Tax Tip 128: Capping your Tax Rate at 30%

At what income level is it more tax effective to retain income in a company?

Tax on income of a company (that is not a small business) is just 30% tax. (28.5% for “small business entities”)

Tax on an individual is up to 51% (47% plus medicare of up to 2% and the Budget Repair Levy of 2%). But the personal tax rate is progressive – it is lower on the lower parts of the income so someone on a high income wouldn’t be paying 51% of their whole income in tax. See my post from yesterday on this: https://propertychat.com.au/community/threads/tax-tip-127-your-average-tax-rate.10954/


Example someone on $500,000 taxable income would pay $214,632 in tax or 42.93%


So at what point does the person income tax rate equal 30% on average?


Someone on a taxable income of $137,400 would pay income tax of $41,218 which is exactly 30%.


Therefore, if you are able to, receiving income of $137,400 then retaining any other earnings, where possible, in a company would mean overall tax savings.


This is easy if you are self-employed, or have investments held in discretionary trusts or companies.


Example

David is on a taxable income of $120,000 and has work related deductions of $20,000 so his taxable income would be $100,000 after expenses.

David is also a beneficiary of a discretionary trust which he controls. He has no other family or potential beneficiaries of the trust which he would want to benefit from the money. The trust has an income of $100,000 after its expenses.

What he does is cause the trust to distribute $37,400 to himself and then the remainder, being $62,600, to be distributed to a company set up solely to receive trust distributions and nothing else (especially no trading). The company would pay tax on the $62,600 at 30% which is $18,780.


Had David received the whole $100,000 from the trust his total income would have been $200,000 and the tax he would have paid would have been 67632


His income tax on $137,400 would have been $41218 plus the company tax of $18.780 = $59,998


Tax saving $7,634


But it doesn’t stop there. Later David marries an unworking woman. She is now a beneficiary of the trust that owns the shares in the company. David causes the company to distribute income to her. She gets the income tax free, but she also gets back tax that the company has paid.

Of course the next problem is getting money out of that company so that you can enjoy it - see
Tax Tip 108: Using Bucket Companies to Save Tax

Tax Tip 111: Getting money out of a Bucket Company

 

I should add a 'it depends' to this. Get tax advice before trying at home as sometimes it may still be better for income to be paid to an individual even though they may be on the top tax rate. One example is a capital gain via a trust. A person recieving the distirbution of a capital gain would mean the 50% discount is applied whereas a trust would not. This would mean the individual would pay a lower amount of tax than the company.

 

Minus the cost of running the company. It should be very simple, so fees should be, what $500-1000?

 

The difference in capital gains tax for a company and an individual on the top marginal rate is not that different. If the libs win the election and get their company tax rates changed then eventually the difference will be almost zero.

 

The FINAL rate of tax on a company profit is generally almost never just 30% (or 28.5% for a small business).

1. Personal services income may be taxed in the hands of the individual at normal marginal rates and the company effectively disregarded.

2. For a profitable company it is almost inevitable that taxed profits will be returned at some point to shareholders. This means that the shareholder/s where they are either a discretionary trust or a unit trust with human beneficiaries then the franked income would become taxed in the hands of a shareholder.

The marginal income tax scales in Australia would cause a tax shortfall to any shareholder who receives a dividend of $25,900 or greater since this grosses up to $37,001 which is where marginal tax rates exceed the company tax rate (ie 34.5%). The greater the CGT isssue the greater the problem. This is why companies can make a very poor investment vehicle v's other entities. It is why most investment funds use a trust model and a company is not used.

3. Capital gains in a company do not flow through to shareholders with a CGT discount. Thus companies that substantially generate taxable income from capital gains will pay more tax than human investors however this effect is not linear. The greater the gain, the greater the flat rate of 30%. A company that solely derives A $100k cgt profit would pay $30K tax. A human investor may pay tax on 50% however at a tax rate between 0% and 52% depending on other income.At its worst case the human investor may pay $26K. This is less than a company in its simplest form.

4. Losses in a company may become quarantined and incapable of offset v's other income. This is particularly evident with CGT losses. Until or unless future capital gains occur these losses may be trapped.

5. Issues of control for a company can be complex. Especially where it holds dutiable or other assets. Transactions costs to transfer and correct estate changes can be complex and expensive.

6. Transaction costs for a company are often more. eg accounting, tax fees, ASIC fees etc.

7. Division 7A and loan issues can mask an apparent tax benefit. Many company Directors will loan company funds to themselves, another company or a trust and disregard tax compliance. Apparent tax savings may be lost or a contingent tax concern may occur.

8. Substantial add on costs can result from companies and how they may remunerate others including associates. eg Superannuation guarantee, payroll tax, workers comp, FBT.


I believe it is misleading to state that the full and final tax rate for a company is 30%. Its like me suggesting that a discretionary trust has a final tax rate of 0%. Anyone who is lured to the 30% tax rate really should seek sound tax advice.

 

am i doing something wrong? if i put in 150000 into paycalculator.com.au, it shows i pay 103,553.00 in tax (31%).

 

Not when the shareholder achieves their share of that income. You cant look at just part of the transaction. The return of the investment proceeds arising from the sale must also be considered. Yes it may remain in the company but if it doesnt.....

 

Total taxes are $46,447 - the $103k is the net income.

 

As I understand it the company must have an EOFY bank balance of at least the outstanding income for every year ie if your company profit was $100k for 5 years your bank balance on July 30 in year 5 would need to be $500k. Not something I've done but is this correct?

 

Not necessarily.
But where has the company's $500k gone? If you have taken it, how has it been accounted for?

 

Are there any mathematicians out there?

I think my calculations are wrong because it is not the average tax rate that is important, but the marginal tax rate.

Every dollar over $37,001 would be taxed at 32.5% so it may work out better, in terms of tax savings, for a bucket company to be used at this point.

Example
Tom makes $40,000 solely from rental income received from a discretionary trust. He only needs a little amount to live on - say $20,000 so he could choose to make the trust distribute in these different ways.
1. $40,000 to Tom
2. $40,000 to Bucket Company Pty Ltd
3. $37,000 to Tom and $3,000 to Bucket Company

Overall Tax amounts payable would be
1. $4,947
2. $12,000
3. $3,867 (Tom) and $900 (company) = $4,767

The winner is the third option because less tax is payable overall.

Of course there are other things to consider - the ASIC fee would mean the first option is the more efficient. But the purpose of this thread is just to show the possible potential to save tax by using a bucket company.

 

sorry i meant income. yes so that means 31%. If it were 30% it would be $45000. This means you'd be 'up' only if the associated expenses with a bucket company didn't come to over $1447

 

At what income amount should a person change from a sole trader to a company and trust if only to pay less income tax?

 

'should'?

No necessity in changing structure, but if someone earns over $37,001 they will be on the 32.5% tax bracket plus Medicare.

But even this does mean you will save tax by using a company because if you pull all the money out you will end up paying the same rate anyway.

And there are things to consider other than tax.

 

Perhaps $1.

 

in 2022 a resident taxpayer could earn approx $167,000 and pay $50,197 in that which would be 30% average tax rate.

 

The part I dont understand is how to get the money from the company to the individual. At some stage you will need to pay the extra 17% tax approx (47% personal - 30% company rate) if you continue to be in highest tax bracket forever.

If there is any way around that then would be interested to know!

Otherwise you are just delaying the inevitable. Sure in retirement one could stop operating business to a large degree and then take out the funds. But that's a long way away and if investment income is high by that point then you will still be in highest tax bracket regardless.

 

Have a read of my other tips I have covered this. Even if you will pay the exact same tax rate throughout your life there will be extra compounding occurring in the company until you take it out. But most also aim to take it out later when they retire and income is lower or it can be diverted to kids once they hit 18.