Bruce Brammall: Private investment companies offer bucketload of tax breaks for small business owners

Water doesn’t need much of a slope to run. And if it has a slope, it will always find the route to the lowest point to settle. And it’s usually happy there. Until the slope changes. At which time, it will move again to find the next low place that gravity takes it. But water doesn’t have a brain. It just acts on gravity. Australians are pretty good, when it comes to tax, at finding the lowest tax point to settle . . . on an instant basis. We generally focus on minimising tax this year, not necessarily taking an approach that might reduce overall taxes over many years. The long game Minimising tax each year, for most PAYG earners, makes complete sense. It’s the best option. But for a growing number of Australians — particularly those running successful small businesses — taking a smarter longer-term view about tax will deliver far better outcomes. Contributing to superannuation is one way of reducing tax immediately, and for the longer haul. But there are limits to how much you can put into super. And the new Division 296 tax changes for those with more than $3 million in super have increased those complications. Diverting income One strategy that will become more popular for particularly successful small business owners and higher-income earners is private investment companies — also known as “bucket” companies. While the top marginal tax rate is 47 per cent (including the Medicare levy), PICs pay tax at 30 per cent (some qualify for 25 per cent). Let’s tax a small business making a profit of $500,000 a year. If the owner of the business took all of that as income, he would pay about $205,600 in tax. However, if the business was owned in a family/discretionary trust, the owner could, for example, pay himself $190,000 and be taxed at $51,600. Assuming he didn’t need all of the income, the remaining $310,000 is diverted via the family trust to the PIC. There it pays $90,000 tax, versus the $141,000 the owner would have paid if he/she received the extra. A tax saving of $51,000. That money, including the saved tax, can then be invested and will only pay 30 per cent tax on income generated, versus 47 per cent if generated in the owner’s name. Steak knives Compounded each year, this becomes a very powerful strategy, particularly getting to invest the extra money not paid in tax over the course of a decade or longer. All the while, the PIC is building franking credits for the tax it has paid. If it earns $100,000 and pays $30,000 tax, the $30,000 is a credit for tax paid to the individual when the PIC pays a dividend. How could this work best? Let’s say business owner “Michael” diverts excess income to the PIC during his working lifetime, then retires with no taxable income (noting most super pension payments are not taxable income). He could then draw dividends from the PIC, including franking credits. Depending on how much he draws, he could end up receiving back, in his tax return, most (possibly all) of the tax the PIC paid over the years because of the franking credits that would come with the dividends. And it’s not just Michael who can benefit. Michael’s partner or children (or potentially even broader family members) could also potentially benefit from the franked income. It’s both the lower 30 per cent tax rate and the franking credits eventually being paid out that make PICs so powerful. Super still trumps For the majority, superannuation is still arguably the most tax-effective retirement vehicle. It pays minimal tax during accumulation and no tax during pension phase. But successfully business owners, higher income earners and those who have built near or more than $3m in super are looking for other strategies to reduce their overall tax. PICs are another tool in the kitbag. They have always been there. But the Division 296 changes (to tax super funds with more than $3m in super at a higher rate) are going to broaden the appeal to a wider group of income earners. Unlike water, humans have brains. When the course changes, the good brains get advice. Bruce Brammall is the author of Mortgages Made Easy and is both a financial adviser and mortgage broker. bruce@brucebrammallfinancial.com.au.