Many individuals opt to operate their businesses through a company or trust rather than as sole traders, seeking the asset protection and flexibility offered by these structures. Typically, income generated within these structures is taxed in the hands of:
- in the case of a company, the company; and
- in the case of a trust, any beneficiaries, trustees or unitholders who receive distributions through the trust.
However, when the company income is primarily a result of an individual’s personal services, it may fall under the category of “personal services income” (PSI). This leads to specific tax implications. This article will explain what the PSI regime is, its tax consequences and exceptions to the rules.
What Is the Personal Services Income Regime?
PSI encompasses income received mainly as compensation for an individual’s personal efforts or skills. This applies whether the income is directly received by the individual or through a company, trust, or partnership, termed as a personal services entity (PSE). If the income is received by a company, trust or partnership, this entity is known as a personal services entity (PSE).
PSI does not include income that is mainly:
- for supplying or selling goods, such as by selling products via an e-commerce site;
- generated by income-producing assets, such as by leasing coffee machines to cafes;
- for granting a right to use property, such as royalties received from a music licence; or
- generated by a business structure, such as a lawyer working for a large law firm.
What Are the Tax Consequences of Being Captured by the Personal Services Income Regime?
The PSI rules in the Income Tax Assessment Act 1997 (Cth) aim to address two key outcomes:
- Apply tax consequences to those individuals who seek to reduce their income tax liability by diverting their PSI to PSEs.
- Limit the deductions an individual or PSE can claim relating to their PSI.
Income
If the PSI rules apply, the PSI will be treated as the individual’s income. It will be included in their individual tax return for the relevant financial year, regardless of the business being operated by a PSE and the income being received by them. The individual will then be taxed on that PSI at their personal marginal rate.
Deductions
If the PSI rules apply, both the individual and the PSE will face limitations on deducting expenses from the PSI. The Taxation Ruling of 2003/10, which delves into deduction restrictions, outlines that:
- the individual is restricted in claiming home office occupancy expenses and generally can only avail deductions comparable to those available to an employee; and
- the PSE can only claim deductions for salary and wages paid to employees, as well as fees paid to associates, subject to compliance with specific conditions.
Contractual Obligations
Even if the PSI rules apply, they will not impact the legal, contractual, or workplace arrangements of the relevant entity.
Continue reading this article below the formWhat Are the Exceptions to the PSI Rules?
Generally, an individual or PSE exempt from the PSI rules is one that qualifies as a personal services business (PSB). To achieve PSB status, the individual or PSE receiving PSI must successfully undergo a series of tests.
The Results Test
An individual or PSE (the taxpayer) will pass the results test if they can answer “yes” to all of the following in relation to at least 75% of their PSI:
- is the PSI paid to achieve a specific result or outcome;
- does the taxpayer have to provide the tools and/or equipment necessary (if any) to do the work? If there are no tools/equipment required, answer “yes”; and
- is the taxpayer responsible for rectifying any defects in the work?
The 80% Rule
If the taxpayer fails to meet the results test, they can self-assess against one of the “other tests” if 80% or more of their PSI does not originate from a single source.
However, if 80% or more of the taxpayer’s PSI comes from a single source, they cannot use the “other tests”, and the PSI rules will apply unless they obtain a PSB determination from the ATO.
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The Other Tests
If the taxpayer does not satisfy the results test but fulfils the 80% rule, they must pass one of the following tests to avoid the application of PSI rules.
Unrelated Clients Test
The taxpayer must answer “yes” to both of the following:
- Is the taxpayer who completes the personal services work receiving PSI from two or more clients unassociated with each other or the taxpayer?
- Did the taxpayer provide personal services by making offers to the public, such as placing ads on social media?
Employment Test
The taxpayer must answer “yes” to either of the following:
- Does the taxpayer engage employees (not including associates), subcontractors or other entities to perform at least 20% of the work?
- Does the taxpayer have an apprentice(s) for at least half of the financial year?
Business Premises Test
The taxpayer must answer “yes” to all of the following in relation to the relevant financial year:
- Did the taxpayer own or lease a business premises?
- Was that business premises mainly used for personal services work by the taxpayer?
- Was that business premises used exclusively by the taxpayer?
- Was that business premises physically separate from the private residence of the individual doing the personal services work or their associates?
Personal Services Business Determinations
A taxpayer can seek a PSB determination from the ATO. If granted, the taxpayer will be considered as operating a PSB, exempting them from the PSI regime.
Key Takeaways
Operating a business as an entity other than a sole trader offers benefits like asset protection and flexibility. However, if a sole individual provides services through this entity, they must be aware of the PSI rules and their impact on tax obligations. Generally, the PSI rules apply when an individual or entity receives income for their efforts and skills, excluding income derived by an employee. This holds true even if the individual operates through a PSE, such as a company, trust, or partnership. The PSI rules do not apply if the individual or entity qualifies as a PSB. To qualify as a PSB, a series of tests must be passed by the relevant taxpayer.
If you need help understanding what the PSI is and how it may affect you, our experienced commercial lawyers can assist as part of our LegalVision membership. You will have unlimited access to lawyers to answer your questions and draft and review your documents for a low monthly fee. Call us today on 1300 544 755 or visit our membership page.
FAQs
What is the personal services income regime?
The PSI regime applies when an individual or entity receives income based on the skills and labour of that individual. It is relevant whether they run the business individually or through a company or trust.
What are the tax consequences of the personal services income regime applying?
The PSI regime broadly results in taxing the individual (rather than the business entity) for PSI and imposes limitations on deductible claims.
Does the personal services income regime always apply?
No. If the taxpayer qualifies as a PSB (through passing a series of tests), they will be exempt from the PSI regime.
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