Doctors earn their money by ‘doing things’. Performing surgery, diagnosing an illness. This is great from a ‘personal fulfilment’ perspective, but not so great from a ‘personal tax’ perspective.
Doctors earn their primary living from what is termed ‘personal exertion’ (i.e. doing things themselves), as opposed to earning ‘business income’ from employing others or using plant, equipment or IP. This is of course a generalisation. There are plenty of doctors who make significant money from employing people, and who own very expensive plant, equipment and IP that generate a good passive business income. But the majority of highly-paid medical professionals earn most of their income personally.
So coming back to personal exertion, our tax laws impose a fundamental principal that the person who ‘earns the money’ must ‘pay the tax’.
With progressive marginal rates of tax (i.e. the rate goes up as your income goes up), this means that doctors earning high incomes will end up paying the top marginal rate of tax (47%) on a significant portion of their income. There is generally no way around this so far as their personal exertion income is concerned other than ‘negative earning’. But that’s a topic for another day.
Over the years, doctors and their accountants and lawyers have tried to come up with ways to move (or ‘alienate’) some of their personal exertion income to other taxpayers, to relieve the personal tax load. Back in the 70s and 80s there was a string of cases involving doctors who stopped practising in their own names on Friday and started up as ’incorporated’ medical businesses on Monday. The Tax Office took them on and won, bringing this idea to an end.
However, another concept took hold and eventually prevailed. This was the concept of a ‘service trust’ or ‘practice trust’.
As medicine has become more complex, the personal activities of doctors have required a higher level of support. This has taken the form of nurses and other complementary service providers, diagnostic equipment, medical supplies and business systems to keep it all working. Doctors have required a ‘clinic platform’ on which to work effectively and efficiently.
So for every dollar that a patient spends on medical services, a portion pays for the personal activities of the doctor and a portion pays the ‘business platform’ that supports the doctor.
The benefit of this from a tax perspective is that the business platform is able to make a ‘business profit’, and this profit is not from the personal exertion of the doctor. The doctor (or their family) can then wear two hats: the ‘doctor hat’ that generates personal exertion income, and the ‘business owner hat’ that generates business profits. The business element can be owned by someone other than the doctor, so the business profit can be distributed to someone other than the doctor, i.e. their spouse and children.
The next question becomes how does the doctor own their interest in the clinic business? There are basically three options: they can own it in their own name (or the name of a spouse), they can own it through a company (which in turn would be owned by the doctor and/or their spouse), or they can own it in a family trust. Most opt for the family trust. Why? Because a trust achieves two things – the flexibility to stream the income to their spouse, and the ability to protect their assets from attack. Let’s take each of these in turn.
Starting with the ability to ‘stream’ income to a spouse. There is no magic to this. A trust can distribute business income to a non-working spouse or child, and this works perfectly from a tax perspective. But the same outcome could be achieved by simply having the spouse own the clinic interest directly, or by having the spouse own shares in a company that owned the clinic. Most doctors opt for a family trust, but the trust itself does not create any tax magic. It is just the most obvious entity to use, when all factors are considered. To understand the limit to the tax benefits of a trust, read this.
Turning to asset protection, this is often the prime motivating factor for doctors (and their families) using trusts. No person ‘owns’ a discretionary family trust. So if the doctor is sued, or their spouse is sued, the assets in the trust have a good level of protection. Not only is a doctor likely to hold their clinic interest in the trust, but also other assets such as investment properties and share portfolios. The trust is just a good place to hold assets and to earn passive business and investment income.
So what would change if we ‘banned’ trusts or taxed them like a company? Likely nothing. We would still see wide-ranging use of trusts.