Chapter 02 – Legal structures

In this chapter, we examine the various legal structures financial planners can use to derive income from their practices.

For financial planners who are employees, the range of options available to them to receive that income is limited. The financial planner will basically receive a wage or salary from the employer.

We concentrate on income received by financial planners in private practice with some (potential) discretion as to how to receive their income. It is this income to which substantial tax planning can be applied. A financial planner in private practice has three broad forms of practice available. These broad forms are:

  1. to operate as a sole trader (that is, practice in their own name);
  2. to operate via a practice trust; or
  3. to operate via a company.

Typically, there are few benefits available to operating a practice via a company. Any benefits that are available to a company are also available to a practice that is operated via a trust. There are various negatives to operating a practice via a company, (particularly the loss of some of the CGT small business concessions) and these are largely avoided if the practice is operated via a trust. For this reason, we rarely recommend practices be owned by companies[1].

There are various benefits available to operating as a sole trader. Once again, those benefits are also available to a practice that is operated via a trust. Once again, there are various potential negatives to operating a practice as a sole trader, most of which are avoided if the practice is operated via a trust.

Because of this, our starting point for a financial planner selecting the appropriate practice structure is typically a practice trust, whether it is a PSI (personal services income – income that cannot be attributed to someone or something else for the purposes of income tax) practice trust or a traditional family trust. Such a structure combines the benefits of being a sole trader with the benefits of being a company, while allowing the practice to avoid almost all of the negatives associated with practicing either as a sole trader or as a company. Trusts provide ‘the best of both worlds’ with few of the negatives of either. 

We recommend using the simplest and lowest cost structures possible, and as few entities as possible.

This means we usually recommend:

  1. solo financial planners deriving personal services income use:
    • a PSI practice trust, or
    • a family trust with an arm’s length reward to the financial planner;
  2. solo financial planners deriving personal services income also consider using a service entity to protect assets and to divert net income to lower tax rate family members and/or investment companies;
  3. solo financial planners deriving business income use a family trust to divert net income to lower tax rate family members and investment companies;
  4. group financial planners (i.e. more than one principal in the practice) deriving personal services income use a hybrid trust with the units owned by family trusts with an arm’s length reward to the financial planners; and
  5. group financial planners deriving business income use:
    • a hybrid trust with the units owned by family trusts, or
    • a partnership of family trusts.

These structures generally achieve optimal business efficiency, avoid unnecessary payroll tax and Workcover premiums on returns to owners, simplify BAS arrangements, minimise bank costs and minimise external accounting fees as well as achieving income tax and capital gains tax optimality.

A table summarising the range of possible practice structures is set out below. This table does not include all possible combinations of structures – just those most likely to be relevant for financial planners.

Where one is used, a service entity may be a service trust, a service company or a service partnership of companies or trusts, and each of these options is discussed in the following pages. But in most cases the preferred entity will be a service trust.

An “arm’s length family trust” is a normal family trust (i.e. discretionary trust) where the financial planner receives an arm’s length reward for actual work completed. The total reward is made up of salary, trust distributions, super contributions and concessionally-taxed fringe benefits such as multiple car fringe benefits.

Type of practice Type of income Type of Structure Service Entity?
Solo Personal services income PSI Practice Trust Possibly
An arm’s length family trust No
Solo Business income Discretionary trust No
Group   Personal services income Hybrid trust with an arm’s length reward to owners (recommended) Possibly
Associateship of PSI practice trusts or arm’s length family trusts (not recommended) No
Partnership of PSI practice trusts or arm’s length family trusts (not recommended) No
Group Business income Hybrid trust with units owned by family trusts No

Personal services income and business income: the basic idea

A financial planning practice can generate two general types of income. The first is known as personal services income (‘PSI’). The second is known as business income.

Which form of income is being generated is a matter of fact. That is to say, there are certain criteria that must be met in order for income to qualify as business income. If these criteria are not met, the income will be treated as PSI. The key, then, is to ascertain whether the income is business income. If it is not, it is PSI.

PSI and business income are subject to the same marginal tax rates. The key difference between the two forms of income lies in the way the income can be distributed. PSI can only be distributed to the individual owner, i.e. the financial planner who provided the personal service. Business income can be distributed to any legitimate owner of the practice. If the practice is owned via some sort of discretionary vehicle, such as a family trust, the income can be divided between two or more eligible beneficiaries of that family trust, as they are the beneficial owners of the business. In other words, if the practice is a business, its income can be legitimately shared with lower tax rate family members under a family trust arrangement.

When two or more people pay tax on a given amount of income, they will pay less tax in combination than an individual would pay if he or she received all the income. That is, if the tax liability on a given amount of income is spread between two or more people, less tax is paid. This is because Australia uses a system of taxation known as progressive taxation, whereby the amount of tax paid per dollar increases as the number of dollars received increases. Spreading income between related persons usually reduces the total amount of tax paid and the average tax rate.

The ATO has set out its thoughts on when professional practice income is business income and when it is personal service income, and these can be read at Income Tax Ruling IT 2639 dated June 1991. In summary, the ATO accepts as a rule of thumb that:

  1. a practice derives business income if it has more equivalent full time material fee earners who are not owners than owners; and
  2. a practice derives personal services income if it has fewer equivalent full time material fee earners who are not owners than owners.
  3. The ruling also indicates that a practice may be a business where this rule of thumb is not satisfied, depending on a range of factors including:
    1. the total revenue;
    2. the total costs;
    3. the total number of staff, including professional staff and support staff;
    4. the degree of system and organization; and
    5. the amount of capital invested in the practice.

Personal Services Income Trusts

PSI Practice Trusts are routinely used by financial planners whose practices are not businesses for income tax purposes and which derive personal services income.

IT 2639 permits PSI trusts to be used.

What is a PSI Practice Trust?

In summary, a PSI Practice Trust is a trust created to run a practice that does not meet the ATO’s definition of a business. Basically, a practice will meet the ATO’s definition of a business if it has the same number or more non-owner material fee earners than owners. That is, more fee-generating staff than there are fee-generating owners. If one owner has two fee-generating staff, the practice is a business. In combination, the staff need to ‘add up to more equivalent full time work than the owner. So, a full-time owner with two staff each working two days per week (four days per week in total) is not generating business income. But, a full-time owner with two staff each working three days a week (six days per week in total) is.

If this criterion is not met, the practice is a personal services income practice.

In other words, a personal services income practice is a practice where the income is predominantly derived from the personal services of the owner or owners.

The question of whether a particular financial planner is deriving personal services income or business income is a question of fact, not law. In each case you have to look at the facts of the practice and apply the law to these facts. In applying the law, common sense tells you to apply the law as it is accepted by the ATO, and hence as a practical matter, we regard the ATO’s “rule of thumb” as set out in sub-paragraph 10(a) of Income Tax Ruling IT 2639 as the measure to meet.

As a general comment, it is better for income to be business income than just personal services income, as tax planning options tend to be better and more numerous. As a general proposition, para-planners will be “material fee earners” for the purposes of IT 2639 even though they do not bill clients directly, because they are in fact “material fee earners”. Their work leads to fees being generated.

Why do we recommend PSI practice trusts?

We recommend PSI practice trusts because they are simpler, cheaper and more tax efficient than the alternative practice structures. More expansively, practice trusts allow better tax planning results for clients by taking advantage of the intrinsic benefits attached to trust based structures. These include the timing of tax payments and the ability to withdraw cash from the trust without triggering a tax charge, and the fringe benefits tax rules connected to the employer and employee relationship between the trust and the financial planner.

A PSI practice trust uses a special trust deed designed by MLA Lawyers that only permits income to be distributed to the relevant financial planner, in line with the ATO’s published rulings on the incorporation of professional practices. The PSI practice trust is an integral part of many financial planners’ tax planning strategies and allows the financial planner to combine the benefits of running a practice in his or her own name with the benefits of using a practice company.

What are the advantages of a PSI practice trust?

The advantages of a PSI practice trust include:

  1. a deferral of tax payments of up to 23 months in the first year of use where the financial planner was previously an employee, as the financial planner changes from the pay as you go withholdings system to the pay as you go instalments system;
  2. better debt management, via an enhanced ability to borrow to pay outgoings where the ATO accepts the interest is deductible, such as tax, super contributions, management fees/costs and personal deductible costs. Borrowing for these outgoings ‘frees up’ the cash flow of the practice. This freed up cash flow can then be used for non-deductible private purposes such as reducing non-deductible home loans and credit cards;
  3. superior super planning potential, including the ability to superannuate a financial planner receiving significant super benefits from some other third party employer (this is often most relevant where the financial planning practice is conducted part time);
  4. the ability to provide concessionally taxed fringe benefits, particularly multiple car fringe benefits;
  5. reduced substantiation requirements, leading to lighter administration;
  6. a better domestic travel tax profile; and
  7. easier employment of related persons.

Statutory personal services income rules

The income tax law contains special rules directed at independent contractors that in effect deem their income to be like employment income. These rules do not apply to financial planners unless the financial planner derives all their income from one source.[2]

Few financial planners derive all their income from one source. Most derive their income from literally hundreds of sources, being the individual clients they see in a year. This is so even if their fees are collected for them by their AFSL.

Most financial planners are not covered by the statutory personal services income rules. This has been accepted by the ATO. The ATO’s views on how the statutory personal services income rules apply can be accessed here: Personal Services Income.

Summary of the advantages of a practice trust

Feature Individual deriving PSI Practice company deriving PSI Practice trust deriving PSI
Cost to set up? Nil $900[3] $500
Cost to run? Varies As for individual plus $212 ASIC fee plus costs re more complicated BASs As for individual plus $212 ASIC fee
Tax collection system? Pay As You Go Instalments, which means tax is paid later than otherwise Pay As You Go Withholdings, which means tax is paid sooner than otherwise Pay As You Go Instalments, which means tax is paid later
BAS simple? Yes No, due to PAYG withholding rules Yes
Can borrow to pay deductible business outgoings? Yes Yes, but cannot extract cash from company Yes
Can borrow to pay tax? Yes Yes, but cannot extract cash from company Yes
Can borrow to pay super contributions? No Yes, but cannot extract cash from company Yes
Tax efficient access to cash in entity? Yes No (deeming rules apply if money lent by company to a related person) Yes. Practice trusts are effective for debt conversion strategies
Full deduction for super contributions? Yes Yes Yes
Concessional fringe benefits available[4]? No Yes Yes
Multiple car fringe benefits[5] No Yes Yes
Payroll tax Not applicable Yes, if total salaries exceed threshold ($500,000 pa) No.
Workcover Not applicable Yes No
Compliance with ATO rulings on incorporation of professional practices: the break even rule Not applicable Difficult: must estimate salary. May inadvertently breach rule and expose the owner to a risk of penalties. Simple: compliance is automatic as net income is automatically distributed to the owner

 

Business Practice Trusts

Business practice trusts are the simplest and easiest way to own a professional practice where the practice is a business for tax purposes. The ATO says that a practice will be a business for income tax purposes where it employs or otherwise engages an equal or greater number of non-owner financial planners than owner financial planners, on an equivalent full time basis[6].

Diagram

Business practice trusts can be depicted as follows:

recommended-structure-for-one-owner-practice-business

This structure is extremely simple and cheap to run. It avoids payroll tax and Workcover costs on payments to owners and maximises income tax and capital gains tax efficiency, both on current year practice profits and the long term investment of the after tax amounts of those profits.

Business practice trusts mean the top marginal tax rate faced by a financial planner is potentially 30%, and the average tax rate will be somewhere below 30%. This is because the financial planner has the ability to control the amount of taxable income derived by him or her, and in particular to cap this amount at $80,000, which means the financial planner is just below the 37.5% tax rate.

This reduces current year income tax and also improves future year investment performance because:

  1. the financial planner has more money to invest, since he or she is investing after tax income that has only been taxed at 30%, and hence 70% remains available for investing; and
  2. the after tax rate of return on the investment is greater than otherwise, since the investment company pays less tax than otherwise.

Think of a snowball: if it starts off bigger and rolls faster it will end up a lot bigger, with a double whammy effect at work compounding the growth.

Obviously any amounts distributed to an investment company must be in fact paid to the investment company, or documented and treated as a real loan, to avoid a deemed un-frankable dividend under the private company loan rules.

Significant commercial advantages

The benefits of a practice qualifying as a business are not restricted to superior tax treatment. A practice that engages one or more non-owner financial planners will also enjoy higher levels of profit.  Even better, the additional profit is not conditional upon the personal contribution of the owner or owners of the business.

A business practice trust is the simplest way to set up and to run a practice that is a business. The trust requires just one bank account, one tax return, one set of accounts and one BAS each quarter. Business practice trusts are tax efficient, and as a practical matter in most cases mean the practice’s income is taxed efficiently, so that:

  1. net income can be legitimately distributed to related persons who face a lower tax rate than the owner;
  2. the top marginal tax rate is as low as 28.5%, being the current corporate tax rate for companies with less than $2 million annual turnover;
  3. the average tax rate is less than 28.5%. The extent of this advantage depends on the family tax profile and in particular the age and number of children and other close relatives.

As for PSI practice trusts, the advantages of a business practice trust include:

  1. a legitimate 23 month deferral of tax payments in the first year of use where the financial planner was previously an employee;
  2. an enhanced ability to borrow to pay outgoings where the ATO accepts the interest is deductible, thereby freeing up cash flow for non-deductible private purposes such as the reduction of non-deductible debts;
  3. better super planning potential, including the ability to superannuate a planner receiving significant super benefits from another employer;
  4. ability to provide concessionally taxed fringe benefits, particularly multiple car fringe benefits;
  5. reduced substantiation requirements;
  6. better domestic travel tax profile; and
  7. easier employment of related persons.

Other advantages of a practice trust

Business practice trusts are simple and cheap to set up and to run each year.

Business practice trusts distribute their reward to owners without paying a salary, which means there is no payroll tax on salary payments and no mandatory work-cover insurance premiums. (Such insurance might still be a good idea, but it is not mandatory. The planner has control).

A trust with a corporate trustee (that is, which has a company as a trustee) has all the advantages of a company. But it also has relatively few of the limitations often experienced by a company. For example, a practice that is operated via a company has fewer avenues via which it can implement optimal debt management.

Service entities

Where a financial planner is operating his or her private practice via a PSI trust, consideration can be given to whether or not a service entity should also be applied.

A “service entity” is usually another trust that provides administrative services to a professional practice. A service trust can be either a discretionary trust, a unit trust or a hybrid trust. The service trust of a solo practice will normally be a discretionary trust (i.e. the financial planner’s family trust) and the service trust of a partnership or an associateship will normally be a unit trust or a hybrid trust, with the units owned by the financial planners’ family trusts in line with their partnership percentages.

The service entity provides the services to the professional practice, whether it is a solo financial planner, a partnership, a practice company or an associateship. These services are provided for a fee, and the fee will include a profit component. The income of the service trust is business income.  Therefore, the profit component of the fees paid to the service trust can be distributed with discretion between eligible beneficiaries of the service trust.

Types of service entities

A service entity may comprise:

Type of entity Where used Comments
Discretionary trust (ie family trust) Typically used by one owner practices with related persons facing lower tax rates Can be used with a corporate beneficiary
Unit trust (with units owned by owner’s family trusts (or companies) Typically used by multi-owner practices where some owners have related persons facing lower tax rates and some do not Need a unit-holder’s agreement to regulate co-owners’ relationships
A company Typically used by one owner practices with no related persons facing lower tax rates Consider having shares owned by a discretionary trust
A partnership of companies or family trusts Typically used by multi-owner practices where some owners have related persons facing lower tax rates and some do not Need a partnership agreement to regulate co-owners’

Service Companies

A service company is a company beneficially owned and controlled by a financial planner or a group of financial planners for the purpose of providing services to a related professional practice.

Readers looking for detailed information should refer specifically to Income Tax Ruling TR 2006/2 dated 20 September 2006 “Income Tax Deductibility or service fees paid to associated entities: Phillips arrangements” and the related guide.

A service company may be used where a PSI practice is owned by a financial planner who does not have any related persons in lower tax brackets to whom net income can be efficiently distributed. The use of a service company to provide arm’s length services to the practice allows net income to be moved from a 47% tax environment to a 30% tax environment[7]. This saves tax of 17% of the net income distributed to the service company.

Who should own the shares in the service company?

The shares in the service company should not be owned by the financial planner. This is because they will become valuable over time as assets build up in the company, and this creates asset protection problems.

The shares are ideally owned by a separate family trust controlled by the financial planner or a trusted relative. This creates asset protection advantages, and also allows for future franked dividends paid by the service company to be channelled to a low tax rate beneficiary, thereby reducing the overall level of tax ultimately payable on the service company income (and the investment earnings thereon). Think of that snowball again: there is more to invest, and the after tax earnings are greater, leading to a much bigger snowball later on as earnings compound in a low tax rate environment rather than a high tax rate environment.

Diagram

The arrangement can be depicted as follows:

one-owner-practice-using-service-trust

Investment Companies

Financial planners can set up companies for the purpose of investing monies distributed from discretionary trusts (and hybrid trusts) used to run the practices and the service entities connected to practices.

The investment company pays tax at 30%, compared to 47% tax paid in the financial planner’s hands. This means, for example, there is a cash tax saving of 17% of the amount distributed to the company each year.

Investment companies are best used by persons facing a high marginal tax rate even after super contributions and distributions to related persons are completed. In summary, despite not receiving the 50% CGT exemption, companies are still usually very efficient investment vehicles because:

  1. the financial planner has 70 cents in the dollar available to invest in the company, compared to just 53.5 cents in the dollar available to invest in his or her own hands;
  2. eventually a franked dividend will be paid, and this can trigger income tax refunds for excess franking credits; and
  3. the lower company tax rate translates to a higher after tax rate of return, which means more rapid after tax growth in the value of the investments.

Think again of the snowball: if it starts off bigger and rolls faster it will end up a lot bigger, with a double whammy effect at work compounding the growth.

Where should companies not be used to invest?

Companies should not be used to invest in some circumstances including:

  1. where the new investment is expected to generate a significant capital gain in a reasonable short period of time (but more than 12 months), such as a property development (here an investment trust should be used); and
  2. where the new investment is expected to generate a significant tax loss due to negative gearing, and there is no other investment income available to offset the loss, such a geared residential property investment (here the financial planner should own the property in his or her own name, using the relatively-high debt level that leads to the negative gearing situation as a form of asset protection).

The cash must be paid

The critical practical point is that the cash must be paid to the investment company. Un-paid trust distributions to investment companies are deemed to be un-frankable dividends, and are penalized under the tax law. Ideally the cash is paid before 30 June in the year the distribution occurs. Second best is as soon as possible afterwards, and the minimum position is by the time the tax return for the relevant year is lodged. This is a very important point with investment companies: the cash must be paid.

Who should be the shareholder?

The shares in the investment company should typically be owned by a separate family trust controlled by the financial planner or a trusted relative. This creates asset protection advantages, and also allows for future franked dividends paid by the investment company to be channelled to a low tax rate beneficiary, thereby reducing the overall level of tax ultimately payable on the service company income (and the investment earnings thereon).

it’s the snowball again: there is more to invest, and the after tax earnings are greater, leading to a much bigger snowball later on as earnings compound in a low tax rate environment rather than a high tax rate environment.

Diagram

Investment companies are used in many of our client structures and one application is for a one owner practice that is a business because it has more non-owner fee earners than owner fee earners.

This application is depicted in Diagram 1.0 which is reproduced here:

discretionary-trust-used-to-derive-psi

The practice trust:

  1. distributes up to $416 net income to beneficiaries under age 18 including immediate family members and if appropriate extended family members;
  2. distributes up to $80,000 to each beneficiary over age 18;
  3. pays deductible super contributions to the SMSF; and then
  4. distributes any remaining net income to the investment company.

The investment company then pays 30% tax, invests the after-tax amount of the money and pays a fully franked dividend to the shareholder family trust at some time in the future when a low tax rate beneficiary presents (say, after a child turns 18). The beneficiary includes the franked dividend in his or her taxable income and claims a credit for the 30% tax previously paid, generating a refund of excess franking credits. This means the ultimate rate of tax is less than 30%, and may even be nil%. It will depend on the marginal tax-rate of the eventual beneficiary in the year they receive the benefit.

Investment Trusts

Investment trusts, particularly family trusts/discretionary trusts are often used to hold investments. Often the investment trust function is combined with a service trust function, but practice trusts should not hold investments due to asset protection issues: the investment would be unnecessarily exposed to a risk of client litigation.

The advantages of family trusts as investment vehicles include:

  1. asset protection;
  2. income tax distribution flexibility;
  3. capital gains tax exemption (after 12 months);
  4. capital gains tax distribution flexibility;
  5. can be combined with investment companies to get the ‘best of both worlds.’

[1] And a significant tax deferral of up to 23 months can be achieved on changing from a practice company to a practice trust.

[2] See paragraph 15 of IT Ruling 7 of 2001, which can be downloaded here: ATO Ruling 7 of 2001

[3] See www.legaledocs.com.au for a full list of prices of companies, trusts and other legal services

[4] Examples include, $300 per employee tax exempt fringe benefits, tax free meal allowances, and similar tax benefits that require an employer/employee relationship to be present

[5] There is no limit on the number of deductible company cars able to be provided as a fringe benefit. This is a useful way to provide financial assistance to low income relatives such as university age children or elderly pensioner parents

[6] See Income Tax Ruling 2639 Income Tax Ruling IT 2639 dated June 1991

[7] With the possibility of a refund of all or part of the 30% tax on the ultimate payment of a dividend.

The Dover Group