Future Focus: Can I lower my tax rate with a company?
Can a company structure help you lower your tax obligations?
I recently explored if investors could lower their tax obligations with a trust. The conclusion was that it can work for investors that make substantial passive income and have eligible individuals on lower tax rates that they are willing to distribute income to. This is not the only alternative structure to paying taxes at your individual tax rate.
Another option is to invest and distribute income as a company. Companies enjoy a 25% or 30% tax rate (depending on circumstances discussed below). This is a significantly lower rate than the highest marginal tax rate of 45%. This difference in tax rates makes this option extremely attractive to high income earners or those that have significant passive income.
That isn’t the end of the story, however. There are restrictions that come with a company structure. Unlike trusts, they offer no flexibility to distribute income across family members. Income must be distributed as dividends, proportionate to shareholdings. Income cannot be distributed based on personal tax circumstances. Companies also miss out on a CGT discount – eligible to both individuals and trusts.
So how do they work, and in what circumstances would you consider one?
Companies 101
As with trusts, you are not able to distribute your income from employment through a company. You are able to distribute investment income and capital gains through the company.
The major difference of setting up a company is that it is a distinct, separate entity. The profits and debts that are held by the company in the process of investing do not become the profits and debts of the individuals.
The tax rate is also 25% or 30% (dependent on circumstances), which is preferable to the higher marginal tax rates. The main circumstances that determine whether you are eligible for the 25% tax rate are:
- the company’s aggregated turnover for the income year is less than $50 million; and
- 80% or less of the company’s assessable income for the year is ‘passive income’.
We encourage long-term investing over trading. Long term investors will receive the 30% tax rate for companies.
As mentioned, companies are not eligible for a CGT discount like individuals and trusts.
To set up a company, you would seek the advice of a tax professional. Companies have initial set up costs, ongoing advice and administration costs.
Sometimes, investors utilise a structure with both a trust and a company, in this instance categorised as a bucket company. Trusts can own the shares in an investment company, and this allows flexibility for the on flow of income/profit to all trust members. This is not just useful for a case where there are large disparities in income and therefore tax rates. It can be especially useful for individuals who may have career breaks due to caring responsibilities where income may be redistributed.
The other case is when the trust distributes profits to the company, and the company pays the 25% or 30% tax rate. This cash is then used to invest in assets and can provide franked income in the future.
Let’s take a deeper look at the advantages and disadvantages of a company structure. This can help to determine the circumstances where a company might be advantageous.
Main advantages and disadvantages of a company structure
Advantage: Tax rate
30% is a lower tax rate than the higher marginal tax rates. This means that the company tax rate is lower than the marginal tax rate
However, 30% is a flat rate. Marginal tax rates operate in a way where effective tax rates are important to consider. Take for example, an income of $200,000. You may be on a 45% marginal tax rate, but your effective tax rate is 31.6%. That is the percentage of your income that you pay to tax.
It’s important to consider the sources of income to understand how important this is. If you have a salary ($200,000) and you are earning passive income on top of that from investments, you will be paying a rate of 45% on that passive income.
If you do not have a salary and are deriving passive income, the effective tax rate does matter when considering a company structure.
What this means for investors: A company structure may suit investors who have or on a high marginal tax rate and derive considerable passive income. Or, those that derive considerable passive income that pushes their effective tax rate past 30%.
Disadvantage: Capital gains
There’s no capital gains discount for companies, unlike with individuals and trusts. Experiencing the full capital gains tax without a discount can significantly impact total return outcomes.
What this means for investors: You must take into account how often assets will be disposed of when considering how valuable a company structure will be in your tax strategy. Companies may be more efficient for individuals who are looking to retain and reinvest their earnings, instead of generating capital gains.
Advantage: Retain earnings
Earnings do not need to be distributed, which can open options for tax strategy. The company has the ability to retain earnings, and profits are left in the company after they are taxed once, and personal tax can be deferred by postponing removing the profits from the company.
What this means for investors: Smart strategies can utilise this to minimise taxes, especially for individuals that foresee years where they will experience lower tax rates.
Disadvantage: Administrative burden
Companies have a heavier administrative burden. To establish and maintain a company requires several registration processes and oversight. I’ll address costs further down.
What this means for investors: You must be ready to pay for professional services and/or be willing to carry the administrative burden.
Advantage: The company tax rate matches the fully franked rate.
If a fully franked dividend is issued to the company and retained within the company, it is net 0% tax as the company is taxed at 30%. The company can also issue franking credits to shareholders.
What this means for investors: This can be tax efficient for individuals who the company is distributing income to.
Cost of a company structure
The cost of establishing and maintaining a company must be less than the potential tax savings.
According to SprintLaw, establishing a company can vary greatly in cost. It can be between $1,000 (DIY with minimal extras) to $4,000+ (including professional service fees for legal and tax advice).
To maintain your trust, the cost can also vary depending on the complexity of your investments. Companies with simple investment portfolios can average $1,000 per year, with complex portfolios reaching up to $5,000.
Final thoughts
Company structures can be beneficial for investors on high incomes that derive considerable passive income. A company can retain earnings, which means that it can open the doors for tax planning and strategy. They are however, expensive to set up and maintain. Ensure that you seek professional tax advice to understand if this is the best option for you. It must be carefully considered as it can be a headache to unwind and cost you more in the long run.
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