It’s not commonly understood that co-owners of passive investments are partners in a partnership for tax law purposes, and therefore any associated financial planning considerations are often overlooked or misunderstood.
This article looks at which can then impact financial planning strategies such as the government co-contribution and spouse contribution tax offset. Co-ownership can also impact related party transactions when a self-managed superannuation fund (SMSF) is involved. Limited partnerships are outside the scope of this article.
TAX LAW PARTNERSHIPS
For general law purposes a partnership is defined in various state and territory partnership acts as a relationship that exists between persons carrying on a business in common with a view to profit. ‘Carrying on a business’ is an important factor for a partnership at general law to exist.
However, for tax law purposes, a ‘partnership’ is defined as an association of persons (other than a company) carrying on business as partners or in receipt of ordinary income or statutory income jointly.
Under the tax law definition, co-owners of a passive investment, such as a rental property, a share portfolio or a bank account are partners for tax law purposes as they share income from the investment. This is the case irrespective of whether the investment is owned as joint tenants or tenants in common. However, co-owners may not be partners at general law, unless the ownership amounts to the carrying on of a business.
Section 91 of Income Tax Assessment Act 1936 (ITAA36) states ‘a partnership shall furnish a return of the income of the partnership, but shall not be liable to pay tax thereon’. In general terms this means a partnership at tax law is a reporting entity but not a taxable entity. A partnership does not pay tax on its income and a partnership loss is not tax deductible to the partnership. Rather, tax is payable by the partners in the partnership based on their share of the partnership’s net income, or partners may be entitled to a deduction for their share of partnership loss.
As a partnership is a reporting entity, it must lodge an information return to provide the basis to determine the partner’s share of net income or loss in the partnership.
However, how the information return is lodged depends on whether the partnership carries on a business or not. The Australian Taxation Office (ATO) in its partnership tax return instructions – general information instructs:
For a business that carried on in a partnership, a partnership tax return must be lodged. Each partner then includes their share of net income or loss from the partnership in their individual tax return; and
For co-owners of an investment that does not amount to the carrying on of a business, a partnership tax return is not required. Co-owners are required to report their share of gross investment income, such as rent or dividends, and associated expenses in their individual tax returns.
PARTNER’S ASSESSABLE AND TAXABLE INCOME
Assessable income for tax law purposes includes ordinary and statutory income before any deductions. It excludes exempt income and non-assessable non-exempt income. In comparison, taxable income is assessable income less allowable deductions for income tax purposes.
Assessable income of an individual partner in a partnership includes the partner’s share of partnership’s net income, and partnership’s net income is the assessable income of the partnership less allowable deductions.
This applies to partnerships at tax law, that is, both partnerships that carry on a business and co-owners of an investment who share income from the investment.
Where a partnership’s allowable deductions exceed its assessable income, a partnership incurs a partnership loss. The partnership loss is then distributed to the partners in the year in which it is incurred according to the partners’ respective interests in the loss.
Where a partnership loss resulted from carrying on a business, an individual partner can only claim their share of loss against other income if certain tests can be satisfied. These tests apply to certain non-commercial business losses and further detail can be found on the ATO website.
Where a partnership does not carry on a business and partners are mere co-owners of an investment, the owners of the investment can generally claim their respective share of investment loss as a deduction to offset against other income in their individual tax returns.
Where a partnership is carrying on a business, a partnership tax return must be lodged to report the partnership’s assessable income and deductions. An individual partner is only required to declare their share of the partnership net income or partnership loss in their individual tax return. It is relatively straight forward to identify that only the partner’s share of the net income of the partnership will be included in a partner’s assessable income as the gross business income from the partnership is not reflected in the individual’s tax return. If a partnership incurs a loss, $0 is included in the individual partner’s assessable income.
On the other hand, where a partnership is not carrying on a business and partners are mere co-investment owners who receive income jointly, it can be tricky to determine a co-owner’s assessable income from the investment. This is because co-owners are not required to lodge a separate partnership tax return. Rather, they are required to declare their share of the gross investment income and associated expenses in their own individual tax return. It is a common misconception that a co-owner’s share of gross investment income forms part of their assessable income, rather than the net investment income after applying any allowable deductions. As a result, a co-owner’s assessable income can very often be less than expected.
The two examples below illustrate the differences in tax return reporting between a partnership that carries on a business and a partnership where partners are mere co-owners of a passive investment who receive income jointly.
EXAMPLE – PARTNERSHIP 1 CARRIES ON A BUSINESS
Wendy and Linda are both 40 years old. They have been friends since school. They run a small business designing figure skating costumes through a partnership structure and they are both partners in the partnership. The partnership generates $200,000 gross profit and claims $140,000 tax deductions in a tax year. The net income of the partnership in that tax year is $60,000. Wendy has 40% interest and Linda has 60% interest in the partnership.
Wendy and Linda’s assessable income includes their share of net income in the partnership, that is:
- Wendy’s assessable income includes 40% of the partnership’s net income (i.e. $24,000); and
- Linda’s assessable income includes 60% of the partnership’s net income (i.e. $36,000).
As Wendy and Linda’s partnership carries on a business, a partnership tax return must be lodged to the ATO. The partnership tax return provides a statement of distribution. Wendy must then declare $24,000 and Linda $36,000, representing distribution from the partnership, at the relevant item in their respective individual tax returns.
Because Wendy and Linda’s share of net income in the partnership, instead of the gross partnership income, is required to be declared in their individual tax returns, it is relatively straight forward to identify that only $24,000 is included in Wendy’s assessable income and $36,000 in Linda’s assessable income.
EXAMPLE – PARTNERSHIP 2 CO-INVESTMENT OWNERS
Wendy and Linda also have an investment property owned as tenants in common. Wendy has 60% interest and Linda has 40% interest in the property. The property generates $50,000 gross rental income and the associated tax deductions are $30,000 in a tax year.
As Wendy and Linda receive rental income from this property jointly, they are partners in a partnership for tax law purposes. However, because this partnership doesn’t carry on a business, Wendy and Linda are not required to lodge a partnership tax return to report the rental income and expenses. Instead, Wendy and Linda are required to report in their individual tax returns the information as follows:
- Wendy reports her share of gross rental income of $30,000 (i.e. $50,000 x 60%) and deductible expenses of $18,000 (i.e. $30,000 x 60%) in her tax return. Wendy’s share of net rental income is $12,000; and
- Linda reports her share of gross rental income of $20,000 (i.e. $50,000 x 40%) and deductible expenses of $12,000 (i.e. $30,000 x 40%) in her tax return. Linda’ share of net rental income is $8,000.
Because Wendy and Linda’s share of the gross rental income is reported in their individual tax return, the common misconception is that $30,000 forms part of Wendy’s assessable income and $20,000 counts for Linda’s assessable income. It is also commonly misunderstood that Wendy and Linda can then claim their share of deductions. As a result, it is commonly thought that $12,000 counts towards Wendy’s taxable income and $8,000 counts towards Linda’s taxable income.
Actually, as Wendy and Linda are tax law partners, a co-owner’s share of net income in the partnership, rather than the gross income, is included in their assessable income.
That is, only $12,000 counts towards Wendy’s assessable income and $8,000 counts towards Linda’s assessable income.
The tables below summarise the common misconception and the correct application of a partner’s assessable income when it comes to co-owners of an investment.
As illustrated in the tables, either under the common misconception or the correct application of the legislation, Wendy and Linda will end up with the same amount of taxable income. This means even if their assessable income can be mistakenly overestimated as co-owners of a passive investment asset, the amount of tax they need to pay (based on their taxable income calculated by the ATO based on the information reported in their tax returns) would not be overstated.
If an individual overestimates their assessable income, they could miss out on valuable financial planning strategies where the related income tests are based on an assessable income. Examples include the government super co-contribution and spouse contribution tax offset.
It is important to note that where an investment is held solely by an individual, the gross investment income will form part of their assessable income and they can then claim allowable deductions in their own right. The issue surrounding mistaken inclusion of the gross investment income in assessable income stated above only relates to co-owners of an investment (i.e. a partnership at tax law), but not to a sole owner of an investment asset.
PARTNERSHIPS AND FINANCIAL PLANNING CONSIDERATIONS
If a co-owner’s assessable income is over estimated, it may not affect financial planning strategies based on taxable income or adjusted taxable income. However, valuable financial planning strategies based on assessable income could be impacted, such as the government super co-contribution and spouse contribution tax offset.
Being a partner in a partnership could also impact related party issues when an SMSF is involved.
1. Government super co-contribution eligibility
If an individual’s total income is less than $53,564 (in 2019/20 financial year) and at least 10% of this income is derived from employment activities (including self-employment), an individual may qualify for the government super co-contribution.
Total income for this purpose includes an individual’s assessable income, reportable fringe benefits and reportable employer super contributions.
In Wendy and Linda’s example, assuming they both do not have income from other sources, their respective assessable income is $36,000 and $44,000 respectively in a tax year. Given more than 10% of their income is from carrying on a business (i.e. net income distribution from partnership 1 that carries on a business), both Wendy and Linda are eligible for government super co-contributions if they make after-tax member contributions to super.
However, if Wendy and Linda’s share of gross rental income is mistakenly included in estimating their assessable income to assess their eligibility for the government co-contribution, their total income would have exceeded the eligibility threshold. As a result, they may miss out on making after-tax member contributions to super to receive government co-contributions.
The ATO instructs that if an individual receives any income as a co-owner of an investment or partnership distributions, they may need to complete the additional labels and associated worksheets in their tax return to work out their income for co-contribution purposes. If the additional label in the individual tax return is not completed, or completed incorrectly, this individual may not receive the correct co-contribution payment.
When recommending the government co-contribution strategy to individuals with income from partnership distributions or shared income from a passive investment, it may be worthwhile directing them to speak with their tax accountants to ensure that the government co-contribution label in an individual’s tax return is completed correctly.
Partnership loss and the impact on co-contribution 10% test
To qualify for the government super co-contribution, one condition is to require at least 10% of an individual’s total income (i.e. assessable income, reportable fringe benefits and reportable employer super contributions) to be derived from employment activities (including self-employment).
Where a partnership carries on a business, the distribution of partnership net income to a partner will form part of their assessable income and can count towards meeting the 10% test condition. However, if this partnership incurs a loss, $0 relating to this partnership distribution is included in a partner’s assessable income and count towards the 10% test. If the partner does not have any income from other employment or self-employment, the 10% test cannot be satisfied and therefore this partner won’t qualify for the co-contribution, even though their total income may be lower than the eligibility threshold.
2. Spouse contribution tax offset
The thresholds for spouse contribution tax offset purposes increased from 1 July, 2017, and since then many individuals may now become entitled to this tax offset by making spouse contributions.
The maximum tax offset of $540 is available to the contributing spouse for making a $3,000 contribution to their spouse’s super, where the receiving spouse’s assessable income, total reportable fringe benefits and reportable employer super contributions is $37,000 or less. The tax offset gradually reduces for income above $37,000 and completely phases out when income reaches $40,000.
This non-refundable tax offset can help the contributing spouse to reduce their tax liability.
Similar to the government co-contribution, if assessable income is mistakenly overestimated for co-owners of a passive investment asset, their spouse may miss out on making a spouse contribution and receiving the spouse contribution tax offset.
To receive the correct spouse contribution tax offset, the relevant item (i.e. Superannuation contributions on behalf of your spouse) in an individual’s tax return needs to be completed correctly.
Similar to government super co-contributions, when recommending the spouse contribution strategy, it may be worthwhile directing individuals with income from partnership distributions or shared income from a passive investment to speak with their tax accountants to ensure that the spouse contribution tax offset label in the contributing spouse’s tax return is completed correctly before the tax return is lodged.
3. Partnerships and related party issues
A number of investment restrictions, such as the related party acquisition rule and the in-house assets rule, apply to transactions involving ‘related parties’ of an SMSF.
A related party is defined under section 10(1) of the Superannuation Industry (Supervision) Act 1993 (SIS Act) as any of the following:
(a) A member of the fund;
(b) A standard employer sponsor of the fund; or
(c) A Part 8 associate of an entity referred to in paragraph (a) or (b).
Part 8 associates of a member in an SMSF include a partner (and their spouse and children) of a member or a partnership in which the member is a partner. The definition of partnership under section 70E of SIS Act has the same meaning as in section 995-1(1) of ITAA97. This means a partnership for SIS purposes not only includes partners in a partnership that carries on a business, but also includes co-owners of an investment that receives income jointly.
In our example, Wendy and Linda are friends but are not otherwise related. However, they are considered to be associates either because they are partners in their partnership that carries on a business, or because they jointly own the investment property and they receive rental income jointly.
If Wendy wants to sell her share in the jointly owned rental property to Linda (or vice versa), their SMSFs are prohibited from acquiring that interest in a residential rental property due to the application of the related party acquisition restriction.
Advisers need to exercise caution if the trustee(s) of an SMSF are looking at acquiring an asset (that is not exempt from related party acquisition rules) from an otherwise unrelated party such as a friend. It is important to check whether parties are running a business through a partnership, or simply receive income jointly as co-owners of an investment.
Linda Bruce is senior technical manager at Colonial First State.