How Does Income Splitting Work?

Income splitting is a commonly used concept in Australian tax planning, but it is often misunderstood.

This article explains how income splitting works and the structures people tend to use, with practical examples.

We’ll cover how PSI rules apply, how trusts and family distributions operate, the key anti-avoidance risks, and when you should seek professional advice.

What is income splitting?

Income splitting refers to arranging income so it is taxed across multiple individuals or entities rather than on a single taxpayer. The goal is usually to reduce the total tax paid across a family group or business structure.

In practice, this may involve spouses, adult children, companies, trusts, partnerships, or other related entities. The tax benefit arises where income is taxed at lower marginal rates or under a different tax regime, such as the company tax rate.

However, income splitting only works where the arrangement reflects a genuine legal and commercial structure. It’s not the same as simply redirecting income you personally earned to someone else without a valid basis.

Is income splitting legal in Australia?

Income splitting can be legal in Australia, but it depends heavily on how the arrangement is structured and whether it reflects economic reality.

Legitimate income splitting often occurs through recognised structures such as trusts, partnerships, companies, or jointly owned assets. In contrast, the ATO is more likely to challenge arrangements that are artificial or primarily designed to reduce tax.

The ATO assesses these arrangements by looking at who actually earned the income, who owns the relevant asset, who bears the financial risk, and whether the structure operates as it claims.

Various rules may apply, including PSI rules, trust taxation provisions, and general anti-avoidance laws.

Why do people use income splitting?

People use income splitting for a range of practical and commercial reasons. These often include reducing tax across a family group, managing income from a family business, distributing trust income, and recognising different ownership interests.

It can also be used to pay family members for genuine work, retain profits within a company, manage jointly owned investments, or support longer-term succession and estate planning.

Common ways income splitting works

There are various ways to implement Income splitting, each with its own rules and risks. The table below explains them.

Each of these approaches is governed by different income splitting rules in Australia, so it’s important to review the structure carefully before relying on it.

Let’s look at some of these in more detail.

How does income splitting work through a family trust?

Family trusts income splitting is a central tax strategy in Australia, particularly through discretionary trusts.

In a discretionary trust, the trustee decides how to distribute income to beneficiaries each year. Those beneficiaries are then generally taxed on their share of the trust’s net income. This flexibility allows income to be allocated in a tax-effective way, provided the distributions are valid.

The trust deed plays a critical role, as it determines who can receive distributions and under what conditions. It’s also critical to properly make timely trustee resolutions and document the distributions.

There are also specific risks to consider. Distributing income outside the defined family group may trigger family trust distribution tax. Minor beneficiaries may be subject to penalty rates on certain unearned income.

The ATO also scrutinises arrangements that appear artificial, such as circular distributions or transactions that lack real economic effect.

How does income splitting work through a company?

Company income splitting provides a different framework for managing and distributing income.

A company pays tax on its profits at the applicable corporate tax rate. Owners or shareholders may then receive value through wages, dividends, or retained earnings. This can allow some flexibility in timing and managing income.

However, there are strict rules around how this operates.

Wages may be paid only to family members who genuinely work in the business and must be commercially reasonable.

Dividends can only be paid to shareholders.

Any loans or financial benefits provided to shareholders or their associates may trigger Division 7A consequences.

Importantly, PSI rules may apply where income is largely generated from one individual’s personal effort, limiting the effectiveness of using a company for income splitting.

How does income splitting work in a partnership?

In a partnership, income splitting usually happens following the partnership agreement. This agreement should reflect the true economic arrangement, including each partner’s contribution, capital, and level of involvement.

Unlike companies, partnerships are not separate taxable entities. Instead, each partner reports their share of income on their own tax return.

The ATO may scrutinise family partnerships where income is allocated to a partner who hasn’t contributed meaningfully through work, capital, or risk.

Can a sole trader split income with a spouse?

A sole trader generally can’t split their income simply by allocating it to a spouse.

Income is typically taxed to the individual who earned it. However, you can pay a spouse for genuine work performed in the business. For this to be acceptable, they must actually do the work and receive a reasonable payment for the duties performed.

Good record-keeping is essential, including evidence of hours worked, responsibilities, and how you determine the payment.

Artificially inflating wages to reduce tax through family business income splitting is likely to be challenged, particularly where PSI rules apply.

What are the personal services income rules?

The personal services income (PSI) rules are a key limitation on income splitting in Australia.

These rules apply where income is mainly generated from an individual’s personal skills, effort, or expertise. Importantly, PSI income splitting limitations can apply even if the income is earned through a company, trust, or partnership.

When PSI rules apply, the income may be attributed back to the individual who performed the work, effectively preventing income splitting. These rules commonly affect professionals such as consultants, IT contractors, medical practitioners, lawyers, and accountants.

Whether PSI applies depends in part on the personal services business tests, which assess the nature of the working arrangement.

What is income alienation?

Income alienation in Australia refers to the practice of diverting income away from the person who actually earned it to another entity or individual.

This concept is closely linked to PSI and is often considered in professional or contractor arrangements. The key issue is whether the income has been artificially redirected for tax purposes rather than reflecting a genuine commercial structure.

If the main reason for income splitting is to avoid tax, anti-avoidance rules may apply.

What does the ATO look for in income splitting arrangements?

When reviewing income splitting arrangements, the ATO focuses on the substance of the arrangement rather than just its form.

Key factors include:

• Who actually performed the work.
• Who owned the income-producing asset.
• Who bore the financial or business risk.
• Whether the arrangement has real commercial substance.
• Whether family members genuinely contributed to the business.
• Whether payments, such as wages, are reasonable.
• Whether trust resolutions and distributions are valid.
• Whether funds were actually paid or merely recorded.
• Whether there are circular or reimbursement arrangements.

These factors help determine whether the arrangement is legitimate or primarily tax-driven.

Examples of income splitting

Practical examples illustrate when income splitting may be acceptable and when it may raise concerns.

1. Family member paid for genuine work

A business owner pays their adult child market-rate wages for bookkeeping work the child actually performs. This arrangement may be acceptable where the work is real, the pay is reasonable, and proper records are kept of hours, duties, and payments.

2. Spouse paid without doing the work

A sole trader pays their spouse a large salary even though the spouse doesn’t work in the business. This is likely to be challenged because the payment doesn’t reflect genuine services and lacks commercial justification.

3. Family trust distributing business income

A family trust distributes income to adult beneficiaries within the family group. This may be valid where the trust deed permits the distribution, the trustee resolutions are properly executed, and the arrangement complies with tax rules.

4. Consultant using a company to split PSI

An IT consultant earns income through a company, but the income is mainly generated from their personal skills and labour. In this case, PSI rules may apply to attribute the income back to the consultant, limiting any tax benefit.

5. Jointly owned investment property

A married couple jointly owns an investment property and shares the rental income according to their ownership interests. This is generally a legitimate form of income allocation and differs from the artificial redirection of personal services income.

When should you get tax or legal advice?

Income splitting is highly fact-specific, and small differences in structure or documentation can significantly affect the outcome. Getting advice before setting up or changing a structure can help avoid costly mistakes.

Lawpath’s tax and legal experts can assist in reviewing your structure, identifying risks, and implementing compliant strategies for paying family members, distributing trust income, and managing company profits.

FAQs

What is income splitting?

Income splitting is a strategy for distributing income among individuals or entities to reduce total tax liability, provided the arrangement is legally valid.

Is income splitting legal in Australia?

Yes, but only where it reflects genuine economic activity and complies with tax laws.

Can I split income with my spouse?

Only in limited cases, such as paying for genuine work or through shared ownership or formal structures.

Can a family trust split income?

Yes, trustees can distribute income to beneficiaries if permitted by the trust deed and tax rules.

What is personal services income?

PSI refers to income mainly derived from an individual’s labour or skills, which may be attributed back to them.

What is income alienation?

Income alienation is a means of artificially redirecting income away from the person who earned it to reduce taxes.

Can a company help with income splitting?

A company can provide flexibility, but strict rules such as PSI and Division 7A limit how income can be distributed.