Bucket companies: how they work and where they go wrong

A bucket company is a simple idea that is often run badly. A family trust distributes part of its income to a company, so that income is taxed at the company rate rather than at a family member's top personal rate. Done properly, it can be a useful part of a family business structure. Done carelessly, it creates Division 7A loans, unpaid entitlements and a tax bill that arrives years later.

How it works

A discretionary trust can usually distribute income to any beneficiary named in its deed, including a company. A bucket company is simply a company, typically owned by the family or by the trust itself, set up to be one of those beneficiaries.

The logic runs like this:

1. The trust earns profit from a business or investments.
2. The trustee distributes enough to family members to use their lower tax brackets.
3. The balance is distributed to the bucket company.
4. The company pays tax on that income at the company rate.
5. The after-tax money is retained, invested or later paid out to shareholders as franked dividends.

The rate the company pays matters. A company that earns mostly passive income, such as trust distributions, interest, rent or dividends, may not qualify as a base rate entity and may pay 30% rather than 25%. Check this each year with your adviser rather than assuming the lower rate.

An illustration

Suppose a family trust has $400,000 of profit. The trustee distributes amounts to the two adult family members up to the level where their marginal rates are comparable to the company rate, and the remaining $200,000 to the bucket company. At a 30% rate, the company pays $60,000 tax and is left with $140,000.

Compare that with distributing the extra $200,000 to an adult on the top marginal rate, where the tax would be substantially higher. The difference is real but, as with any company, it is often a deferral. When the company later pays a dividend to someone on a high rate, top-up tax is payable after the franking credit. The benefit is greatest when the retained funds are reinvested for the long term or eventually paid out to shareholders on lower rates.

These figures are illustrative only.

Where it goes wrong

The money never reaches the company

The most common problem. The trust resolves to distribute $200,000 to the company, the company records that it is owed $200,000, but the cash stays in the trust and keeps funding the business. That amount is an unpaid present entitlement.

The ATO's view is that, in many cases, an unpaid entitlement left with the trust can be treated as a form of financial accommodation from the company to the trust, which brings Division 7A into play. In practical terms, if the money is not paid to the company within the required time, it may need to be put on a complying loan agreement with interest and minimum yearly repayments, or it can be treated as an unfranked dividend. The rules here have changed over time and the details matter, so check the current position with your adviser each year.

The company lends the money back

Even when the cash is paid to the company, owners often want to use it. If the company then lends it to the shareholders, the family or the trust, that loan is caught by Division 7A unless it is repaid or placed on a complying loan agreement. See Division 7A: taking money out of your company the right way.

Distributions with no real benefit

A bucket company distribution must be genuine. Arrangements where the company is allocated income but the money is effectively applied for someone else's benefit can attract the anti-avoidance rules, including section 100A in some circumstances.

Wrong company tax rate

As noted above, a company that earns mainly passive income may pay 30%, not 25%. Planning on the wrong rate produces the wrong distribution decision.

Trapped profits

Profits retained in the company are taxed at the company rate, but extracting them later means dividends, which bring further personal tax for shareholders on higher rates. A bucket company that keeps accumulating cash with no plan becomes a store of deferred tax.

Liquidation and sale issues

A company does not receive the 50% CGT discount. If investments are held in the bucket company for growth, any gain on sale is taxed at the company rate without a discount, and passing that gain out to individuals later involves a dividend. This is a common reason to think carefully about what the company should invest in.

A bucket company is only as good as the cash management behind it. If the money is not paid, or is paid and then lent back, you have created a Division 7A problem.

Running it properly

• Plan the distribution before 30 June with the year's numbers and each beneficiary's position in view.
• Pay the cash to the company, or put any unpaid amount on the correct footing before the relevant deadline.
• Keep the company's money separate. Its own bank account and its own records.
• Decide what the company will do with its funds. Reinvest in the business through a proper loan agreement, invest for the long term, or pay dividends in a planned way.
• Document any loans to the trust or family before the company's tax return lodgment day, with a written agreement and minimum yearly repayments.
• Review the company's shareholding. Who owns the bucket company affects who eventually receives its dividends and the asset protection of its funds. A lawyer should prepare the constitution and any share issue.

Is a bucket company worth it?

It is most useful where a family trust consistently earns more than the family can sensibly distribute at lower personal rates, and where the after-tax funds can be retained for a meaningful period. It is less useful when the family needs every dollar to live on, because extracting the money soon after brings the personal tax back.

For background on the trust side of the arrangement, read Discretionary (family) trusts explained.

How we can help

We help families plan trust distributions each year, set up and run bucket companies, and clean up unpaid entitlements and Division 7A loans before they become a problem. If you would like a second look at your arrangement, contact us or read about our accounting services.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.