in this simple example). The distribution phase goes on for 10 years, with distributions peaking at $111k in the two years that all three children are receiving distributions.
The cash that is distributed to the children has three sources. First, the annual income from the Trust’s assets, which is now distributed to the children instead of the CB. Second, the value accumulated in the CB. Third, the 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 of the distributions to the CB that were made during the 12 years of the accumulation phase are returned to the Trust and then distributed to the children. All of 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, in this simple example). The Trust then passes the dividends, with franking credits attached, to the children who use the franking credits to reclaim all 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 $620k is the gifts from couple and $760k 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 choose with the $1.38 million. They could take it out of the Trust and pay it into their superannuation (at $100k each per year). Or, they could gift it to the children to launch them in the property market. Or, they could leave it in the trust and start accumulating again through the CB. Or, they could just spend it on a new house, holidays, or whatever.
How should we think about the tax effectiveness of using the family trust? The $620k 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%. That is pretty good. It is less that the 15% income tax rate in superannuation during the accumulation phase.
Why is the effective tax rate 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 $3867 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%? Because, yes it is true that 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%
What will be the effect of the tax on small corporations (< $10 million in income) slowly falling from 30% to 25%. In our example, if the corporate tax rate is 25% instead of 30%, then the Trust has $1.41 million in assets after 22 years and the effective tax rate falls to 11.3%.
Why is the effective Trust tax rate 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. In this example, if the corporate tax rate is 30% then the ATO has collected about $79k 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 $67k.
If there was 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%.
You might wonder whether a corporate beneficiary actually meets the ATO’s requirement that a corporation be carrying on a business to qualify for the lower tax rate on small businesses. Here is what the ATO’s website says: This is so 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.
The tax planning of our couple might encompass many other things, including wills and estate planning, or the ownership of a business, for instance. I am not trying to cover everything here, but instead discuss how recent changes to corporate tax rates for small corporations will make family trust arrangements more tax efficient.