The use of service entities by professional practices is not uncommon and they can have significant benefits in a number of areas including separating professionals from administrative duties linked to running their business, and the protection of assets. There can also be some nice taxation benefits potentially facilitating the splitting of income away from the professional to their spouse and/or other family members.
Service entities are generally used by professionals such as doctors, solicitors, accountants, engineers. Professionals who could potentially be sued directly by their customers should they make an error.
Services provided by service entities generally include
- provision of office administration tasks
- client management
- billing and collection
- hiring of other professional staff
- provision of assets essential for the professional to provide their services
While the Australian Taxation Office (ATO) accept there can be valid reasons for setting up and using a service entity they are keen to ensure such entities serve legitimate purposes and aren’t simply a means to avoid or reduce tax liabilities.
If you are a professional considering the use of a service entity there are some key issues you need to consider and document
- Dominant purpose – you need to ensure the dominant purpose of setting up/using a service entity is not to gain a tax benefit. Valid reasons can include protecting the assets of the principals or to relieve principals of administrative duties associated with running the practice
- Asset protection – If arguing asset protection as a reason to use the service entity you really need to be able to answer:
- As many assets as possible should be held by the service entity
- Are the assets sufficiently valuable to warrant protection
- Is there a real possibility of the practice being sued
- Any new assets should be acquired by the service entity
- Calculation of service charges – any charges need to be commercially realistic. What would you expect a completely independent entity to pay or charge for the same services
- a fully documented service agreement describing the services provided and rights and obligations of both parties;
- how the pricing structure was agreed
- tax invoices and evidence of payments made
- any relevant minutes for the service entity
- Employer obligations – service entities are required to meet their employer obligations which can include
- registering for PAYG withholding and/or FBT;
- obtaining workers compensation insurance;
- registering for payroll tax and
- making all required superannuation contributions
- GST – if the turnover of the service entity is over $75,000 per year, it must be registered for GST and charge and remit on all taxable supplies made including to the practice entity
- Capital Gains Tax – the service entity may be able to access small business concessions where assets are used by the service entity itself or while they are used in the business of an entity connected with the service entity.
The risk of operating a service entity without giving strong consideration to these issues, is the ATO could challenge the validity of the arrangement and seek to amend returns to either fully or partially wind back service fees charged, increasing the income of the professional/s and ultimately increasing income tax liabilities. They may also seek to add penalties and interest.
Bottom line, service entities can be very useful to reduce the burden on professionals and protect hard earned assets while providing some nice reductions in tax payable. However, failing to use them properly can be more trouble than the intended benefits.
To use a saying our politicians love to repeat “Does it pass the pub test?”. If it does, then you are probably fine, if not, you really should reconsider.