The ability to split income with family members has long been a Holy Grail for medical professionals. The tax burden on families where one spouse is a doctor can be significant, yet the other spouse can be tax free or in a lower taxed threshold which is underutilised. This is a characteristic of our tax system shaped by individual marginal tax rates.
Here are the base principles of understanding income splitting and how to use it to your advantage.
Marginal Tax Rates
Australian individual income tax is based on the premise that the higher a person’s income, the higher the tax they pay in accordance with a series of income tiers. Once an individual crosses the threshold into a higher tier, the increased tax rate only applies on the amount, or margin, over the tier threshold and therefore the applicable rate is called the marginal tax rate. Hence a medical professional with higher income not only pays more tax, but also pays a higher % of their income in tax.
Marginal tax rates are individual. In the case of two spouses, each calculates their own taxable income and marginal tax rates are applied to that income independently from the other spouse. In an example case, you as a doctor earning $400,000 p.a. would pay $150,667* in tax (an average rate of 37.7%), while your spouse working part-time and earning $25,000 is subject to only $1,292* in tax (an average rate of only 5.2%). In this scenario you pay significantly more tax as a percentage of your income.
Generally, Income Splitting is a tax planning method to more evenly distribute taxable income, and therefore reduce the overall tax burden. If the taxable income from the example above could be split evenly between the spouses, you would each earn $212,500 and pay $66,292* in income tax, an average rate of 24%. Even though the same amount of income is earned, this even-split creates a tax saving of $19,375 per annum for the family, enough to put towards another car or an investment in shares. The savings can be even greater where the income gap between couples is larger, or where the income can be split in more than two ways.
Income Splitting Through Discretionary Trusts
Australian tax laws allow for multiple methods of income splitting such as through the use of companies, partnerships, assignments, leases between spouses and the most common method – by using a discretionary trust (sometimes called a ‘family trust’). Depending on a medical practitioner’s circumstances, a discretionary trust can be used as a trading structure to operate a medical practice or as the shareholder in a company which operates a medical practice. Income earned by the trust, either directly from trading or from company dividends, is distributed amongst beneficiaries as determined by the trust, making income splitting among those beneficiaries very simple. Beneficiaries can include both spouses, but also adult children or further extended family. Non-adult children can be included as beneficiaries, but additional limits apply to curtail the benefit of income splitting with younger children. Beneficiaries can even include non-family members, if you feel particularly generous!
Operating from a business structure involving a company or a trust also has other benefits, most widely known as being the enhanced asset protection. While these benefits certainly have value, exploring them is subject for a topic of its own.
While appropriate structuring opens up opportunities for income splitting, particularly in the case of doctors, these opportunities do come with a catch. As a medical professional, the income that you earn is most commonly the result of your personal work or exertion, rather than the collective exertion of a team in a business. For the payment of tax, income from personal exertion is treated under the Personal Services Income (PSI) attribution regime. This means that special rules for PSI can override the income splitting benefits of a trust or another structure and force the individual to receive all taxable income.
However, many medical practices provide far more than just the doctor directly performing medical tasks – these can be administrative staff, marketing, medical support staff and the cost for diagnostic equipment or medical supplies. These can all contribute to an enterprise being run. Therefore, the patient bills may not be solely paying for the doctor’s services, but a portion is towards the supporting business structure and equipment. With careful consideration of these components it is possible to determine an appropriate allocation of PSI against general business income. While the PSI will be applied directly to the doctor, the general business income remains available to reap the benefits of income splitting. Aside from business income the concept of income splitting can also be applied to other forms of income including investment and capital gains, which warrants a holistic approach to your tax planning with a competent accounting professional.
*Example tax calculation excludes levies and offsets
Article provided by Moore Australia (QLD/NNSW), an accounting firm offering a comprehensive range of services to medical professionals.