The How and What: Income Splitting
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.
Definition of Income Splitting
Income splitting is a tax reduction strategy employed by families living in countries that are subject to tax regulations. The goal of using an income splitting strategy is to reduce the family’s gross tax level, at the expense of some family members paying higher taxes than they otherwise would.
Breaking Down Income Splitting
An example of income splitting is a higher income family member transferring a portion of his or her income to a family member who earns less through legal means. This consists of hiring a lower income family member and deducting the cost of the labour as a business expense. Although the family still earns the same amount of money, the overall amount of tax it must pay is reduced. Subsequently, this method benefits those more on higher incomes as opposed to lower incomes.
The most common form of income splitting in Australia is through directing earnings into a private trust fund. 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 your circumstance and thus evaluate whether any opportunities arise in relation to lowering tax payments. It is imperative to adhere to the tax guidelines, as noncompliance could lead to heavy substantial payments.
Alex currently works in the content team as a Legal Tech Intern for Lawpath. He has finished his Bachelor of Commerce (Professional Accounting) and is currently undertaking his last year of Bachelor of Laws at Macquarie University. His passion resides with commercial, corporate and tax law.