Working through a company, trust or sole trader business can be a sensible commercial choice. However, it does not automatically mean all income is treated as ordinary business income for tax purposes.
For consultants, contractors, professional service providers and other owner-operators, the Personal Services Income, or PSI, rules can change who is taxed on income and which deductions are available. Getting this wrong may lead to amended tax returns, denied deductions and unexpected tax liabilities.
The key question is not simply whether you have an ABN, invoices or a company. It is whether the income is mainly generated by your personal efforts and skills, and if so, whether you are conducting a genuine personal services business.
What is Personal Services Income?
Personal Services Income is income that is mainly a reward for an individual’s personal efforts or skills. It can be earned directly by an individual or received through a company, partnership or trust.
Common examples include income earned by:
– Consultants and advisors
– IT contractors and software specialists
– Designers, engineers and project managers
– Medical, legal and accounting professionals in sole practice
– Trainers, entertainers and speakers
– Tradespeople where the client is mainly paying for the individual’s labour and expertise
PSI is assessed by looking at the substance of each arrangement, rather than the label used in a contract or invoice. Calling a payment a “service fee”, invoicing through a company or using a business name does not, by itself, change its character.
As a practical guide, income will generally be PSI where more than half of the amount received under a contract is a reward for an individual’s work, expertise or skill. If the services are integral to the arrangement, the contract needs to be considered as a whole.
For example, an IT specialist who personally performs the contracted work using a client’s systems may be earning PSI, even if the invoices are issued by a company.
When income is more likely to be ordinary business income
Not every service-based business earns PSI. Income may instead be generated mainly by the sale of goods, income-producing assets, property rights or a broader business structure.
Income is less likely to be PSI where it is mainly produced by:
– Selling or supplying goods, such as retail, wholesale or manufacturing activity
– Significant income-producing assets, such as specialised machinery or equipment
– Granting rights to use property, including some intellectual property arrangements
– A business structure that generates income beyond one person’s individual efforts
A genuine business structure may involve employees or contractors who materially contribute to delivering the work, established systems, goodwill, substantial equipment, a recognisable brand or operations that can continue without relying primarily on one person.
This does not mean that hiring an assistant or operating through a company will automatically turn PSI into business income. The real issue is whether the income is generated mainly by the business structure, or by one individual’s personal skills and efforts.
It is also possible for a business to earn both PSI and non-PSI income. A contractor may have one engagement that is mainly a reward for their own expertise, while another part of the business earns income from selling products or providing services through a team. These arrangements should be reviewed separately and supported by clear records.
The personal services business tests
If income is PSI, the next question is whether it has been earned in the course of conducting a personal services business, often called a PSB.
A person or entity may be treated as conducting a PSB if they satisfy at least one of four tests. These tests are designed to distinguish independent businesses from arrangements that are effectively income from one person’s labour being channelled through another entity.
The results test
The results test focuses on whether the work is genuinely outcome-based.
To meet this test, at least 75 per cent of the relevant PSI must be for producing a result. For that same portion of income, the individual or entity must generally:
– Be paid to achieve a specified result, rather than simply for time worked
– Supply the tools, plant or equipment needed to do the work
– Be liable for the cost of rectifying defective work
Industry custom and practice are relevant when assessing these requirements. For some professions, it may be normal for a client to provide access to systems, equipment or worksites. That does not automatically prevent the test being met, but the full arrangement needs to be considered.
A contract describing an engagement as “fixed price” is not enough on its own. The practical terms matter. Is the contractor genuinely responsible for the deliverable? Do they bear the financial risk of fixing errors? Are they engaged to produce an agreed outcome, rather than fill a role?
The unrelated clients test
This test is aimed at businesses that actively seek and win work from the market.
To meet it, the individual or entity must provide services to at least two unrelated clients during the income year. The work must also result directly from making offers or invitations to the public, or to a section of the public.
Advertising, tendering, maintaining a public website, responding to public requests for quotes and other genuine marketing activity may be relevant. A referral from an existing client or labour-hire intermediary does not necessarily demonstrate that work resulted from public offers or invitations.
The test is not simply about having several invoices. The clients must be genuinely unrelated, and there must be evidence that the work was obtained through the business’s own market-facing efforts.
The employment test
The employment test considers whether the business has others performing a meaningful share of the principal work.
Broadly, the business must engage other people or entities to perform at least 20 per cent, by market value, of the principal work for the year. There are specific rules about associates, and work that is merely administrative or supportive may not be enough if it is not part of the principal work being sold to clients.
A business can also meet this test where it has one or more apprentices for at least half of the income year.
This test can be relevant for a growing practice that is no longer dependent solely on the founder. However, the records need to show what work was done, who performed it and the market value of that contribution.
The business premises test
The business premises test is deliberately strict. The individual or entity must maintain and use premises that are used mainly for the PSI-producing activities, are exclusively used by the business and are physically separate from both private premises and the client’s premises.
A home office will generally not satisfy this test because it is part of premises used for private purposes. A desk at a client’s office will also generally not satisfy it.
This test may be relevant for a business operating from a dedicated commercial office, workshop or studio. It is not simply a question of paying rent. The premises must meet all of the required conditions throughout the income year.
Why the 80 per cent rule matters
The 80 per cent rule is one of the most important PSI rules to understand.
If 80 per cent or more of an individual’s PSI comes from the same client, or from that client and its associates, the individual or entity cannot self-assess against the unrelated clients, employment or business premises tests.
The results test can still be self-assessed. If the results test is not met and the 80 per cent rule applies, a personal services business determination from the Commissioner may be needed before the PSI rules can be set aside.
This often affects contractors who have a long-term engagement with one large client. Having one major client does not automatically mean the arrangement is incorrect or that the individual is an employee. It does mean the PSI analysis needs to be handled carefully.
The PSI rules themselves also do not decide whether someone is an employee or contractor for employment law, superannuation guarantee, PAYG withholding or other purposes. Those issues require separate analysis based on the relevant legal tests and the actual working arrangement.
What happens if the PSI rules apply?
When PSI is earned through a company, trust or partnership that is not conducting a PSB, the tax outcome may not follow the entity structure.
The net PSI may be attributed to the individual who performed the work, rather than being taxed in the company, trust or partnership. This limits the ability to retain profits in a company, distribute income to family members or otherwise split income that was generated by one person’s services.
The PSI rules can also limit deductions. In broad terms, an individual who earns PSI but is not conducting a PSB can generally claim deductions only to the extent they would have been able to claim them if they were an employee earning that income.
This can affect claims for expenses such as:
– Rent, mortgage interest, rates and land tax relating to a home
– Payments to associates, including family members, where they are not performing the principal income-producing work
– Superannuation contributions for associates, subject to limited exceptions
– Expenses that would ordinarily be private or non-deductible for an employee
There are important exceptions. For example, the law specifically allows certain costs associated with obtaining work, income protection and liability insurance, and engaging non-associates to perform work.
The outcome depends on the facts. A deduction should not be claimed simply because it was paid by a company or trust. The PSI rules look through the structure to the person who generated the income.
Common PSI mistakes to avoid
The most costly mistakes are often caused by assumptions made when a structure is set up, then never reviewed as the business develops.
Assuming a company solves the issue
A company can be commercially useful for many reasons, including asset protection, branding and operational needs. But it does not automatically convert income from one person’s work into ordinary business income.
Treating all contractor income as non-PSI
Being an independent contractor, having multiple short engagements or charging a daily rate does not automatically mean the PSI rules do not apply. The terms of each contract and the actual work performed matter.
Confusing multiple invoices with multiple clients
Several projects or purchase orders from the same client group may still be treated as income from one source. The relationship between clients, including whether they are associates, needs consideration.
Paying family members without considering the work performed
Payments to a spouse or other associate may be restricted where the PSI rules apply, particularly if the work is administrative, bookkeeping or otherwise not part of the principal work sold to clients.
Overlooking changes during the year
A business may begin with one major client and later develop a broader client base, employ staff or move into dedicated premises. Conversely, a business that previously met a PSB test may become highly dependent on one client. PSI should be reviewed each income year.
A practical example
Consider a management consultant who operates through a company. The consultant performs nearly all client work personally and is engaged by one corporate group for most of the year. The company invoices the client, pays some expenses and retains part of the profit.
The use of a company does not answer the PSI question. The income may still be PSI because it is mainly a reward for the consultant’s own expertise and efforts.
If the consultant is not paid to produce defined results, does not bear responsibility for rectifying defects and does not meet the results test, the 80 per cent rule becomes important. If most PSI comes from that one corporate group, the consultant cannot simply rely on having a small number of other clients, a home office or minor administrative support to self-assess as a PSB.
The company may therefore be unable to use the structure to retain or distribute the consultant’s net PSI in the way it could with ordinary business income. A review of the contracts, client mix, working arrangements and deductions should occur before lodging the tax return.
Keep records that support the real arrangement
PSI reviews are much easier when records reflect how the business actually operates. Useful documents may include:
– Signed contracts, scopes of work and variations
– Quotes, tenders and evidence of public marketing
– Invoices showing whether work is charged by time, milestone or outcome
– Evidence of responsibility for rectifying defects
– Insurance policies and records of tools or equipment supplied
– Timesheets, subcontractor agreements and payroll records
– Client lists showing whether clients are related or unrelated
– Lease documents and evidence of exclusive business premises
Do not attempt to reshape arrangements solely to meet a test. The legal and tax position should reflect genuine commercial operations, supported by accurate records.
The key takeaway
Personal Services Income is not a label reserved for sole traders or freelancers. It can apply even where income is earned through a company, partnership or trust.
The right approach is to identify PSI contract by contract, assess whether a personal services business test is met, consider the 80 per cent rule and ensure deductions and distributions are treated correctly.
This article is general information only and is not personal financial or tax advice. PSI can be highly fact-specific, so it is important to speak with a registered tax agent or accountant, such as, about your particular contracts, structure and business circumstances.