Service entities 101

A lot of professional businesses – like medical clinics, law firms, or accounting practices – set up what’s called a service entity. This is usually a separate trust or company that’s owned or controlled by the practitioners themselves, or their family members.

So, what does this service entity actually do? It provides all the support a firm needs to run smoothly – things like admin and clerical services, office staff, recruitment, equipment, and even renting the premises.

The service entity makes money by charging the professional firm for these costs plus a margin. The firm then claims a tax deduction for those service fees, since they’re genuine business expenses. Meanwhile, the profits earned by the service entity are often distributed to family members or related entities, such as a spouse, adult children, or a family trust.

Company vs trust structures

Sometimes, though less often these days, the service entity is set up as a company. The upside is that company profits are taxed at the lower company rate (currently 25%). The downside is those profits are “trapped” in the company, and there’s no capital gains tax (CGT) discount if the company sells assets like property. That setup can work if there’s no family to distribute profits to and the owners are happy to keep the funds in the company.

More commonly, the service entity is a trust. This is because the trust can distribute profits flexibly – usually to family members or associates on lower tax rates than the main practitioner. That way, there’s a tax saving between the practitioner’s higher tax rate and the lower rate paid by the beneficiaries.

How fees are set

Service fees are usually calculated by marking up the actual costs the service entity incurs. The ATO is clear that these fees must:

Relate to services and equipment genuinely used to produce income, and
Be commercially reasonable and properly worked out.

The ATO’s booklet “Your Service Entity Arrangements” sets out the rules. Their main worry is that practitioners might set up service entities just to shift income away from themselves and into the hands of lower-taxed family members.

As a general guide, if the service entity doesn’t make more than about 30% of the combined net profits of the firm and service entity, the risk of attracting an audit is low. Another safe approach is to benchmark each type of fee (like rent, staff costs, or admin) against real-world commercial rates.

Record-keeping is critical

To stay compliant, firms need clear paperwork showing exactly how the service fees were calculated – including a breakdown of costs and the agreed mark-up. The fees can’t be excessive, and the arrangement must be backed up by a proper service agreement. Also, charges must be real, paid, and supported by evidence – journal entries alone don’t cut it.

The ATO has challenged cases where fees were technically reasonable but weren’t supported by enough documentation. Courts have sometimes sided with the taxpayer that the arrangement was legitimate, but the ATO still denied deductions because the paperwork was lacking.

Example – from the ATO

Three GPs set up a service entity to run their medical practice. The entity employs staff, rents the premises, manages supplies, keeps patient records, handles admin and compliance, and covers all running costs.

The doctors just focus on treating patients. Each pays the service entity a fee equal to 40 per cent of their patient fees.

Because the services clearly support the doctors’ ability to earn income and the 40% fee is considered commercially reasonable, the ATO views this as low risk. The doctors can deduct the service fees, and there’s little chance of an audit.

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