11 – Practice trusts for business income practices
Trusts are best for professional practices
If your practice meets the ATO definition of a business, and its income is therefore business income, the simplest, safest and cheapest way to set and run your practice is through a trust based structure.
You can read the ATO’s thoughts on owning professional practices through trusts here: Assessing the risk: allocation of profits within professional firms. This publication sets out the rules and conditions for distributing professional practice income to persons other than the professional who generated it, and should be observed by every professional practice.
The good news is that the rules and conditions are quite generous to professionals. You can read a discussion of these rules in the context of doctors and dentists at: A discussion of the ATO’s views on professional practice income.
Dover advisers can set trusts up for free (exclude trustee company formations) using Dover’s LegalEDocs service.
Solo practice that is a business
If you practise on your own, in the sense you own the whole practice and are not a co-owner and your practice is a business, a family trust is probably the best option.
Family trusts, also known as a discretionary trusts, are the most common form of business organisation in Australia. The ATO accepts that professional practices can be operated through trust based structures.
A non-solo practice that is a business
If you co-own a practice that is a business with another financial planner you should still use a family trust. But this time your family trust will own units in an interposed unit trust or hybrid trust, rather than run the business itself.
Diagram of a solo business practice trust
A solo business practice trust can be depicted as follows:
This structure maximizes 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:
- 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
- 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:
- net income can be legitimately distributed to related persons who face a lower tax rate than the owner;
- 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;
- 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.
The advantages of a business practice trust include:
- a legitimate 23 month deferral of tax payments in the first year of use where the financial planner was previously an employee;
- 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;
- better super planning potential, including the ability to superannuate a planner receiving significant super benefits from another employer;
- ability to provide concessionally taxed fringe benefits, particularly multiple car fringe benefits;
- reduced substantiation requirements;
- better domestic travel tax profile; and
- 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 financial 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.