27 – Employing related persons

A coffee with Ken

I was enjoying a coffee with a new Dover adviser. Ken is in his mid-thirties, married with two young kids, aged 8 and 6. Ken is working long and hard to get his practice up and running. He wanted to chat about what he was doing and pick my brain about what he could do better.

Ken is a solo practitioner. He does everything. The marketing, the website, the client meetings, the SOAs and the implementation. Everything.

Barbie’s plan

Ken’s wife Barbie had been tied up with the kids. But the youngest is now at school and Barbie wants to re-join the workforce, she told Ken. A good first step was handling Ken’s administration tasks, she told Ken. This would free up Ken to do more marketing and client work and indirectly lead to a significantly higher combined income, she told Ken. Plus Ken would get a bit more time with the kids, she told Ken. 

Ken asked me what I thought of Barbie’s plan. 

I thought what Barbie told Ken was great (which was just as well because Barbie was going to do it anyway).

In fact I thought Ken should take it one step further and encourage Barbie to complete an RG 146 Kaplan diploma of financial planning so Barbie could eventually provide personal advice and make it a two-person practice. But learn the ropes on the administration side of the practice first.

Barbie told me she would do that.

A real SOA

The strategy made a lot of sense. In fact it was a textbook example of real financial planning advice.

A point form SOA for Barbie could read:

  1. change your career path to be self-employed. The benefits include:
    1. flexible working hours with time off without notice if the kids are sick
    2. coordinated annual leave
    3. only one work car needed
    4. no commuting time
    5. an understanding and caring boss
    6. the real commercial reward comes in the form of increased profits, net cash flow and CGT free goodwill,
  2. up-skill, ie complete the Kaplan diploma, because education is the best investment and this increases your marketability, your income earning capacity, your self esteem and your enjoyment of work and feeling that you are contributing to your community
  3. it’s a great example for your kids
  4. Ken gets a great employee with 100% aligned goals who thinks she owns the practice and
  5. there are significant tax benefits, including those connected to tax deductible salary payments from Ken to Barbie and superannuation contributions for Barbie

Salary payments to related persons

The salary paid by Ken to Barbie will be a deductible loss or outgoing in Ken’s hands under the general principles of deductibility.

However, the tax law caps the amount able to be deducted, by imposing a reasonableness test. The Commissioner of Taxation may reduce the deduction for salary paid to a related person to an amount that is reasonable[1]. The amount that is reasonable is determined by looking at the actual work done, the actual hours worked and the market value of that work.

As a practical matter this means Barbie’s salary has to be market based, and this should be documented, ideally before or at the time the salary starts to be paid. Ken and I discussed market value and decided an experienced practice manager would be paid a salary of at least $80,000 a year, including superannuation. Barbie would be working thirty hours a week, so we reckoned a market based salary for the actual work she would be doing was $60,000.

Ken profit was running at about $130,000 a year.

This meant Ken’s profit would initially fall by $60,000 to $70,000, but would then start to climb up as he increased his marketing and took on more new clients. Barbie would dissolve the administrative bottleneck that was holding the practice back, and would be a catalyst for new growth and increased profits and CGT free goodwill.

Barbie would free Ken up to do more high end work attracting and retaining clients.

Tax savings

The strategy also saved about $11,000 a year in tax.

The before and after scenario looks like this:

  Before After
  Taxable income Tax payable Taxable income Tax payable
Ken $130,000 $36,000 $70,000 $14,000
Barbie Nil Nil $60,000 $11,000
Total $130,000 $36,000 $130,000 $25,000
Tax saved $11,000

Saving $11,000 a year in tax, on a marginal tax rate of 37%, is the same as earning an extra $17,500 a year in pre-tax profits, which is almost an extra two months profit a year.

Summary

The commercial and family benefits plus the tax benefits of $11,000 cash a year create a persuasive case for Barbie working for Ken.

Barbie got the job. Which was just as well for Ken.

The Dover Group