Making your business into an entity can be a strategic move to mitigate the tax burden on your personal service income. However, you need to be careful of the rules and regulations regarding profit distribution to avoid being audited or involved in tax avoidance.
Here are some rules and tips you need to know!
How to avoid an ATO audit for your professional services firm
Tax audits can be time-consuming and may require significant effort and resources to gather and present the necessary documentation. Avoiding an audit helps save time and money.
ATO has guidelines and rules in place to address personal services income.
Personal Service Income (PSI) rule provides a common set of criteria to determine if income is considered PSI.
Practical Compliance Guidline (PCG) is a guideline to assess the risk and compliance regarding the allocation of profits in professional firms. PCG combines 3 risk assessment measures into a single method. This gives a risk rating of low (green zone), moderate (amber), or high risk (red) for your profit arrangements.
Part IVA is a general anti-avoidance provision. It is designed to counteract tax avoidance schemes that have the dominant purpose of obtaining a tax benefit. The entity is required to pass two gateways, the commercial rationale gateway and the high-risk features gateway, to avoid an audit on tax avoidance. For more information about gateways, refer to Part IVA and this Guideline section.
To minimise the risk of an ATO audit for your professional services firm, it's crucial to satisfy both gateways under Part IVA and always stay in the green zone in PCG assessments.
Why the ATO investigates professional services firms
One key concern for the ATO is the risk of improper income splitting or income diversion, where individuals seek to reduce their tax liability by diverting income through an intermediary entity.
The ATO aims to prevent situations where the economic reality of the arrangement aligns more with an employee-employer relationship rather than a genuine independent contracting arrangement.
Therefore, the PSI rules are applied to attribute income derived from personal services to the individual who performed those services. For more information about PSI, refer to ATO- Personal Service Income.
How to self-assess your risk profile
There are three risk assessment measures combined in PCG. *IPP= Individual Professional Practitioner
The proportion of profit entitlement from the whole of firm group returned in the hands of the IPP
Total effective tax rate for income received from the firm by the IPP and associated entities
Remuneration returned in the hands of the IPP as a percentage of the commercial benchmark for the services provided to the firm
You can either assess your risk against factors 1 and 2 only or use all three factors. The cumulative score obtained from each assessment will be categorised into the risk levels outlined in the following table.
Example: low-risk arrangement
Brooke, an accountant managing her own tax agency, adheres to the Personal Services Income (PSI) rules. Brooke's total income from the tax agency is $425,000. She retains 30% of the business profit within her company and allocates 70% for herself.
The total income of $425,000 is taxed as follows:
Tax on Brooke's income of $297,500 (70%) is $104,542 (applying 2023–24 individual tax rates) excluding the medicare Levy.
Tax on the company’s income of $127,500 (30%) is $31,875 (applying 2023–24 base rate entity company tax rate of 25%).
The total effective tax rate on the income is $104,542 + $31,875= $136,417 ÷ $425,000 × 100 = 32.10%
The risk assessment for this arrangement is as follows:
Brooke returns 70% of her business profit in her personal tax return, which gives her a score of 3 against the first risk assessment factor.
Brooke and her company pay an effective tax of 32.10% on her PSI, which gives her a score of 3 against the second risk assessment factor.
Brooke has worked out that in the circumstances it is impractical to accurately determine an appropriate commercial remuneration to benchmark against, so she self-assesses against the first 2 risk assessment factors only.
As the total score under the first 2 risk assessment factors is 6, this arrangement is considered low risk.
How much tax can you save with the right professional services entity structure?
If Brooke operated as a sole trader and reported the entirety of her business profit in her personal tax return, her tax liability would amount to $161,917. However, in the previous scenario, she can reduce her tax payment on her Personal Services Income (PSI) to $136,417 by operating through a company. Company arrangements offer better asset protection and are a good vehicle for introducing new equity participants in the future and are therefore desirable for many professional services firms.
CTK Accounting is a full-scope accounting firm based in Wollongong, servicing clients nationally.