18 – Tax efficient investment structures
The first variable in the tax efficient investing equation involves choosing income tax and CGT efficient investments. Homes, businesses, business premises and franked shares each have a role to play.
The second variable in the tax efficient investing equation involves choosing the best legal structures. Companies, trusts and SMSFs each have a role to play too. This role has two functions:
- diverting assessable investment income to a tax efficient investment entity, via trust distributions or deductible contributions, to be taxed at a lower tax rate than otherwise; and
- owning investments in the name of the tax efficient investment entity so the assessable income is taxed at a lower tax rate than otherwise.
How are the different legal structures taxed?
Clients pay tax at a range of tax rates depending on their income level. Typically a lot is taxed at 40% or 45% plus Medicare levy, plus, for the years ending 30 June 2015 to 2018, a 2% deficit reduction levy on incomes above $180,000.
Companies pay tax at 30% (28.5% for certain “small business companies”). However, the 30% tax payment is just round one of a multi-round game. This is because the ultimate rate of tax is not known until the company’s after tax profits are paid out as franked dividends to an individual shareholder. If the individual’s tax rate is more than 30%, extra tax will be paid, which means the ultimate rate of tax will be more than 30%. If the individual’s tax rate is less than 30%, there will be a part or full refund of franking credits, which means the ultimate tax rate is less than 30%.
Companies create income distribution flexibility over a number of income years.
Trusts are normally not taxed. A trust’s net income is instead attributed to its beneficiaries (unit- holders) and these persons are taxed on the net income depending on their own tax profile. Sometimes net income passes through a series of trusts until derived by an individual or a company, in whose hands it is ultimately taxed.
Discretionary trusts, or family trusts, allow the trustee to allocate net income among the beneficiaries, usually family members or trusts and companies controlled by family members, who will pay the least amount of tax on it. Trusts create income distribution flexibility among related persons in a particular income year.
Growth assets in companies?
MLA Lawyers and LegalEDocs have set up investment companies where the shares are owned by a discretionary trust. Growth assets are held by the company. Usually the company does not pay a dividend and instead reinvests its after tax profits in fresh investments. This allows the client to get the best of both worlds: multi-dimensional distribution flexibility, over time and between beneficiaries due to:
- the income distribution flexibility among related persons within a particular year, created by the discretionary trust and
- the income distribution flexibility over a number of income years created by the company, and the dividend franking.
We discuss the idea of owning growth assets in companies in more detail here: Growth assets in companies?
SMSF tax profile
SMSFs have a complex complex tax profile and it is best summarized in table form:
|Income||Tax rate in accumulation mode (ie under age 60)||Tax rate in pension mode (ie over age 60)|
|Dividends||15%, less franking credits||Nil %, less franking credits (ie refunds are paid)|
|Realized capital gains < 12 months||15%||Nil%|
|Realized capital gains > 12 months||10%||Nil%|
|Un-realized capital gains||Nil%||Nil%|
In summary, it is probable, but not certain, that any particular investment will do better owned by a tax efficient structure, such as a family trust, a company owned by a family trust or a SMSF.
Financial planners who use tax efficient investment structures will probably get better after tax results than those who do not, both for themselves and for their clients.
Contact the Dover Team today if you need help structuring your clients’ investments, or advice on your own business and legal structure. We are here to help.
Further relevant reading
You can read further on tax efficient investing here: The Dover Way. Tax Efficient Investing.
You can read further on tax planning for financial planners here: The Dover Way. Tax Planning for Financial Planners.