Tax planning - Should we just pay the tax

The late Kerry Packer is often quoted as boldly declaring before Australian Federal Parliament that anyone who doesn't minimize their tax needs their head read as the government in his opinion weren't spending it that well that we should be donating extra.

We talk to every profitable business about managing taxation along with a host of other activity in the management of their affairs, preparing for the future and handing on of legacy assets to the next generation. Knowledge of Taxation and how it works is the topic for today.

First, a few of the assumptions. The first is that paying tax is actually a good thing. When I first mention this to people, I am often met with a gaping open mouth or a stunned silence but consider for a moment the alternative. If you pay no tax, you have either made a loss or under the tax free threshold. The tax free threshold for individuals is roughly half the resources you need to have a roof over your head, eat nutritious food and keep yourself clothed and warm. The resources need to come from somewhere, which is either debt, family/friends or going without. Each of these mechanisms is not sustainable in the longer term and no way to plan your life.

Therefore - my assertion stands that it is a good thing to pay tax as that is the only way you can earn enough to have choice about how you live. When we are talking about planning your tax, it is therefore not about eliminating it altogether. Each family will have needs and wants. We think it is critical to establish a plan over an extended period of time to meet these needs and wants. Within that context, we will be able to establish what "after tax" requirements there are to provide the framing of actions to be undertaken. Wants include all the good things in life, the entertainment, family holidays, experiences and material goods. Some confuse wants with needs, but that is a topic for another day.

As a very broad rule of thumb, I suggest respectfully that 17-25% tax is not a bad range to start from. By way of reference, the tax rate in accumulation phase in superannuation be that self managed or otherwise is 15%. The purpose of superannuation as an environment is to provide capital for retirement. Generally this capital is either legislated such as super guarantee, or patient money in the form of "choice" to put some away now to get a benefit later.

The company tax rates have filled many inches of newspaper space in recent times with news of a 25% rate some way out into the future on one side of politics or a return to 30% tax rate on the other side of politics and everything in between.

Trusts are not always well understood, Keeping it very simple, the short answer is that Trusts enable a trustee to choose the beneficiary (and hence by extension the tax rate) which may be either company tax rate or individual tax rates depending on the choices made.

Individual tax rates are subject to a sliding scale. I keep a table in my office each year to inform me what the average rate of tax is as the actual taxable income goes up. In 2019 as it currently stands, the average rate of tax is just over 20% for a taxable income of $60,000, just over 25% at $90,000 and just over 30% at $150,000. The reason I use average rather than marginal rate is that the choice of what structure to use will be based on the average rate of tax over all your income when comparing with other structures.

There is so much complexity beyond this analysis, but this pretty well tells the tale. When bringing forward deductible expenditure or delaying the earning of assessable income, advisers generally have a number in mind based on after tax requirements that they are working towards. Individual taxpayers are penalized if they have volatile swings in income levels. You pay less overall if your difference between high years and low years is kept relatively tight. Only after meeting your needs should you look at choice to reduce tax levels.

Some may be surprised by what the reduction in tax at a given income level is. For example, Jim is an entrepreneur who has income of $100,000 in early June when he visits his accountant. He has not repaired his equipment for a while nor has he put away any significant sums into superannuation over the years. Jim has two kids in their teenage years attending the local high school with both likely to go to University over the next few years. Jim's wife Alice does some part time teaching work earning about $30,000 for the year.

We worked through the process of determining Jim and Alice's needs and came to the conclusion that the family unit had $10,000 free cash flow that they could exercise some level of choice. In Alice name, we recommended no action required as her tax impost was under the target levels. We discussed that Jim would presently be paying something like 26.5% tax if he did nothing and might consider some action to bring his rate back into the ideal range perhaps. If $10,000 was spent on upgrading his equipment or repairing to original condition then his average rate of tax might drop to 25.11%. In whole dollars, it might cost $10,000 to save just under $4,000. This is an important point. It costs whole dollars to bring forward a deduction but the tax rate is only cents in the dollar so you don't get it all back.

Conversely, if the $10,000 was put into superannuation, the superannuation fund would pay 15% or $1,500 on the contribution. Jim might save the same just under $4,000 for a net saving of $2,500. Lots forget that the super fund pays tax in accumulation phase. We made sure to make this point clear to Jim. The added bonus of the superannuation environment of course is that any earnings on the $10,000 would be taxed at 15% rather than Jim's tax rate AND if the funds weren't withdrawn until after retirement, no capital gains tax would ever be payable. A compelling story for some particularly when minds start to turn to planning retirement.

In the end, Jim and Alice actually decided that they would exercise their choice to go on a holiday to Bunbury to watch their teenage son play in a cricket tournament and to visit some old friends who had moved over there. A two week holiday for all four of them filled with fun and laughter was thought to be well worth the price to be paid.

From an advisory point of view, we were comfortable that we established the facts, went through the needs and that family goals were being met in the prudent exercising of choice. There is more to life than tax, and sometimes families make the conscious choice to live now and pay the tax when the tax rates are made clear to them. That is ok.

Another family in the same situation might defer resources to a later point in superannuation and yet another family might upgrade the equipment to continue the income stream with resilience. There is no right and wrong. It all depends on the visions and goals of the family concerned. Have your family had a chat about what free cash flow you have and how that cash flow might be spent? If not... do you think you should?

Food for thought.