Structuring medical practices – clear as mud?
Insights by Harrison Dell (Senior Associate) and Patrick Simon (Associate), Velocity Legal
To say that the medical field has seen a few significant advances since the 1950’s would be a serious understatement. Indeed, the breakneck speed at which medicine has expanded and refined existing knowledge has been a major contributor to the quality of life that modern Australians are fortunate enough to enjoy.
Unfortunately, Australian taxation laws regarding structuring medical practices have changed surprisingly little over the years and unfairly penalise medical practitioners by applying the top marginal tax rates in most cases.
While the Australian Taxation Office (ATO) has been reasonably accepting of newer tax structuring arrangements for other professionals, such as accountants and lawyers, this has not been the case for medical practitioners.
The three general choices available to a medical practitioner to structure their business are:
- the traditional sole practitioner or individual partners in a partnership structure;
- utilising service entity arrangements to alienate a portion of the practice income; or
- operating out of a Medical Practice Company (MPC) or other entity.
This article is intended to guide medical practitioners and their advisors about whether they have an opportunity to optimise the practice structure for income tax, and to highlight potential tax risks.
Traditional Sole Practitioner and Partnership Structures
From a tax structuring perspective, the most conservative structure is where medical practitioners operate in a personal capacity, either as a sole practitioner or as a partner in a partnership with other medical practitioners.
A sole trader/partnership of individuals structure is usually the most straightforward structure choice for medical practitioners, as all of the income generated by the practice is assessed to the practitioners directly. However, that simplicity also comes with two major downsides:
- medical practitioners are inherently exposed to a significant degree of operating risk, and under a traditional structure where all of the business assets are owned by the practitioner(s) in their own capacity or as partners in a partnership, it can be difficult to quarantine those assets from operating risks; and
- the fact that the practitioner(s) are conducting all of the business functions (e.g. owning or leasing premises, employing administrative staff, purchasing medical equipment) in their own personal capacity significantly restricts tax planning opportunities, as profits generated by the practice will ultimately be assessed at the practitioner’s individual marginal tax rate (i.e. up to 47%).
While this is the simplest structure, it will often lead to the most tax payable on the practitioner’s income.
Service Entity Arrangements
Operating any professional practice involves more than simply providing the actual services to end clients or patients. Any professional practice usually requires systems to keep track of clients or patients, premises to complete the work, plant and equipment, and administrative or support staff to assist with tasks that are ancillary to the principal services offered by the practice.
The decision in Phillips v FC of T (1978) 8 ATR 783 (Phillips) opened the flood gates for professionals to use service entities and allocate some profit to a service entity. The decision was generally that, the general anti-avoidance rules did not apply to using a service entity under the tax law so long as the service fee was commercial. Since Phillips, service entity arrangements have become a wildly popular method for professional services practitioners to divert some income from their personal names to a company or trust (however, less so in the case of other professionals – for example accountants and lawyers).
To apply this to a medical practice, a service entity arrangement would broadly involve:
- the medical practitioners provide the principal medical services to the patient directly, either in their own personal capacity, as a partner in a partnership, or through some other structure where they are subject to tax personally; and
- in consideration for a fee, a service entity owned or controlled by the medical practitioners, their family members, or other related entities, provides the medical practice with all things required for the medical practitioner’s business. This includes leasing or purchasing appropriate business premises, employing support staff, purchasing plant and equipment, and undertaking practice general management functions such as invoicing.
Implementing a service entity arrangement can create considerable tax planning and asset protection opportunities for the medical practitioners, for two reasons:
- Asset protection – valuable assets such as medical equipment and business premises can be purchased or leased by the service entity rather than the medical practitioner, which may provide some degree of asset protection and flexibility if new medical practitioners wishes to ‘buy-in’ to the practice; and
- Tax benefits – a portion of the income generated by the medical practice can be paid to the service entity as a service fee, which is usually tax deductible for the medical practitioner. The service fee is income for the service entity, though it can either be capped at the corporate tax rate (if the service entity is a company) or distributed to trust beneficiaries of the trust in order to achieve effective tax outcomes.
Although implementing a service entity arrangement can be a very attractive option for a medical practice, it is crucial that the service fees charged by the service entity can be justified by reference to an objective commercial explanation. For medical practices, determining an appropriate service fee is often easier said than done. Despite issuing Taxation Ruling IT 276 and TR 2006/2 on this subject, the ATO is unhelpful on providing definitive guidance to professionals determining an appropriate service fee. Instead, the ATO has published a set of non-binding guidelines, which explains that the following circumstances would be the highest risk cases:
- service fee expenses of over $1 million;
- service fee expenses represent over 50% of the gross business income; and
- net profit of the service entity is over 50% of the group profits.
While these flags are somewhat useful, there are many situations where these circumstances are met yet the services fees are still commercial.
Like the guidelines for professional practices (now withdrawn), it is important to note that the position advanced by the ATO in the guidelines is not clearly supported by income tax legislation or applicable case law. In many cases it may be commercially appropriate for a service entity to charge more than 50% of the medical practice’s gross practice fees. General practitioners are permitted to charge a flat 40% of gross fees under the guidelines (45% for rural GP’s). There is no such guidance for specialist medical practitioners.
It is strongly recommended that professional advice be sought when setting up or restructuring a medical practice to implement a service entity arrangement. This advice should be on what is required for the service arrangement to be legally effective, the tax treatment of that arrangement, and the risk of the ATO scrutinising the arrangement. These arrangements also need regular review, especially if a practice changes substantially (e.g. a new practitioner joins the practice).
Medical Practice Companies (MPC)
Carrying on a business through a company can be an attractive option for many professionals. An MPC simply carries on the medical practice, and the medical practitioner provides the relevant medical services to patients, usually as an employee of the MPC. Most states allow for the use of an MPC, for example, the Australian Medical Association (NSW) by-laws part 7 specifically allow for an MPC to be used in NSW with some alterations to allow for personal liability for negligence and other matters.
Using an MPC is highly desirable due to the corporate tax rate (now 26% for the 2021 financial year for base rate entities), potential for income splitting to the medical practitioner’s family and clear separation between business and personal finances. However, the ATO’s current view is that medical practitioners are not entitled to enjoy the benefits that professionals in other fields can access through a corporate practice structure.
The ATO’s position is generally that ‘personal exertion income’, or income derived mainly for providing personal services, cannot be alienated to another entity even where the Personal Services Income regime (PSI) does not apply. Taxation Ruling IT 25 (IT 25) and Taxation Ruling IT 2503 (IT 2503) essentially allow a medical practitioner to use an MPC if all income is distributed to them personally though salary and wages, among other conditions. If an MPC is used and the conditions are not satisfied, the ATO has clearly stated that they will rely on the general anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936 (Cth) to remove the tax benefits of an MPC. While these tax rulings are almost 40 years old, they remain the ATO’s position until withdrawn.
Furthermore, Taxation Ruling IT 2330 (IT 2330) and Taxation Ruling IT 2121 (IT 2121) confirms the ATO’s current view is that medical practitioners are not entitled to split personal exertion income to non-practitioners by any means aside from the service entity arrangements discussed earlier.
The ATO views rely most heavily on the High Court decision in FCT v Gulland (1985) 160 CLR 55 and other old cases. This view may no longer be correct, as the concept of ‘personal exertion income’ has been mostly codified in the PSI rules contained in Divisions 84 to 87 of the Income Tax Assessment Act 1997 (Cth) which does not usually apply to medical practitioners in private practice. However, Part IVA may still apply to arrangements that otherwise satisfy the Personal Services Income rules.
In recent times, there have been no cases brought before the Federal Court. The most recent matter, where the ATO lost, was the Federal Court decision in Leidig v CoT (1994) 121 ALR 561 (Leidig). In his decision, Hill J specifically rejected that a general law doctrine existed that personal exertion income is not capable of being earned by a trustee. Since Liedig was decided in 1994, there have been no cases brought to the Federal Court or higher to consider whether personal exertion income can be alienated.
There may be significant reason to doubt the ATO’s position long-standing in relation to MPC’s and personal exertion income. While Leidig was a single judge decision, Hill J was undisputedly, and deservedly, recognised as the leading tax judge in this country. It should give practitioners some encouragement that past decisions may have either been incorrect or limited strictly to their facts (which often focus on the restructure of existing medical practices, rather than the structuring of a new business).
It is strongly recommended that medical practitioners who wish to use an MPC obtain robust professional advice regarding the application of the current tax law, as well as the risk of ATO review or audit.
Many medical practitioners operate a small business but yet are unable to achieve the same tax structuring outcomes as other small businesses. An accountant or lawyer can achieve lower levels of income tax, merely by being able to operate as a larger firm.
Simply, there is a void in the tax law which the ATO have attempted to fill by relying on guidelines and dated rulings. Advisors needing to warn medical practitioners that Part IVA may apply to a simple company and discretionary trust structure is evidence that the current system is flawed and in serious need of reform.
To pile on, advisors have been awaiting the new guidelines for allocating profits for professional firms that were pulled in late 2017 due to abuse. Further controversy in this area should be expected when the guidelines are re-published.
Perhaps that will be the last straw and the Federal Government will create comprehensive rules for professional firms and medical practices?
 Justice Richard Edmonds, ‘The Contribution of Justice Hill to the Development of Tax Law in Australia’ (2006) 2(1) Journal of the Australasian Tax Teachers Association 1.
A background as an ATO auditor, a decade in the family cinema business and a bachelor of psychology make Harrison an incredible problem solver. His unique insights give practical solutions for all tax and duty matters with a special interest in trusts, business succession planning, international tax and corporate tax issues. Harrison can do more than just heavy lifting with ATO dealings, he’s also an amateur powerlifter.
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