Tax Issues of High Income Earners in Single Income Households
Apart from single people who are not in a relationship, single income households are most common in a family situation. More often than not, when two people first entered into a relationship, they both worked and enjoyed double income for a period of time before the arrival of their first child. At which point, one of the parents may opt to quit their job and stay at home to look after the child. The arrangement may be prolonged if another child comes on the scene.
This article looks at some of the tax issues for single income households where the breadwinner is a high income earner. At the risk of being controversial, for the purpose of this article, a high income earner is taken to be someone who earns taxable income of more than $180,000 per year, which is the cut-off point exceeding which every dollar is taxed at the marginal tax rate of 46.5%, inclusive of Medicare Levy.
he biggest issue confronting a single income household is obvious – the hefty tax rate means that almost half of the income earner’s income over $180,000 per year will become a tax liability . This result seems particularly absurd in a family situation where the parent staying at home may not be earning any income or may be earning significantly less income and is therefore paying no or minimal tax. Unlike some other countries, the Australian tax law does not provide for joint family tax returns, which means that the low marginal tax rates of the non-working partner cannot normally be utilised.
As a general proposition, the two broad ways in reducing the tax liability of a high income earner in a single income household is to either shift some of the taxable income to a lower taxed entity by way of structuring or reduce the income of the high income earner directly.
Shifting income to a lower taxed entity
Depending on the type of income derived and assuming that you are the high income earner, there may be an opportunity to structure your affairs to shift some of your income to a lower taxed entity (eg, a non-working partner) or at least defer some of the tax liability. The structure will generally need to be in place before the income is earned; otherwise, tax and stamp duty costs may be incurred to implement the structure at a later point in time. Also, the structure adopted must take into account the general anti-avoidance provisions in the tax law, which means that you need a commercial reason to justify the structure that is not related to taxation.
The type of income is an important factor to consider because income from personal exertion (eg, employment income) is always taxed in the hands of the individual who earned the income. On the other hand, income from property (eg, rent, dividends, interest) is taxed in the hands of the owner of the property that gives rise to the income. Therefore, if you own your own business that derives income from activities other than personal services, a company structure may be appropriate to cap the tax payable on the business profit at the corporate tax rate of 30% to the extent that the profit is left in the company, which would otherwise be subject to 46.5% if the business was operated in your own name. However, any profit you extract from the company will be subject to your marginal tax rate, even if the monies are extracted by way of a loan owed to the company.
It is important to note that simply operating a business in a company structure does not automatically cap the business profit at the 30% tax rate. If the company derives income from personal services, which is income from the exertion of an individual’s skills, knowledge, expertise, or efforts, then the personal services income (PSI) will only be taxed in the hands of the company if certain “PSI tests” are passed. Otherwise, the PSI will be attributed to the individual who performed the personal services. The broad aim of the PSI rules is to differentiate income earned by an individual’s skills and efforts as opposed to a profit yielding structure.
For instance, if the company operates a share trading business, the profit from the share trading activities will be taxed in the hands of the company because the income will be from the sale of trading stock (being shares), rather than personal services. On the other hand, if the company carries on an information technology (IT) consultancy business, then the income of the business will be classified as PSI, which means that certain PSI tests will need to be passed to prevent the income from being attributed to and taxed in the name of the individual who performed the personal services.
If say more than 80% of the income of the IT consultancy business of the company is derived from one source by a single person employed by the company and the company does not have two or more unrelated clients or its own business premises, then it is likely that PSI tests will not be passed and the income will be taxed in the hands of the person who rendered the personal services.
On the other hand, if the company employs a number of professionals to provide IT services to a number of unrelated clients at an office in a commercial building in the CBD, it is likely that the income will pass the PSI tests and be taken to have been derived by the company as a profit yielding structure, which means that the business income will be taxed at the company tax rate.
Further, in limited circumstances, it may be possible for the income earner to employ their spouse to undertake work for the business, eg, the provision of bookkeeping service. Such an arrangement has the effect of shifting some of the income from the income earner to their spouse. However, the amount charged by the spouse must be commensurate with the market value of the service provided and if the business does not pass the PSI tests, this type of arrangement is generally not allowed unless the spouse is performing work that earns the principal income of the business.
Similarly, if you are a high income earner who can afford to buy investments with limited or no borrowing, ie, the investments are not “negatively geared” as the investments produce a net income after costs, discretionary trusts may be highly effective in diverting the income and/or capital gain from the investments to a lower taxed entity such as your non-working spouse or a corporate beneficiary.
Careful planning is recommended if you are considering the use of a corporate beneficiary, following a recent taxation ruling issued by the tax office. The ruling expresses the tax office’s view that any income distributed by a trust to a corporate beneficiary may attract the deemed dividend provisions (Division 7A) if the monies representing the income are not physically paid to the company, which calls to question the efficacy of the previously widespread practice of trusts distributing income to corporate beneficiaries to be taxed at the corporate rate but retaining the cash representing the income to buy further investments in the trust.
To that end, the tax office has also issued a related Practice Statement, which provides various alternatives under which the use of a corporate beneficiary will not attract a deemed dividend upfront. Some of these alternatives may well support the previous practice with careful planning. For instance, if you intend that your trust will buy investments that will be sold within 10 years, the “10 year sub-trust arrangement” will allow you to cap the investment income at the 30% tax rate; while the trust will be required to pay interest to the company, the interest will be assessable to the company and deductible to the trust, which may be revenue neutral in any event. Once the investments are sold within 10 years, the trust may then repay the company without incurring further tax liabilities.
In summary, is it generally more flexible for those who derive income from activities other than traditional employment to structure their affairs to achieve a better tax outcome than salary or wage earners.
Reducing income directly
For salary or wage earners, the logical alternative is for the high income earner to reduce the amount of income that is subject to tax. This is where negative gearing may come in handy, which is by far one of the most popular tax and wealth accumulation strategies.
As most property investors would know, negative gearing involves a high income earner buying an investment that will produce a net tax loss, which will offset and reduce their salary or wage income. Normally, it would not be sensible to buy an investment that will produce a loss but in a negative gearing arrangement, the investor is punting on a future capital gain, which is not taxable unless the investment is sold.
For example, a high income earner may buy a rental property which produces a net loss, ie, the interest expense and other costs exceed the rental income. A rental property, like most investments, gives rise to an overall return that includes an “income return” and “capital return”. In a negative gearing arrangement, the income return is negative, which provides tax savings as the loss reduces the tax payable on the relevant individual’s salary or wages while the tax on the capital return is deferred until the property is sold.
The tax deferral mechanism may even go beyond a mere deferral because by the time the property is sold, the high income earner may no longer be deriving the same level of taxable income, eg, if the property is sold after the person has retired. Further, provided that the property has been held for at least 12 months, the capital gain will be halved under the 50% CGT discount. As the investor retains the discretion over the timing of when the property is sold, the deferred capital gains tax may effectively be managed.
The conundrum with negative gearing is that the investment must be owned by the high income earner to maximise the tax benefit, which should not be an issue in a single income household. However, this will also mean that the investment should not be owned by say a discretionary trust, unless the trust owns other assets that produce sufficient profit to fully utilise the negative gearing loss. Otherwise, the loss will be trapped inside the trust.
This requirement represents a trade-off that goes against conventional asset protection wisdom, which espouses the principle that valuable assets should always be owned by a low risk entity such as a discretionary trust. More often than not, the high income earner by virtue of their position is the more risky person in a household (eg, they are a director of a company, who could potentially be liable to the directors duties provisions in the Corporations Act). In these circumstances, alternative asset protection strategies such as the “gift and loan back arrangement” should perhaps be considered.
Another important issue to consider is how the investment is financed. For instance, if the property is financed by way of a principal and interest (P&I) loan, then at some point in time, the principal loan may be repaid to the extent that the interest expense may no longer exceed the rental income, which means that the property will no longer provide negative gearing benefits but is stuck in the name of a high risk and high income owner.
Accordingly, the negative gearing arrangement should be considered as part of a wider wealth accumulation plan, which may preempt various tactics to mitigate the potential future implications of some of these issues, eg, the rental property should perhaps be financed by way of an interest-only loan or, if a P&I loan is used, another negatively geared rental property should be acquired at the point when the original property ceases to be negatively geared.
For completeness, it should be noted that a net loss from a business that is carried on in the high income earner’s name may not be available to offset their salary or wage income. Under the “non-commercial losses” provisions, certain tests have to be passed before the net loss is available to offset the individual’s other income. Otherwise, the net loss is quarantined until the business activities that gave rise to the original loss return a profit in future. In other words, gone are the days when hobby farms were used by high income earners in an attempt to reduce their taxable income.
The tax issues of high income earners in single income households are by no means peculiar to them, which is why there is an abundance of anecdotal tales of tax minimisation strategies at local pubs, dinner parties, or Sunday afternoon barbecues.
Some of these strategies may work while others belong to the realms of science fiction. It is important to recognise that after decades of exploitation and challenges, the tax law has been amended and updated so many times that tax loopholes are becoming increasingly at risk of extinction. Therefore, if a tax miniminsation idea sounds too good to be true, run it past a professional tax advisor because getting it wrong could set you back years of hard work.