9 March 2021

Don’t fall foul of the ATO on income splitting

Finance KnowCents Tax

The latest Australian Taxation Office ruling sets a higher and more complex bar for doctors and their medical practices for  income splitting to family members or related entities that pay less tax.

From 1 July, the Allocation of professional firm profits – ATO compliance approach will apply to doctors and practices that use medical practice companies and trusts to bill their patients predominantly for labour services to reduce their tax.

Based on the amount of work required to assess most doctors’ structure on these setups, you should probably budget for an increase in your accounting and legal fees.

The new robot data matching using STP and E-invoicing by the ATO is making it easier to automatically audit practices, so simply keeping your head down and crossing your fingers isn’t likely a great strategy.

In addition, being an honest fool is not a legal defence, so blaming it on your accountant is off the table – especially if you don’t ask the right questions in writing.

To protect yourself personally you will need to be able to clearly explain the commercial reason (not just a “tax reason”) for setting up your structures and show the relevant business models and documentation.

If your accountant cannot explain the commercial reason behind your structure, you may need to look for another accountant to manage this change. At the least you might want to get a second opinion from an experienced lawyer or accountant who solely specialises in this area.

Unfortunately, many doctors naively trust their accountants to set them up in the right structure without really understanding why or how it works.

My first rule of thumb is: if you do not understand something, ask more questions or do not do it. 

There is much devil  in the detail of this new ruling. It is not a Do-It-Yourself job.

The ATO is giving everyone some time to tidy things up as they recognise the complexity as well, but given the complexity it would be a good idea to get started as soon as you can.

What must practices and doctors do now?

  1. Review the purpose of your medical practice companies, family trusts and service trusts structures and agreements. Clearly establish their underlying purpose beyond tax savings;
  2. Be prepared to prove your arrangements are not solely tax-driven. Prove they are commercially driving your medical practice or your service entity;
  3. Profit-sharing arrangements: formalise and get them signed before the end of the tax year; and
  4. Make sure your business systems reflect points 1 and 2 above. Pay attention to the details.

On the positive side

Over many decades, the ATO has lost many high profile court cases that have allowed for a genuine commercial reason for these various structures to exist. See ATO Service entity arrangements.

Today the ATO wants to refine and increase their scrutiny of what they consider to be a high-risk arrangement. 

For many practices, the new ruling may mean a simple tweaking of existing arrangements and for others something more may be involved.

The good news is that if you do not cut corners and do it properly, some of these arrangements may do more good than harm. The use of service entities e.g. a service trust is still a legitimate way to succession plan and pay the right amount of tax.

The benefits still outweigh the costs when a service trust is set up and administered correctly. 

Why now?

Due to the pandemic, the looming national and state budget deficit spending deficits, professionals such as high-earning DIY-finance doctors are low hanging fruit.

The new ruling continues to reaffirm a long-held Australian Taxation Office (ATO) concern that professionals like doctors who primarily earn their income from their personal labour are using various tax vehicles to reduce their tax bills in a manner not in keeping with the spirit of the law.

Some officers of the ATO have attempted over the years to maintain a position that any income earned by professionals predominantly due to their own labour should be declared 100% in their own name.

It is quite common to see sole practitioners operate through a family trust or company. This is then used to channel income to lower taxpayers such as family member.

This can range from the entity employing your spouse at a higher than market value rate or distributing profits to a lower taxpayer, such as a child over 18 attending university. If this is not available it might mean the use of a practice company that is not paying out dividends and allowing the profits to be taxed at a maximum rate of 30c in the dollar. 

I do not recommend any of these strategies.

At times I hear advisers tell doctors to use a company to avoid payroll tax.

Needless to say a more thorough holistic and less piecemeal approach is needed.

If a doctor owns their practice the only legitimate way to income split is to use a service trust

Practitioners have been able to reduce their tax bill by up to $30,000 p.a. using this structure.

Key questions to ask yourself

As a doctor or practice owner, 

  • Am I paying a family member an excessive amount of remuneration e.g. for bookkeeping or managing your practice?
  • Am I using market rates?  
  • Am I transferring money to another entity or person to simply reduce my tax bill?
  • Do I know why and how?
  • Are they more than just journal entries the accountant does, is it real? 
  • Am I using a practice company, trust or service entity like a service trust or company (aka ending with “Pty Ltd” after my practice name) to divert income away from me to lower tax-paying family members or entities – like a company that pays a maximum tax rate of 30%?

Without a sound response to these questions together with this new self assessment ruling you may risk facing an expensive audit and a hefty tax bill with penalties. 

Asking your advisers the right questions

Ask your advisers in writing whether the  Allocation of professional firm profits – ATO compliance approach ruling affects you, how and what should you do next.

Where do doctors, practices and some advisers start to go wrong?

It takes more than getting the right legal agreement or arrangements from a high profile glossy brochure law or accounting firm. 

Nationally over the last three decades, I have personally reviewed many medical practice structures and rulings.  I am yet to see one perfectly set up. Quite a number are worryingly taxation driven as this is a primary concern for many practitioners. 

Many arrangements do not begin to address important issues the new ruling seeks to address namely:

  • The commerciality i.e.investment rates of return on their business arrangements
  • Succession planning
  • Legitimate income splitting arrangements
  • Asset protection. 

This is where many doctors and practices start to go wrong.

Matters tend to snowball when a piecemeal approach has been taken and can put the practice at risk beyond tax issues, such as  medico-legal exposure.

Structures often look more like a patchwork of well intended ideas with little attention paid to the many devils in the detail. 

Remember, it is not if you get caught but when, especially with the ATO new data matching and sharing capabilities and mandatory laws such as Single Touch Payroll and E-Invoicing. Robo audits are becoming a reality. 

Defending a tax audit

The main rule is to keep it commercial. This is the predominant test in the new ruling: defence in the Income Tax Act is Part 4a. 

If the predominant reason you entered into the arrangements was commercial you jump a number of big hurdles. Without these reasons given above you leave yourselves exposed to an expensive audit.

If you are employing related parties such as a family member e.g. a spouse who is a practice manager it is important to be benchmarking their salary to a practice managers salary or you will lose a legitimate tax deduction.

If you are using a service trust, set a commercial service fee to run a viable business.

Our clients use monthly national practice benchmarks and the Doctors (Service Fee) Pay Calculator to reduce scrutiny.

It is important to understand that if the tax office is knocking on your door it will be too late to start addressing these issues. When they come knocking you will want to be able to prove and provide an independent arm’s-length audit trail for the Tax Office. 

Change your attitude: budget and plan for it  

Do the right thing the right way.

Due to complexity, you have to invest money to get it right.

It will provide benefits for a lifetime.

It is a relatively cheap once off investment that requires minimal maintenance.

This is not a Do-It-Yourself exercise.

Don’t just seek the right answers

The ATO are looking for substance over form. 

Starting from the top the following are the key areas to watch out for (these could be questions for your accountant and legal adviser).

  • Can you prove your arrangements are in place and are working?
  • What business structure, documentation, systems and procedures do you have in place?
  • Can key staff and advisers provide a simple explanation to validate your arrangements?

Types of business structure

Ask why you have the structure(s) in place and what is their primary purpose?

Are you a sole trader/practice company/trust?

A common mistake is a sole traders practice owned by a family discretionary trust or a practice company with a pty ltd at the end of its name.

The ATO takes a dim view of this.

Since 2016 this ruling serves as another reminder.

If you are a sole trader operating out of a Practice Company or trust with a corporate beneficiary aka “Bucket company” ask why are you not operating as a sole trader? You may save on a lot of unnecessary accounting fees and headaches.

An explanation must go beyond reducing one’s tax.

I normally recommend new clients to remove such arrangements.

Service entity: Landlord Service Trust or Company v Tenant (“sole trader”) 

Many practices use a service entity arrangement.

Commonly it is a trust but it can be a company.

A big focus is on why your entity exists? What are their roles i.e. is it more than tax avoidance? 

Service entities are another key focus of the new ATO Profits Allocation ruling. 

For many medical practices with a service entity, the “service” entity owns all the site goodwill of the practice, intellectual property, plant and equipment, non-medical staff. It takes on a traditional landlord v tenant relationship with its doctors/provider. As a landlord the practice charges a service/management fee (like a rent for a serviced office), for example 35% of gross billings to a self employed doctor to use the practice. 

This is a legitimate way to income split (see ATO service Entity Arrangements and Doctors Contracts Explainer video). 

The key issue missed here is what is the purpose of the entity beyond the traditional “asset protection” argument. The ATO new ruling which may come as a surprise clearly states they will not accept this as a primary defence anymore.In other words they are questioning the entire legitimacy of your structure. What other value does it bring?

Using the correct type of entity structures and relevant practice agreements a strong case for arguing succession planning does exist. 

This should override any concerns from this latest ruling. This is a commonly overlooked opportunity. It is great for your practice regardless of the ruling if you have recruitment and retention problems.

Template agreements and arrangements exist that can make this easier for practices to execute.

Service trusts and family trusts together with a bucket company for succession and estate planning continue to have a legitimate role. But the planets all need to line up correctly for this to work.

Careful and thoughtful consideration is required. All arrangements between entities from minuted pre-fixed profits distributions, trustee minutes and bank transfers should be properly documented and signed off for. 

Any taxation benefit should be incidental and not the primary reason for the arrangement. The benefits do continue to outweigh the costs beyond tax. Correctly thought out, this ruling can be an opportunity to strengthen your current arrangements.

Practice agreements

Another common mistake is non-existent or out of date and unsigned practice agreements. Well executed agreements provide excellent evidence in the event of an audit. 

Spouse Contract:

Where is your spouse’s employment contract? Do they really do what the contract says they do? What is the commercial market rate for their services? 

If you can produce this information at a moment’s notice this always provides an impressive first mover advantage. Another one is practice service agreements and ownership agreements (which include profit sharing arrangements).

Doctors/Provider: Contractor/Service or Employee agreements:

Do you have up to date and signed service agreements with your providers that name your key business structures?

If you are not able to answer this question clearly other more awkward questions may pop up including but not limited to:

  • Do you really engage contractors, subcontractors or employees?
  • If all of the above why is there no consistency i.e. all contractors why do you employ registrars in your service trust? 

Practice ownership agreements (which include profit sharing arrangements):

Do you have an agreement that pre-agrees how profits are shared? Does it fairly reward risk and return consistently amongst owners? I

I use a set template formulae that is investment and succession planning friendly. This may reduce the ire of the Tax Office concern.

Profit sharing and Income splitting

Payments to relatives

Are your payments to your spouse or relatives not considered excessive from your practice company or trust? What do you normally pay a practice manager? Many of these arrangements can be struck down and deem any tax deduction not deductible

Artificially increased profits

Are the service fees charged by your service trust commercial? Why are some service fees higher than others? Why is a guaranteed minimum or hourly rate offered to a doctor?

Some naughty practices artificially increase their service or management fees via the service trust. This can give themselves an immediate tax benefit. This is risky without appropriate justification. 

The current ATO service entity ruling allows GP’s to use a service fee of up to 45% of gross fees a GP bills to a patient in the service trust. This can be legitimately used to income split. 

The key issue here is some practices are using a higher than ATO recommended service fee.

This can be legitimate however.

For example, owners may use a 60% rate instead of the ATO guidelines rate of 40% metro GP practices to 45% rural GP practices. See ATO service Entity Arrangements

To the contrary, some practices use a lower rate of 35% which may cause a solvency problem.

Providing these arrangements are commercial, this income can be legitimately channelled to lower taxpayer entities for commercial purposes such as succession planning.

A case in point is detailed below. I have successfully argued both publicly and privately that practices can charge up to 60% of a GP patient billings as a service fee. This may be a surprise to many traditional accountants. 

Good commercial reasons such as the freezing of Medicare rebates and comparable live monthly national benchmarks provide a formidable argument to the ATO. 

I was involved in this 2007 national tax ruling in which we successfully argued that a percentage approach be used for medical practices. We won that argument because we could prove listed companies were using this same approach.

We have secured in recent times a private tax ruling for a 60% service fee for a general practice.

Anything is possible if you can prove your argument. 

A good tip is that a commercial service fee is one where the practice will not become insolvent i.e. you can pay your debts as and when they fall due. The bottom line is to charge a commercially realistic management or service fee to owners and non-owners that is commercially consistent with the level of service and risk involved.

Commercially sound profit sharing agreements

Between the owners are there pre-agreed signed profit sharing agreements or is this determined at the end of each year to keep one’s tax bills down?

Can you justify why you direct income to a family member, corporate beneficiary (known as a “bucket company”) from your practice or family trust? Should this come really be declared in the doctors or providers name at a higher rate of tax?

These can be difficult questions to answer however some careful thought needs to be taken now while you have the time.

Systems and Administration

Other factors that may strike down the legitimacy of any arrangement is when a practice does not walk the talk. It is hard for the ATO to accept that your doctors are not independent sole traders when you and your staff refer to them and their stationary makes them look like employees or subcontractors. 

Incorrect website and stationery listing of doctors and providers

The most common example includes why are all your doctors listed as “Our Doctors” or “Our Staff” when they are supposed to be independent sole traders or tenant doctors co-located on your site?

Another example is why are you using the service trust ABN and letterhead to bill patients and not the individual providers for vaccinations and professional services?

Paid out of the wrong bank accounts

Why are doctors paid out of the same bank account as medical receptionists when you have declared the doctors are independent contractors or tenant doctors and not subcontractors?

If you have a service trust why is the same Xero or MYOB ledger and bank account used to pay doctors and staff? Why are they not separate?

Regular complicated/confusing journal entries

Why does your Xero or MYOB ledger have many automated and confusing journal entries that appear to reverse out or negate the actual arrangements in place such as doctor payments? 

Why can you not easily reconcile or explain them? Why do their income and banking not reconcile to your practice management system such as Medical Director, Genie or Best Practice? 

Conclusion

It is not WHETHER you will get caught, it is WHEN! 

These are some of the many uncomfortable questions you need to be prepared for. When you get one bit wrong, auditors – I used to be one – get a little more excited and start asking more tricky questions. In this new digital environment with the ATO’s new STP and E-invoicing looming it is getting harder to unsay or reinvent the past. Data collection and cross agency sharing is creating a ticking time bomb for practices who keep this on the back burner. 

David Dahm is the principal with Healthcare practice advisory, accounting and tax firm, Health and Life.

David’s original article and blog is HERE

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