10 – The nature of commission income
Many financial planners derive commission income.
Most financial planners are not aware of how commission income is taxed. Its tax profile depends on its nature. If commission income is personal services income it must be taxed in the hands of the person who generated it. If commission income is not personal services income, and is business income, it does not need to be taxed in the hands of the person who generated it, and can for example be derived by a family trust and distributed to low tax rate beneficiaries including related companies.
You have to understand the nature of commission income to understand how it is taxed.
You have to understand how commission income is taxed to understand how a financial planning practice should be structured.
Personal services income, business income and property income
Australian tax law distinguishes between at least three different types of income. These are personal services income, business income and property income.
Commission income can be anyone of these three types of income depending on the circumstances. The tax consequences differ significantly. This is because the tax law requires personal services income to be taxed in the hands of the person who generated it and not some other person, such as a low tax rate family member or related company.
This means personal services income is generally taxed at a higher marginal and average tax rate, although obviously many other factors are in the taxable income computation too.
When is commission income not personal services income?
Commission income will not be personal services income when:
- it is connected to the register, ie it is not a first year commission; or
- it is connected to a business structure rather than the adviser’s personal efforts.
When will commission income be connected to the business structure?
The ATO says commission income is connected to the business structure when, as a rule of thumb, the practice has more non-owner material fee earners than owners or if the “badges of business” are otherwise present. The badges of business include facts such as the number of staff, the level of system and organization, the amount invested in assets such as plant and equipment or premises (whether owned or leased) and so on.
In the period up to September 2014 there was some conjecture as to whether the ATO was changing its views, as summarized in the preceding paragraph. This conjecture disappeared in September 2014 when the ATO released a new document called Assessing the risk. Allocation of profits within professional firms.
This document affirms these views and adds a new condition for the ATO accepting that a professional practice, such as a financial planning practice, can be run by a family trust.
We recommend every financial planner who is interested in understanding the ATO’s views on how financial planning practices are taxed read this document closely from cover to cover. The good news is many will discover they are paying too much tax and can re-arrange their affairs to pay less and still stay well within the ATO guidelines and “rules of thumb”.
When can a financial planning practice be run through a trust-based structure?
The ATO says it will accept that a financial planning practice can be run by a family trust and the trust’s net income can be taxed in the hands of someone other than the financial planner provided that one of these three tests are met:
- the financial planner includes an amount in their assessable income:
- equal or greater than 50% of their own fees; or
- equal or greater than the amount paid to the highest earning non-owner; or
- the average rate of tax paid is at least 30%.
Most financial planning practices that operate through a trust based structure will have no difficulty satisfying these tests.
Property income or business income?
For completeness, we note the interesting technical debate whether commission income that is not personal services income is business income or property income.
It can be either, depending on the practice’s specific profile. But there is no tax consequence to the classification, business income being taxed the same as property income, so we leave this interesting technical debate here, unexplored and unresolved.
Interested in learning more?
McMasters’ Financial Planning for Doctors E-Book includes a detailed and extensive explanation of the rules for taxing professional practices, including a discussion of when a practice can be operated through a trust based structure. This e-book is written for doctors but the concepts apply equally to any professional group, including financial planners.