Can a medical practitioner pay less tax by operating through a company?
Many medical practitioners coming to us for advice about tax structures for doctors mistakenly believe that if they operate through a company they will pay less tax by taking advantage of corporate tax rate and ability to split their income between family members. This cannot be further from the truth.
While there is nothing in law to prevent incorporation of medical practices, incorporation will often be ineffective for obtaining tax advantage. Most doctors receive their income from personal exertion, such as personal efforts, skills or expertise, which can be in the form of salary or business income.
In Australia, government does not accept diversion of income from personal exertion of the professional practitioner to family member or other parties. There are anti-alienation and anti-avoidance measures in Australian Tax Law to ensure the income is taxed in the hands of the practitioner who provided the service.
How PSI Regime and General Anti-Avoidance measures affect tax structures for doctors
First of all, any business producing income from personal services is subject to Personal Services Income (PSI) Rules. Under PSI regime, practitioners are ineligible to claim certain deductions and, if the personal service income is received through an entity, it must be attributed to to individual practitioner, unless certain tests are passed. PSI Tests were covered in more details in our blog article “Personal Service Income Rules”.
In our experience, it is not difficult for doctors providing services directly to patients to pass either the Result Test or the Unrelated Clients Test, which means they would not be subject to restrictions imposed by the PSI rules. However, it is a popular misconception that passing PSI Tests gives green light to income splitting. Apart from PSI Rules, there are General Anti-Avoidance provisions to prevent you from getting tax advantage by deliberately structuring your tax affairs to pay less tax.
The ATO expressed their position in IT 25 (issued in 1981) that incorporation of medical practices for income tax purposes would be acceptable if the company is incorporated in accordance with the by-laws of the AMA, which require that the practitioner maintains personal responsibility for his/her acts or omissions, and the effect of incorporation does nothing more in relation to tax return than reduces a professional’s income by the amount of superannuation cover.
Subsequently, in 1988, the ATO issued IT 2503, which applies to practice companies whose income is generated predominantly from personal service of the individual professional practitioner. It is important to note that, while IT 25 only deals with medical practices, IT 2503 applies to all professional practices, including doctors, dentists, legal practitioners, accountants, engineers, architects etc.
The Ruling states that incorporation of professional practices will be accepted by the Australian Taxation Office where:
– there is nothing in the relevant State or Territory law to prevent incorporation;
– there are sound business or commercial reasons for incorporation;
– there is no diversion of income from the personal services of the professional practitioner to family members or other persons; and
– the only advantage for income tax purposes is access to greater superannuation benefits.
Practice company should have no taxable income. The total income for the year should be fully paid out to the practitioner by way of salary. The company is not permitted to retain profit to manipulate timing of distributions to shareholders.
The ATO accepts that it is not always possible to accurately determine the amount of income and pay it as salary by 30 June each year, which may result in small taxable income arising in the company. The ATO permits the remaining part to be paid to the professional as a way of franked dividends in the following year. However, bona fide attempt must be made to break even. If no attempt is made to pay out company profit as a salary, the incorporation will be viewed by the ATO to be undertaken for the purpose of minimising tax.
Additional costs of operating medical practice in a company structure:
– The company will have to pay compulsory Super Guarantee on wages paid to the practitioner (up to a limit based on maximum contribution base). Failure to pay Super Guarantee payment on time will result in Super Guarantee Surcharge, which is not tax deductible.
– Wages will be subject to PAYG withholding, which will have to be remitted to the ATO. Failure to withhold correct amounts may result in wages being not tax deductible to the medical company.
– The company will be required to organise and pay workers compensation insurance for the practitioner. Workers compensation is compulsory in every state and territory in Australia. Heavy penalties apply for failure to comply with workers compensation requirements.
– Depending on the total amount of wages, payment of profit by way of wages to the practitioner may trigger payroll tax liability. Payroll tax rates and thresholds vary between states and territories.
– Wages will have to be processed and reported to the ATO using software with Single Touch Payroll functionality.
– The costs of establishing and maintaining company structure are higher compared to a sole trader. Apart from having to pay Annual Company Review fee to ASIC, you are likely to incur additional accounting and tax compliance costs as the company would be required to prepare full set of financial statements. No decent accountant would prepare a company tax return without preparing financials.
– A company structure may offer a protection of limited liability but being in charge of a company as a director attracts certain responsibilities. If you appoint yourself as a director, you need to ensure you understand your obligations under the Corporation Act 2001. Directors may be personally liable for certain debts incurred by the company.
– Medical practitioners who are members of AMA require to have the constitution of the company approved by AMA.
Is incorporating medical practices ever appropriate?
In some cases, incorporation may be appropriate as company structure provides protection of limited liability. The answer depends on individual circumstances in each case. Business structure decisions should be based on number of factors.
It should be noted that the IT 2503 only applies to those practice companies whose income flows directly or predominantly from the rendering of personal services of the professional practitioner. It does not apply to all medical practices. If the practice derives its income mainly from use of equipment or from business structure, as opposed to personal services, it will fall within the scope of IT 2503 and will not be subject to the above restriction.
Whether a medical practice derives income from rendering personal services is a question of fact and degree to be determined in the circumstances of each case. To determine whether the medical practice falls within the scope of IT 2503, number of factors need to be taken into consideration, including:
– The nature of the practice’s activity
– The extent to which the income depends upon the practitioner’s own skill and judgment
– The extent of the income producing assets used to derive the income
– The number of employees and others engaged
– The ratio of principal to non-principal practitioners
Structuring decisions should not be based on tax consideration alone. There are multiple issues to be considered when making decision about practice structure, such as specialty of the medical professional(s), the need for premises, the need to invest in expensive equipment (e.g. radiology practice), whether the practitioner is required to engage support staff.
Often, greater advantage can be achieved by using a combination of business structures, such as involving a service entity (usually a trust) that charges a service fee for supplying resources (e.g. premises, staff, software) to the practice entity. Services entity arrangement are popular feature in tax structures for doctors. Service entity structure provides advantage of asset protection and allows practice members to split income with family members to a certain degree. Naturally, service trust arrangements are under increased scrutiny from the ATO and if these arrangements are not in line with the ATO guidelines, they will be at higher risk of ATO audit.
If you would like more information on structuring medical practices please send us an enquiry or call our office to see how we can help.