By Elmie de Jager
29/10/2022
It is becoming more and more of a challenge to create wealth in a trust without having to part with a large portion of it, to the benefit of SARS.
By accumulating assets in a trust, you avoid, among other things, estate, and capital gains tax on the death of the individual in whose name the assets would alternatively have been, but unfortunately, there are other complications.
Capital gains in a trust is taxed at an 80% inclusive rate and then at a 45% marginal rate, leaving the trust at an effective tax rate of 36%.
The most common way to solve this problem is to pass down income and capital gains via the conduit principle to beneficiaries who only need to face a 40% inclusion rate and a marginal tax rate of maximum 45% (effectively 18%).
If you have many beneficiaries and the amount is moderate, the exemption of R40 000 per individual per year obviously also helps a lot.
However, when you are dealing with high-value trusts and/or beneficiaries who are all already on high marginal tax rates, even this plan becomes less effective.
Another big problem is that undistributed income and profits lead to loan accounts to beneficiaries which, if you make distributions year after year, puts the estate planning in reverse.
If you currently have this problem with your trust, there is another solution that you should consider to ease your and your accountant’s pain.
You can invest funds that you would like to keep as “legacy investments” in a sinking fund.
I don’t know why it is called a sinking fund, but even though the name is inappropriate, the benefits of this structure are certainly not.
Similar (but not the same) as an endowment policy, an investment in this vehicle is taxed according to the five-fund approach under s. 29A of the Income Tax Act.
Income is taxed at 30% while the inclusion rate for capital gains is 40% instead of 80% (even if it is held in the trust).
The marginal rate used for the calculation is therefore also 30% instead of 45%, which is the maximum for individuals. The effective rate for a sinking fund’s capital gain will therefore only be 12%.
It is important to note that you do not need to use the conduit principle to distribute profits or interest to beneficiaries. The tax is dealt with within the sinking fund, and it is not necessary to submit anything to SARS.
Just take note of a few important points that you should consider before you decide on this investment vehicle.
The investment is fixed for the first five years (well, sort of): You can make one withdrawal and one loan in five years. You may add to the investment, but in subsequent years of the initial investment, you may not contribute more than 120% of what you contributed in the previous year. Any additional investments are then subject to their own five-year term.
Important: Make sure it is a sinking fund and not an endowment policy. The rules are almost exactly the same, but there are some very important differences.
With an endowment policy, you have to insure a life, and once the last insured life dies without there being a replacement life insured, the investment will be included in that person’s estate as a deemed asset, thereby undoing the entire estate plan.
You do not have to have an insured life on a sinking fund, allowing this investment vehicle to “live” in perpetuity or until the trust is dissolved one day.
Income (on cash, bonds and property) will still be 100% taxable at 30%. Therefore, this vehicle works better for more aggressive long-term growth asset allocation.
If you also hold annuities in your structure, consider changing your total asset allocation by holding more income-generating (conservative) assets in your annuities since they can be held there tax-free.
However, discuss this thoroughly with your certified financial planner first as the different allocations can result in undesirable investor behaviour.
If you are going to use this vehicle, make sure that you have the option to borrow against the investment as well as to make one withdrawal.
Some platforms cannot accommodate both functions.
If you have investments in your personal name (and currently pay more than 30% marginal tax), but due to sec. 7C restrictions (or for any other reason) you cannot or do not want to transfer the money to your trust now, you can also use this vehicle by making the trust the beneficiary.
By factoring this into your planning, you will save on executor fees on death, the five-year period expires immediately on death and your beneficiaries have immediate access to the money if they need it.
Since the structure is a life product and you are not the insured life, there will also be no capital gain on your death, only on withdrawal or rebalancing.
Therefore, you will benefit from the growth on the full investment until you realize the capital gain one day.
This product should not come with an additional layer of fees. The administration fees on the different investment platforms should be the same as with, for example, an ordinary unit trust investment.
In conclusion: This is not the solution for all trusts and all planning. Where trust funds are below R10 million, or where there are several beneficiaries or beneficiaries with low tax bases or physical distributions are made to cover beneficiaries’ living costs, other instruments may be more tax efficient.
Where substantial wealth has been accumulated with the intention to continue to grow the largest part of it in a tax-efficient way, this is possibly the ideal route.
Elmie de Jager is a certified financial planner and wealth manager at Woodland Wealth (formerly ProVérte Wealth & Risk Management). Contact her at info@woodlandwealth.co.za.
Although all possible care has been taken in the preparation of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone who intends to take any financial action based on this document is strongly advised to first consult with his/her personal financial advisor. Woodland Wealth is an authorized financial service provider with FSP no. 5966.