Professional firms: How Much Should Business Owners Get Paid?
Are you one of the principals in a professional services business (such as a firm of architects, lawyers, medical practitioners, consultants, surveyors, etc.? Or perhaps a partner in a professional partnership or perhaps your firm has incorporated and you are one of the directors within the firm?
People such as those mentioned above have long been the subject of close attention from the ATO. The reason for this is has been for the tendency to want to divert the income of the practice that is properly attributable to them to other entities with a lower tax rate; eg. a spouse, adult children, other relatives, family trusts, companies, etc. This so-called “income splitting” is not generally allowed, but that does not stop professional practitioners seeking to reduce their tax bills by apportioning part of their taxable income to others.
The basic rule is that all practice income after deducting service entity fees and superannuation contributions for the practitioner should be paid to the practitioner in some form, which is usually as salary or wages but occasionally in the form of franked dividends. If there is income left over that is diverted to other lower tax entities or retained in the structure, the ATO reserves the right to apply the anti-avoidance provisions to treat it as that of the practitioner.
The ATO has recently published draft practical compliance guideline, PCG 2021/D2, to establish the boundaries of what it regards as acceptable tax behavior among professional practices. Essentially, the ATO now takes a slightly more relaxed view of “income splitting”, saying it will not investigate provided it falls within certain parameters.
The draft guidelines basically impose certain hurdles on a professional practice, with two gateways that a practice has to pass:
- first of all, there must be sound commercial rationale for the structure or arrangements and
- secondly, the arrangements must not contain what the ATO describes as “high risk features”, indicating that the practice’s arrangements are motivated by tax avoidance.
If both gateways are passed, the ATO will apply a traffic light risk assessment framework (where red is “danger” and green is “low risk”) to the practice’s arrangements by measuring:
1. The proportion of profit entitlement from the whole of the firm returned in the practitioner’s hands. Practitioners who return 100% of the profit entitlement in their personal tax return are automatically within the green zone and do not need to consider the other risk assessment factors.
2. The total effective tax rate for income received from the firm by the practitioner and associated entities.
3. The remuneration returned in the practitioner’s hands as a percentage of the commercial benchmark for the services provided to the firm.
As a general rule, the ATO treats as high risk any schemes designed to ensure that a practitioner is not directly rewarded for services provided to the firm or receives a reward which is substantially less than the value of those services. The ATO reserves the right to apply the anti-avoidance provisions to such arrangements.
The risk assessment guidelines are seeking to ensure the practitioner is being taxed personally on a reasonable return, by comparison to:
- to the firm’s profits, or
- other practitioners with similar characteristics (using benchmarks or comparables).
The ATO indicates that it will not look at income splitting arrangements provided they fall within the above parameters. To illustrate this, the ATO gives an example.
- Nicholas is a professional practitioner in a partnership, with a total income entitlement from the partnership of $600,000. Nicolas disposes of 45% of his partnership interest to an associated company. The corporate beneficiary’s tax liability on the distribution of $270,000 is $70,200 (26% of $270,000). 55% of the partnership income, $330,000, is included in his personal tax return, with a tax liability of $119,167. The combined effective tax rate is 31.56%.
- Despite Nicholas putting in place an income splitting arrangement, the ATO says it will not apply compliance resources to him as it regards his arrangements as “low risk”. Nicolas receiving 55% of the partnership income in his personal tax return is not low enough to raise risk flags as the total effective tax rate of the two entities combined is 31.56%; a tax rate regarded as appropriate and “low risk” using the risk assessment matrix included in the draft practical compliance guideline. (A combined effective tax rate below 30%, the company tax rate, is generally regarded as higher risk).
Profit sharing in professional practices is complex and it is very easy to set up arrangements which fall foul of the ATO. Talk to our experts at H&R Block Accounting & Advisory for guidance on how to structure your practice’s remuneration arrangements.
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