This article has been published in the Medical Republic on 9/3/2021 – Find article here
Doctors and practices that use medical practice companies and trusts to bill their patients predominantly for labour services to reduce their tax are likely to be impacted by a new ATO ruling that starts later this year.
Commencing 1st July 2021, the latest Australian Taxation Office (ATO) Allocation of professional firm profits – ATO compliance approach ruling sets a higher and more complex bar for doctors and their medical practices for income splitting to family members or related entities that pay a lower amount of tax.
Doctors and practices that use medical practice companies and trusts to bill their patients predominantly for labour services to reduce their tax are affected by this ruling.
Budget for an increase in your accounting and legal fees. This is certainly a wake-up call. Ultimately, the new robot data matching using STP and E-invoicing by the ATO is making it easier to automatically audit practices.
Being an honest fool is not a legal defence so blaming it on your accountant is off the table, especially if you don’t ask the right questions in writing.
To protect yourself you personally should be able to clearly explain the commercial reason (not just a “tax reason”) for setting up your structures and show the relevant business models and documentation.
If your accountant cannot explain the commercial reason behind your structure, it may be time to change your accountant or at least get a second opinion from an experienced lawyer or accountant who solely specialises in this area.
Unfortunately, many doctors naively trust their accountants to set them up in the right structure without really understanding why or how it works. My first rule of thumb is if you do not understand something, ask more questions or do not do it.
Ultimately, you will be responsible for any problems, and it may be too late, too hard or too expensive to blame your friendly accountant.
The devil is in the detail. This is not a Do-It-Yourself job. Tidy things up while you can. Do not leave any stone unturned that may lead to more awkward questions being asked by the tax office.
What must practises and doctors do now?:
- Review the purpose of your medical practice companies, family trusts and service trusts structures and agreements. Clearly establish their underlying purpose beyond tax savings;
- Be prepared to prove your arrangements are not solely tax-driven. Prove they are commercially driving your medical practice or your service entity;
- Profit-sharing arrangements – formalise and get them signed before the end of the tax year; and
- Make sure your business systems reflect points 1 and 2 above. Pay attention to the details.
I will elaborate later.
On the positive side, you can legally and ethically enter into arrangements
On the contrary over many decades, the ATO has lost many high profile court cases that have allowed for a genuine commercial reason for these various structures to exist. See ATO Service entity arrangements.
Today, the ATO wants to refine and increase their scrutiny of what they consider to be a high-risk arrangement.
For many practices, the new ruling may mean a simple tweaking of existing arrangements, and for others, something more may be involved.
The good news is that if you do not cut corners and do it properly, some of these arrangements may do more good than harm. The use of service entities e.g. a service trust is still a legitimate way to succession plan and pay the right amount of tax.
The benefits still outweigh the costs when a service trust is set up and administered correctly.
Due to the pandemic, the looming national and state budget deficit make professionals such as Do-It-Yourself type high earning doctors, easy low hanging fruit targets.
Whether deliberate or not, a set of high-risk factors as detailed in the latest ruling are in play. Specifically, they are targeting non-commercial arrangements and tax structures that are solely there to save on tax.
The new ruling continues to reaffirm a long-held Australian Taxation Office (ATO) concern that professionals like doctors who primarily earn their income from their personal labour are using various tax vehicles to unfairly reduce their tax bills.
This renewed attack is designed to target medical and other healthcare and non-healthcare professionals.
For decades I have publicly and privately been involved nationally in these types of reviews. The ATO and various State Tax Offices are certainly getting better at fine-tuning their audit activities, see ATO complaints a bit rich.
This is not an issue to be ignored. It should be addressed immediately.
Dodgy practice arrangements?!
How have some doctors reduced their tax bill?
For some time, the ATO has maintained that any income earned by professionals predominantly due to their own labour should be declared 100% in their own name. The courts have found this is neither fair nor realistic.
Practice Companies and Trusts
It is quite common to see sole practitioners operate through a family trust or company. This is then used to channel income to lower taxpayers, such as a family member. This can range from the entity employing your spouse at a higher than market value rate or distributing profits to a lower taxpayer. This could be a child over 18 attending University. If this is not available, some use a practice company that does not pay out dividends and allow the profits to be taxed at a maximum rate of 30% in the dollar.
I certainly do not recommend any of these strategies. At times, I hear advisers tell doctors to use a company to avoid payroll tax. Needless to say, a more thorough holistic and less piecemeal approach is needed.
Service Entities e.g. Service Trust or Company
For the reasons given above, if a doctor owns their practice the only real legitimate way to income split is to use a service entity.
Practitioners have incidentally been able to reduce their tax bill by up to $20,000 to $30,000 p.a.
Some key questions to ask yourself about your taxation arrangements
As a doctor or practice owner:
- Am I paying a family member an excessive amount of remuneration e.g. for bookkeeping or managing your practice? Am I using market rates?
- Am I transferring money to another entity or person to simply reduce my tax bill? Do I know why and how? Are they more than just journal entries the accountant does, is it real?
- Am I using a practice company, trust or service entity like a service trust or company (aka ending with “Pty Ltd” after my practice name) to divert income to lower tax-paying family members or entities like a company that pays a maximum tax rate of 30%?
Without a sound response to these questions together with this new self-assessment ruling, you may risk facing an expensive audit and a hefty tax bill with penalties.
Remember, saying “my accountant told me will not be a defence” and being an honest fool is also not a defence.
The next step – ask your advisers the right questions and don’t just look for the right answers
Ask your advisers in writing whether the Allocation of professional firm profits – ATO compliance approach ruling affects you, how it affects you, and what you should do next.
Where do doctors, practice’s and some advisers start to go wrong?
It takes more than getting the right legal agreement or arrangements from a high-profiled, glossy brochure law or accounting firm.
Quite a number are concerningly taxation driven as this is a primary concern for many practitioners.
Many arrangements do not begin to address important issues the new ruling seeks to address, namely:
- Commerciality i.e.investment rates of return on their business arrangements;
- Succession planning;
- Legitimate income splitting arrangements; and
- Asset protection.
This is where many doctors and practices start to go wrong. Matters tend to snowball when a piecemeal and not a holistic approach has been taken.
On the contrary, the practice is at risk beyond tax issues. Often, this includes unnecessary medico-legal exposure.
Structures tend to look more like a patchwork of well-intended ideas with little attention paid to the many devils in the detail.
It is not a matter of if you get caught, but when.
Due to new technology and specialist experienced medical firms, this is no longer the case,
How to Defend Yourself from a Tax Audit
Firstly, just keep it commercial. This is the predominant test in the new ruling. The primary defence in the Income Tax Act is Part 4a.
If the predominant reason you entered into the arrangements was commercial, you jump a number of big hurdles. Without this reason, you leave yourselves exposed to an expensive audit.
If you are employing related parties such as a family member (e.g. a spouse who is a practice manager), it is important to benchmark their salary to a practice managers salary or lose a legitimate tax deduction.
If you are using a service entity, set a commercial service fee to run a viable business. My clients use monthly national practice benchmarks and the Doctors (Service Fee) Pay Calculator to reduce scrutiny. It is a bit late to start addressing these issues if the tax office is knocking on your door.
It is important to prove and provide an independent, arms-length audit trail for the Tax Office.
Change your attitude – budget and plan for it.
Do the right thing the right way. Due to complexity, you have to invest money to get it right. It will provide benefits for a lifetime. It is a relatively cheap, once-off investment that requires minimal maintenance.
This is not a Do-It-Yourself exercise. Seek qualified, experienced medical/healthcare specialist help. Glossy brochures and vanity titles will not save you from a stressful and expensive tax audit.
This should be on the top of your list. Ask how many years and what their specific experience with practices is beyond a tax return.
Get their advice in writing or you will have very little to rely on. Anybody can give free phone advice, but it will not save you if you are hit with an audit.
Start asking the right questions and don’t just seek the right answers.
The ATO is looking for substance over form.
Starting from the top, these are the key areas to watch out for. These could be questions for your accountant and legal adviser.
Can you prove your arrangements are in place and are working? What business structure, documentation, systems and procedures do you have in place. Can key staff and advisers provide a simple explanation to validate your arrangements?
Types of business structure
Ask why you have the structure(s) in place and what is their primary purpose?
Sole Trader: Sole Trader/ Practice Company/Trust
A common mistake is a sole trader practitioner owned by a family discretionary trust or a practice company with a pty ltd at the end of its name. The ATO takes a dim view of this. This ruling serves as another reminder.
If you are a sole trader practitioner operating out of a Practice Company or Trust with a corporate beneficiary (aka “Bucket company”), ask why are you not operating as a sole trader? You may save on a lot of unnecessary accounting fees and headaches.
An explanation must go beyond reducing one’s tax. I normally recommend new clients to remove such arrangements.
Service Entity: Landlord Service Trust or Company and Tenant (sole trader)
Many practices use a service entity arrangement. Commonly, this entity is a trust but it can be a company.
A big focus is on why your entity exists? What are their roles, i.e. is it more than tax avoidance? Service entities are another key focus of the new ATO Profits Allocation ruling.
For many medical practices with a service entity, the service entity owns all the site goodwill of the practice, intellectual property, plant and equipment, and employs non-medical staff. It takes on a traditional landlord and tenant relationship with its doctors/providers. As a landlord, the practice charges a service/management fee (like rent for a serviced office). For example, 35% of gross billings to a self-employed doctor to use the practice.
The key issue missed here is what is the purpose of the entity beyond the traditional “asset protection” argument. The ATO new ruling which may come as a surprise clearly states they will not accept this as a primary defence anymore.
In other words, they are questioning the entire legitimacy of your structure. What other value does it bring?
Using the correct type of entity structures and relevant practice agreements builds a strong case for arguing succession planning does exist.
This should override any concerns from this latest ruling. This is a commonly overlooked opportunity. It is great for your practice regardless of the ruling if you have recruitment and retention problems.
Template agreements and arrangements exist that can make this easier for practices to execute.
Service trusts and family trusts together with a bucket company for succession and estate planning continue to have a legitimate role. The planets all need to line up correctly for this to work. Careful and thoughtful consideration is required. All arrangements between entities from minuted pre-fixed profit distributions, trustee minutes and bank transfers should be properly documented and signed off for.
Any taxation benefit should be incidental and not the primary reason for the arrangement. The benefits do continue to outweigh the costs beyond tax. Do not let this ruling weaken but use it to strengthen your current arrangements.
Another common mistake is non-existent, out of date, or unsigned practice agreements. Well executed agreements provide excellent evidence in the event of an audit.
Where is your spouse’s employment contract? Do they really do what the contract says they do? What is the commercial market rate for their services?
If you can produce this information at a moment’s notice this always provides an impressive first-mover advantage. Another one is practice service agreements and ownership agreements (which include profit-sharing arrangements).
Doctors/Provider: Contractor/Service or Employee Agreements:
Do you have up to date and signed service agreements with your providers that name your key business structures?
If you are not able to clearly answer this question, other more awkward questions may pop up, including but not limited to:
Do you really engage contractors and subcontractors or employees? Why is there no consistency in your arrangements? I.e. If all doctors are contractors, why do you employ registrars in your service entity?
Practice Ownership Agreements (which include profit-sharing arrangements):
Do you have an agreement that pre-agrees how profits are shared? Does it fairly reward risk and return consistently amongst owners? I use a set template formula that is investment and succession planning friendly. This may reduce the ire of the Tax Office concern.
Profit-Sharing and Income Splitting
Payments to Relatives
Are your payments to your spouse or relatives not considered excessive from your practice company or trust? What do you normally pay a practice manager? Many of these arrangements can be struck down and deem any tax deduction not deductible.
As mentioned earlier, if you are employing related parties such as a family member e.g. a spouse who is a practice manager, it is important to benchmark their salary to a practice manager’s salary or lose a legitimate tax deduction.
Profits are artificially increased in the service entity for the sole purpose of reducing tax
Are the service fees charged by your service entity commercial? Why are some service fees higher than others? Why is a guaranteed minimum or hourly rate offered to a doctor?
Some naughty practices artificially increase their service or management fees via the service entity. This can give them an immediate tax benefit. However, it is risky without appropriate justification.
The current ATO service entity ruling allows GP’s to use a service fee of up to 45% of gross fees they bill to a patient in the service trust. This can be legitimately used to income split.
The key issue here is some practices are using a higher service fee than the ATO recommends. This can be legitimate.
For example, owners may use a 60% rate instead of the ATO guidelines rate of 40% for metro GP practices and 45% for rural GP practices. See ATO Service Entity Arrangements.
On the contrary, some practices use a lower rate of 35% which may cause a solvency problem.
Provided these arrangements are commercial, this income can be legitimately channelled to lower taxpayer entities for commercial purposes such as succession planning.
A case in point as detailed below, I have successfully argued both publicly and privately that practices can charge up to 60% of GP patient billings as a service fee. This may be a surprise to many traditional accountants.
Good commercial reasons such as the freezing of Medicare rebates and comparable live monthly national benchmarks provide a formidable argument.
Source: Service Fee Burden BRW article
I was involved in this 2007 national tax ruling. We did successfully argue when asked by the Federal AMA that a percentage approach be used for medical practices. We had won that argument because we could prove listed companies were using this same approach. We have secured in recent times a private tax ruling for a 60% service fee for a general practice. Anything is possible if you can prove your argument.
Tip: A commercial service fee is one where the practice will not become insolvent i.e. you can pay your debts as and when they fall due. The bottom line is to charge a commercially realistic management or service fee to owners and non-owners that is commercially consistent with the level of service and risk involved.
Many practices do not have commercially clear and signed profit-sharing agreements
Between the owners, are there pre-agreed signed profit-sharing agreements? Or is this causally determined at the end of each year to keep one’s tax bills down?
Can you justify why you direct income to a family member, corporate beneficiary (“bucket company”) from your practice or family trust? Should this income really be declared in the doctors or providers name at a higher rate of tax?
These can be difficult questions to answer. However, some careful thought needs to be taken now while you have the time.
Systems and Administration
Other factors that may strike down the legitimacy of any arrangement is when a practice does not walk the talk. It is hard for the Tax Office to accept that your doctors are not independent sole traders when you and your staff refer to them and their stationary makes them look like employees or subcontractors.
Incorrect website and stationary listing of doctors and providers
The most common example includes having all doctors listed under “Our Doctors” or “Our Staff” when they are supposed to be independent sole traders or tenant doctors co-located on your site?
Another example is using the service entity ABN and letterhead to bill patients and not the individual providers for vaccinations and professional services?
Paid out of the wrong bank accounts
Why are doctors paid out of the same bank account as medical receptionists when you have declared the doctors are independent contractors or tenant doctors?
If you have a service trust, why is the same Xero or MYOB ledger and bank account used to pay doctors and staff? Why are they not separate?
Regular complicated/confusing journal entries
Why does your Xero or MYOB ledger have many automated and confusing journal entries that appear to reverse out or negate the actual arrangements in place, such as doctor payments?
Why can you not easily reconcile or explain them? Why do their income and banking not reconcile to your practice management system, such as Medical Director, Genie or Best Practice?
It is not if you get caught, it is when!
These are some of the many uncomfortable questions you need to be prepared for. When you get one bit wrong, as a former auditor, I used to get a little more excited and start asking more tricky questions. In this new digital environment, with the ATO’s new STP and E-invoicing looming, it is getting harder to unsay or reinvent the past. Data collection and cross-agency sharing is creating a ticking time bomb for practices who keep this on the back burner.
BBQ (unwritten and unqualified) advice from friends, family or fools or what another practice is doing will not save you from the awkward questions.
About me: David Dahm BA (Acc.), CA., FCPA, CTA, FFin, CPM, FAAPM, FAIM, FGLF.
Registered Tax Agent, Former AGPAL Surveyor 10 years of service
David Dahm is CEO and founder of the national medical and healthcare chartered accounting firm Health and Life and global Founder and CEO of the not for profit project the International Healthcare Standards and Ethics Board (www.ihseb.org)
After a serious work related car accident in 1989, and nine operations later I continue to be a patient and provider advocate. I enter my third decade as a national Chartered Accountant for Medical and Healthcare practices in Australia. I am a former 10-year Australian General Practice Accreditation surveyor. I come from a medico family. I have served on the AAPM national Board and was the inaugural national Chair of the Certified Practice Manager CPM post nominal. I continue to provide accounting tax and practice management advice to many practices all over Australia.
You know who you are and I thank you for this real honour and privilege to serve you and your community through you. Note, I am not a lawyer please seek appropriate legal and accounting advice. This information is for general information and discussion only.