Are you a sole trader working as a contractor, consultant or freelancer? Do you offer products or services that are based mainly on your personal skills and labour? If so, the income you receive may be classified as personal services income (PSI).
There are some special rules for the tax treatment of personal services income earned by sole traders that you should be aware of.
What is personal services income (PSI)?
Personal services income (PSI) is income that is mainly earned from your personal skills or efforts as an individual.
If more than 50% of the income received for a contract/invoice was for your labour, skills or expertise, rather than being generated by the use of assets, the sale of goods or by a business structure, then that income received is PSI.
You can receive PSI in almost any industry, trade or profession. For example, as a financial professional, IT consultant, construction worker or medical practitioner.
The PSI rules are designed to prevent PSI from being diverted or split with other individuals or entities in an attempt to pay less tax.
Examples of PSI and non-PSI income
Susan is a management consultant operating as a sole trader. She recently completed contracts for 2 of her clients.
Contract 1: Susan provided a 1-hour training course for a client. She charged $1,000 for her course. This included training materials that cost $100. Since $900 (90% of the contract) is for her skills and expertise, this is PSI. Susan is able to report $1,000 as PSI.
Contract 2: Susan provided management software for a client. She charged $10,000 in total. This included $8,000 to cover the cost of the software licence. Since $2,000 (20% of the contract) is for her skills and expertise, this is not PSI. Susan cannot report PSI for this contract.
Like Susan’s examples above, your taxable income can be a mix of PSI and other income.
Determine if you earn PSI
Use the Personal services income tool (ATO) to work out if you have PSI and if the PSI rules apply.
You can receive PSI even if you’re not a sole trader. If you’re producing PSI through a company, partnership or trust and the PSI rules apply, the income will be treated as your individual income for tax purposes.
There are special tax rules around PSI to improve the integrity and equity of the tax system.
When the PSI rules apply
If the rules apply, it will affect:
- The tax deductions you can claim for PSI
- How you report PSI
All other income you earn follows normal tax rules.
When personal services income (PSI) rules apply, there are limitations for deductions that can be claimed against this income. In general, an individual who earns PSI is treated as though they are in the same position as an employee.
Deductions you cannot claim
When the PSI rules apply, you cannot claim 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
Personal services income is also NOT eligible for Small business income tax offset
Deductions you can claim
You can claim deductions against your PSI if an expense occurred earning this income.
For example, you could claim:
- The cost of gaining work, such as advertising, tenders and quotes
- Registration and licencing fees
- Account-keeping fees, including bank fees
- Some insurance costs, including public liability and professional indemnity insurance fees
- Salary or wages and super contributions for an employee engaged at arm’s length (not an associate)
- Reasonable amounts paid to an associate for principal work
- A portion of home office expenses, such as heating, lighting, phone and internet. Do not claim rent, mortgage interest, rates or land taxes
You may be eligible for other deductions depending on what your business is and your contracts.
When PSI rules do not apply
If you operate your business through a company or a trust, income earned by the company or trust from the provision of your personal services (personal services income or PSI) will be attributed to you unless:
- The company or trust is conducting a personal services business (PSB); or
- The PSI was promptly paid to you as salary or wages.
When you’re a PSB, there are no changes to your tax obligations, except that you need to declare any PSI on your tax return.
The company or trust will be conducting a PSB if at least one of four tests is satisfied. These are:
- The results test (the most important test) – this is based on common law criteria for characterising an independent contractor (in contrast to an employee/employer relationship);
- The unrelated clients test – this requires the PSI to be earned from at least two unrelated clients who contract your services as a direct result of an advertisement or other public offer of your services;
- The employment test – this requires at least 20% (by market value) of your work to be performed by employees;
- The business premises test – this requires you to use business premises that meet certain conditions (e.g. you have exclusive use of the premises and the premises must be physically separate from any premises you use for private purposes).
If 80% or more of your PSI (with certain exceptions) is income from one client (or the client and their associate(s) and the results test is not met, the company or trust will only be able to be treated as conducting a PSB if it obtains a PSB determination from the ATO.
If a company or trust is not conducting a PSB and the PSI was not promptly paid to you as salary or wages, the PSI is attributed to you, the company or trust has PAYG withholding obligations, and there are limitations on certain deductions. The company or trust cannot deduct amounts that relate to gaining or producing your PSI, unless you could have deducted the amount as an individual or the company or trust received the PSI in the course of conducting a PSB.
The PSI rules are complicated so talk to our KMT tax adviser if you provide your services through a company or trust.
This is general advice only and does not take into account your financial circumstances, needs and objectives. Before making any decision based on this document, you should assess your own circumstances or get professional advice from a qualified accountant or tax adviser at KMT Partners.