Are you an independent business owner operating as a sole trader in roles such as a contractor, consultant, or freelancer? Do the products or services you provide primarily rely on your individual skills and effort? If this sounds like you, the earnings you generate could fall under the category of Personal Services Income (PSI).

What is Personal Services Income and why does it matter?

As the name suggests Personal Services Income is a term that's used to describe or refer to income that is generated from the personal efforts of an individual (examples include: an HR consultant, accountant, or marketing expert), as opposed to profits generated from an asset (such as rent from a car or property), or from selling a product (such as from a retail shop), or from licensing your intellectual property (such as patent, or video training series).

PSI doesn't affect salary or wages that people earn as employees.

Why does PSI exist?

The government introduced the legislation that governs Personal Services Income in the year 2000 in an attempt to stop people from minimising tax by sharing income with family members or claiming deductions that would not be allowed if earned by a wage earner. The special tax rules that exist around Personal Services Income exist to prevent people from reducing their income tax by diverting income they've received from personal business services through companies, partnerships or trusts.

Will my sole trader business be affected by Personal Services Income?

Determining whether or not your sole trader business violates the Personal Services Income legislation is one of the most important things you need to do ahead of starting your business. To help you determine whether PSI rules apply, work through the following 4 steps provided by the Australian Taxation Office (ATO).

Step 1 – more than 50% of your income is derived from personal efforts

Does more than 50% of your sole trader business income derive from the result of personal efforts? If the answer is yes, PSI may apply to you. If this is the case, move to Step 2 to see whether or not you are in danger of being caught in PSI.

Step 2 – the results test

Are you being paid for a result or for your time? To satisfy the results test, you must meet all three of the following conditions:

1. you are being paid at least 75% of your income to achieve a result (this includes being paid after achieving the result);
2. the risk to rectify any defects belongs to you;
3. you must provide all the necessary tools and equipment to complete the work relating to the above mentioned 75%.

If you meet all of the above conditions, it is unlikely that you will need to worry about PSI rules. If you are having trouble with completing the results test, ask yourself the following question: are you being paid on an hourly rate?

If you cannot satisfy the results test, you may be in violation of the PSI rules and should move to Step 3.

Step 3 – The 80% rule

The 80% rule asks if 80% or more of your income comes from the one client. Note, if you have multiple clients but they are associated with each other, be they subsidiaries, partners or trustees of related entities, then you must count the income as coming from one client.

If more than 80% of your income comes from one client (or associated clients), the PSI rules apply. If this is the case, move to Step 4.

Step 4 – The remaining tests

If you have answered yes to the first three steps, then you must pass at least one of the following three tests to avoid triggering the PSI rules:

1. Unrelated clients test
2. To pass the unrelated clients test you must have work from at least two unrelated clients and obtain the work by advertising to the public, for example, via a website, or word of mouth. Note, any clients you obtain through a labour hire firm will be deemed related even if the clients aren't associated, so for the purposes of this test, even if you have multiple clients they will only be counted as one client.
3. Employment test
4. To pass the employment test, you must employ others to complete at least 20% of your principal work (not support work such as administration tasks, but the work that is key to contract), or you need to have employed an apprentice for at least 50% of the year.
5. Business premises test
6. To pass the business premises test you must have an office for your exclusive use throughout the whole year that is separate to your home or your clients' premises. You must also use the business premises to generate your personal services income for at least 50% of the time.

Business premises that do not pass the test include:

• Leasing a desk in a shared working space (this is not exclusive use of the business premises)
• A home office (as it is not separate from your residence)
• Leasing an office for part of the year (unless you only commenced trading during the year, and you leased or owned the office throughout this full period)

If you are still unsure whether the PSI rules apply to your situation after reading the above 4 steps, reach out to us.

What limits apply for tax deductions for Personal Services Income?

If the PSI rules apply to your situation, you will not be able to claim a tax deduction against the income for the following:

Deductions you cannot claim

In situations where the PSI regulations are in effect, you are not eligible to make deductions against the PSI for:

• Rent, mortgage interest, rates, and land tax
• Payments to associates for non-principal work
• Super contributions for associates' non-principal work

It's important to note that Personal Services Income does not qualify for the Small Business Income Tax Offset (SBITO) as well.

Deductions you can claim

Deductions against your Personal Services Income (PSI) can be claimed for relevant expenses incurred in generating this income. Examples of eligible deductions include:

• Costs associated with securing work, such as advertising, tenders, and quotes
• Registration and licensing fees
• Account-keeping fees, including bank charges
• Certain insurance costs, such as fees for public liability and professional indemnity insurance
• Salary or wages, along with super contributions, for an arm's length employee (not an associate)
• Reasonable payments to an associate for principal work
• A proportion of home office expenses, including: heating, lighting, phone, and internet (note: rent, mortgage interest, rates, or land taxes should not be claimed)

Depending on the nature of your business and contractual agreements, you may also be eligible for additional deductions.

Next Steps

If you're having trouble applying the PSI rules to your situation or are concerned you may be conducting a personal services business and are worried about how this might impact your income tax liability, reach out to us today for a consultation.

If the PSI rules apply to your situation you must complete Item 14 - Personal Services Income when preparing and lodging your personal individual tax return. We have much experience assisting professionals with their income tax obligations and determining whether they are in violation of PSI rules.

If you would like to talk to a tax specialist about your business income and the best entity structure through which to operate your business, reach out to us today for a consultation.