How Does Income Splitting Work?
Need to know what income splitting is? Here we explain how it works and the associated risks involved with redistributing income.
It is common for individuals or businesses to want to significantly reduce their tax. In this circumstance, income splitting has been a popular activity as it has outstandingly lowered tax payments.
Income splitting is a method of minimising tax which involves one spouse (the greater income earner) ‘splitting’ off their income to the lesser-earning spouse. This is done so that the greater income earner does not have to pay as much tax. Therefore, the lower income earner pays tax they otherwise would not have to pay.
The most common form of income splitting in Australia is through directing earnings into a trust. Although these can’t be wage or salary earnings, they are generally business or invest incomes which the trust allocates. The trustee will generally make payments to those beneficiaries with the lowest incomes, who will pay the least tax. Ultimately, this is the process that allows you to lower your tax and thus save income cash.
Income splitting and the risks of tax avoidance
This is a complex area and is difficult to know in advance whether any given reform will close off the many tax avoidance opportunities. Given that professional firms can be structured in a range of ways depending on the choices made by the owners, it is imperative to know what tax opportunities you may exploit.
For example, if Dr Chan is earning $400,000 in personal income from his work as a doctor after business expenses, this income must, by law, be included in Dr Chan’s personal income tax return in the year that is has been earned. Dr Chan does not have the option to:
- Leave significant amounts of income in the medical company account and therefore taxed at the company tax rate; or more importantly
- Split the income with other family members to reduce his tax.
If Dr Chan were to alienate some of this income away from himself, this would be considered tax avoidance and would incur penalties from the Australian Tax Office (ATO). This demonstrates the need to understand your financial position and tax opportunities, however if you have any further questions please do not hesitate to contact a specialised taxation lawyer.
While we all want to lower our tax, it is important to understand what is simple minimisation and what is evasion. The penalties for tax evasion are serious, so it’s crucial to always be honest in your reporting to the ATO.
Alex works in the content team as a Legal Intern for Lawpath. He is studying a Bachelor of Commerce (Professional Accounting) and Bachelor of Laws at Macquarie University. His passion resides with commercial, corporate and tax law.