I have a family trust which I was advised to register after getting married for estate planning purposes, but I have not really been using the trust effectively and am I not sure how the taxation will work since trust tax rates are much higher than that of individuals and I am afraid that I will end up paying more tax through the trust.
The Income Tax Act 58 of 1962 (“Act”), and the Eight Schedule thereto, contain provisions which, if applied correctly, can help lower the high trust tax rate burden.
Section 25B of the Act applies to the taxation of income earned by a trust and the taxation of any capital gain made by a trust is contained within the Eight Schedule to the Act. The Act and the Eight Schedule also recognises the conduit principle and the income splitting opportunities it offers.
The conduit principle determines that income or gain received by a trust can be distributed to the trust beneficiaries and taxed in their hands instead of that of the trust. Assume that there are three beneficiaries, all natural persons, of a trust which earned interest of R90,000 in the current year. If the trust retains the interest it will have to pay income tax at 45% thus resulting in a tax liability of R40,500 and will also have no tax exemptions it can utilize as in the case of natural persons. If the trustees of the trust distributed the interest in the current year to the beneficiaries in equal shares of R30,000 each the tax liability of each beneficiary will be as follows: interest income R30,000 of which R23,800 is exempt leaving R6,200 as taxable income. The income tax liability will be 45% of R6,200 = R2,790 resulting in R8,370 total tax liability payable by all three beneficiaries instead of R40,500 payable by the trust.
In terms of the taxation of gains made by the trust an effective capital gains tax rate of 36% (45% x 80% inclusion rate) will apply. Assume the trust made a capital gain of R150,000 the trust’s tax liability would be R150,000 x 36% = R54,000. If the trustees of the trust distributed the capital gain in the current year to the beneficiaries in equal shares of R50,000 each the tax liability of each beneficiary will be as follows: capital income R50,000 of which R40,00 is exempt leaving R10,000 as taxable income at an effective capital gains tax rate of 18% (45% x 40% inclusion rate). The tax liability will be 18% of R10,000 = R1,800 resulting in R5,400 total tax liability payable by all three beneficiaries instead of R54,000 payable by the trust.
In both the scenarios above the tax rate of the beneficiaries that was used was the highest income tax rate of 45% and could it still be as low as 18% depending on the beneficiary’s total taxable income. It is important to remember that the income or gain received by the trust needs to be distributed to the beneficiaries in the same year it accrued to the trust and that the nature of the income whether it was interest or capital gain will remain the same in the hands of the beneficiaries for taxation purposes.
If you are unsure – get in touch, we can help.