Are you getting paid too little for the hard work you put in to your accounting practice? That’s the question the ATO is asking with its renewed interest in scrutinising the tax affairs of accountants and accounting firms.
The ATO’s main concern surrounds whether the partners and principals are being personally allocated (and taxed on) an appropriate portion of the income and profits of the firm.
As such, accounting firms, and their partners and principals need to be acutely aware of their tax risks. Many accountants and accounting firms could be unexpectedly operating outside the ATO’s new guidelines.
In addition to your own situation, you should also be aware of these risks for your clients – lawyers, medical practitioners, engineers, architects, financial advisors, consultants and any other businesses that provide professional services are also subject to the ATO’s new guidelines.
Remuneration of Partners and Principals
Since the landmark Phillip’s case in 1977, when a partner in an accounting firm successfully defended the validity of his firm’s service trust arrangement, the use of similar arrangements has become common place in the professional services space.
Service trusts can be a highly effective mechanism for improving the asset protection position of professional services firms, and can also deliver a number of tax planning benefits. The ATO has previously issued guidance on service trust arrangements, and continues to follow this commentary.
The ATO’s renewed interest in professional services firms is far broader than service trusts. Given that the ownership of accounting firms or other professional services firms are often via a family trust or spouse of the practitioner, there is a far greater ability to split income than simply using a service trust. The ATO holds significant concerns about this income splitting, which led it to publish guidelines in late-2014, and subsequently update them again in mid-2015. The guidelines outline what the ATO considers to be a reasonable split of income and profits between the partner or principal in the professional services firm and his or her associated entities (such as a spouse, child or corporate beneficiary).
The guidelines are not based on particular judicial decisions or established legal precedents – they are practical, commercial guidelines that seek to distinguish arrangements that the ATO will accept (even though it may not necessarily agree with the treatment) and those which it won’t.
If you are outside of the guidelines, you will automatically be considered ‘high risk’ and are likely to be subject to enquiry from the ATO. If required, the ATO have indicated that they will seek to use Part IVA to enforce their views.
What are the guidelines?
The message from the ATO is clear – the guidelines are like flags at the beach – swim between the flags and you will be okay, swim outside the flags at your own peril.
There are three guidelines. You only need to meet one to be considered “between the flags”:
- The partner/principal receives assessable income from the practice that is at least equal to the remuneration of the highest paid equivalent group of professionals employed in the practice;
- At least 50% of the overall assessable income to which the partner/principal and his or her associated entities are entitled to, is assessable income for the partner/principal; or
- There is an effective tax rate of at least 30% on the income received from the practice by:
- the partner/principal individually; and
- the partner/principal and each of his or her associated entities collectively.
The form of the assessable income is not relevant – it is the end outcome that the ATO is interested in.
The ATO notes that the guidelines apply to firms which operate via a legally effective partnership, company or trust structure. Importantly, if the income is personal services income, such as that of a sole practitioner with no other professional staff, the guidelines do not apply.
The ATO has also commented that you do not have to meet the same guideline each year.
The guidelines aren’t as simple as they seem
Since the guidelines were published, William Buck has assisted many accountants and their professional service firm clients in assessing whether they satisfy the guidelines. We’ve found that the guidelines are often more challenging to apply than they initially appear. Some of the reasons for this include:
- The first guideline, based on equivalent remuneration, is often difficult to apply for regional, suburban or smaller firms. This is because the firm may not have staff who can be considered an ‘equivalent group’ as they do not perform a sufficient level of business development, or involvement in firm management decisions;
- Misunderstanding whether items such as superannuation, cars or fringe benefits are included (or not) in each of the guidelines; and
- Whether to apply the particular guideline at a gross income or net income (after deductions) level.
All professional services firms, and their partners and principals should take action. This includes not only assessing and managing their tax risks, but also seeing if there are valid tax planning opportunities that they are not currently taking advantage of. Could a more tax effective and cost effective way to remunerate partners and principals be implemented? Could on-costs be reduced?
The ATO intends to identify and audit professional services firms with the view to taking them to court to get judicial guidance on these issues. For the vast majority of taxpayers this means it is better to “swim between the flags” than try and take on the ATO.