Accounting & Tax, Entrepreneurs

What You Need to Know About Personal Services Income (PSI)

personal services income

This article is not relevant to you If you are an employee receiving only salaries and wages. However, if you are operating through an entity, such as a company, partnership, or trust, and are an employee of that entity, then you must check if your business is receiving PSI.

Why do you need to know if you are receiving PSI income?

Receiving Personal Services Income will change a person’s or an entity’s tax obligation because PSI may be subject to special tax rules. These rules aim improve the integrity of the tax system and prevents people from reducing or deferring their income tax by diverting revenue they have received from their personal services through companies, partnerships, or trusts.

The tax rate for small companies is just 25% which is much lower compared with the top personal tax rate of 45%. In addition, companies can claim a wider range of tax deductions so really this could be a very effective way of sheltering profits for a small business and for that reason, the ATO often seeks to apply what are known as the personal services income (PSI) rules to discourage such situations.

What is Personal Services Income?

As defined by Taxation Ruling TR 2021/D2, Personal Services Income is income that is mainly a reward for an individual’s personal efforts or skills (or would be considered such a reward if it was the income of the individual who did the work).

Income is PSI if:

  • It’s an Income for skills, knowledge, expertise, or efforts of the individuals who performed the services (as defined by the tax ruling)
  • Majority (more than 50%) of the income received relates to the skills, knowledge, expertise, or efforts of the individuals who performed the services.

To determine if a person or entity is receiving PSI, you will need to look at the income from each contract they complete, and workout what percentage of the payment is for the skills, knowledge, expertise, or efforts, that is, or the labor component, and what percentage of the payment is for the materials supplied and/or tools and equipment used to complete the job.

If you work out that:

  • more than 50% of the income received is for the labor component then the whole income for that contract is PSI.
  • On the other hand, if you work out that 50% or less of the income received is for the skills, knowledge, expertise, or efforts, then the whole income for that contract isn’t PSI.

Income is not PSI if:

  • It is an income from the sale or supply of Goods.
  • It is an income generated by an income-producing asset.

Income that is generated mainly by an asset rather than an individual’s efforts or skills is not PSI. The ATO says it is an income-generating asset if its:

  • Large-scale or high value
  • The asset essential to performing the work, and
  • The asset is specified in the contract

The logic is that, using an asset that has those characteristics will represent substantially more than 50% of the contract price and the services of the person operating that asset will be substantially less than 50% of the contract price.

  • It is an income from granting a right to use a property. Income from granting a right to use property, such as copyright to a computer program or book, is generally not PSI as most of the income is generated from the right to use the property rather than effort, skills & knowledge.
  • It is income generated by a business structure.If a business has substantial income-producing assets, many employees, or both, it is more likely the income is being generated by the structure of the business rather than from an individual’s personal services. The ATO listed out some factors to consider in determining whether an income is generated by business structure. This includes:
    • the extent to which the income is not dependent on a particular individual’s personal skills, efforts or expertise
    • the number of arm’s length employees or others, for example contractors, engaged to perform the work
    • any presence of goodwill
    • the extent to which income-producing assets are used to derive the income
    • nature of the activities carried out
    • the size of the operation

    For example, an income generated by a large national professional firm, is generally not PSI as most of the income is generated by the significant assets, many employees or contractors, sizable operations, or goodwill of the business structure and not specifically the skills, knowledge, expertise, or efforts of the individuals who performed the services.

    If you’re still unsure whether you generate income through a business structure, you can always apply for a private ruling – if needed.

What to do next after determining PSI income?

If your business doesn’t receive PSI, then you do not have to worry any further as there will be no changes to your tax obligations or reporting. On the other hand, if your business receives PSI, then you must check and go through some steps to determine if PSI rules apply to your Personal Services income.

What are the PSI Tests?

The PSI Tests include the:

1) Results Test
To pass the results test, you need to meet all three conditions for at least 75% of the PSI for the income year:

  • You must produce a specific result or outcome before being paid.
  • Required to provide the equipment or tools
  • Required to fix mistakes at your own costs

If you pass the test, your business is a personal services business (PSB) for that income year and the PSI rules don’t apply.

2) 80% Rule

You need to work out the amount of PSI that comes from each client (including their associates) in an income year.

You will pass this test if less than 80% of the PSI comes from one client (including their associates), then proceed to the remaining test.

If 80% or more, you may apply for PSB determination, if you don’t, continue to the 3 remaining tests.

3) Remaining PSI Tests

There are three other tests that you can attempt on working out if PSI rules apply to your PSI income namely, Unrelated Clients test, Employment test and Business Premises test. Remember, you only need to pass one of the remaining tests If you pass any, then PSI rules do not apply If you don’t pass any, PSI rules apply.

a. Unrelated Client Test
You pass the test in an income year if you meet both of the following conditions:

  • You must have received the PSI from two or more unrelated clients.
  • There must be a definite connection between the offer to the public and the engagement for the work.

If you pass this test, you are a PSB, then PSI rules do not apply. If you do not pass this test, you can attempt the Employment test and Business Premises test.

b. Employment Test

To pass this test, you must meet either one of the following conditions:

  • Other employees or contractors that you engage must perform at least 20% of the principal work.
  • You must employ one or more apprentices for at least six months of the income year.

If you pass this test, you are a PSB, then PSI rules do not apply.If you do not pass this test, you can attempt the Business Premises test

c. Business Premises Test

You pass the test if, at all times in the income year, your business premises meets all of the following conditions:

  • you must use the business premises mainly (more than 50%) for work that generates your PSI.
  • you must have exclusive use of the premises. This means you must own or lease the premises.
  • the business premises must be separate from any private premises which you or your associates use for private purposes
  • Physically separate from your client’s premises

If you pass this test, you are a PSB, then PSI rules do not apply. If you don’t pass, PSI rules apply (considering you did not pass the other Unrelated client test and the Employment test)

If the PSI Rules Apply

Your business cannot claim certain deductions against the personal services income.

When 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. So, this means, you may claim deductions against PSI received if:

  • the expenses are incurred in producing the income
  • you (as an individual who earns the income) would be entitled to the deduction.

Generally, you cannot claim deductions against the PSI for:

  • Deductions cannot be claimed for rent, mortgage interest, rates and land tax for a residence, where those expenses relate to a person’s PSI.
  • Payments made to an associate (for example, spouse, child or other relative) cannot be claimed as a deduction for performing non-principal work.
    Non-principal work is incidental or support work that is not central to meeting obligations under a contract/ service. Examples include bookkeeping, issuing invoices, secretarial duties and running the home office.
    Payments to associates include remuneration such as a salary or commission, an allowance, reimbursement of an expense.
  • Super contributions for an associate (for example, spouse, child or other relative) cannot be deducted if the associate does non-principal work

Generally, the allowable deductions are for expenses that are incurred in gaining that individual’s PSI.

The PSI (less relevant deductions) your business received will need to be attributed to each individual who performed the services – that is, the profits can’t be retained in the business.

If an “entity” earns personal services income, that income will be attributed to the individual who does the work. The individual who does the work will have to pay income tax on the attributed income at personal rates. On the other hand, the entity is entitled to exclude that income from its assessable income for the same period. However, the entity will not be able to claim business deductions related to the PSI income.

If you’re a sole trader, you claim deductions directly against your PSI in your individual tax return.

If the PSI is earned through a company, partnership or trust, the business reduces the amount of PSI that it attributes to an individual by the amount of the deductions. Where PSI is generated by more than one individual in a business, you need to allocate the deductions which relate to the income received by everyone.

Your business needs to meet certain tax reporting obligations.

How you report your PSI will depend on whether you operate as a sole trader, company, partnership, or trust.

For sole traders, they need to complete personal services income section in their personal tax return and note if you’re required to complete the Business and professional items schedule you cannot lodge a paper tax return. You must lodge your tax return online through myTax or via a registered tax agent.

Companies, partnerships, and trusts – you just must answer and complete the PSI questions contained in the company, partnership, and trust tax returns.

Your business may have additional PAYG withholding obligations.

Your business will have additional PAYG obligations for the amount attributed to each individual who performed the services. Take note of the word may, because if your business has a net PSI loss (PSI income less PSI allowance deduction) for an income year, there are no additional PAYG withholding obligations as no income will be attributed.

Methods to Workout Additional PAYGW Obligations

  1.  70% of the gross PSI received in the PAYG payment period
  2. A percentage of the net PSI from the previous income year
  3. Legislative method

Regardless of the method chosen, the attributed income should be shown at label W1 on the activity statement and the amount of tax withheld at label W2.

Note that even if an employer reports through Single Touch Payroll (not required to provide their employees with a payment summary after the end of each income year) the PSE or the company earning PSI is still required to issue a PAYG payment summary – business and personal services income to the individual by 14 July each year and report the PAYG withholding to the ATO by 14 August using a payment summary annual report because Alienated PSI payments cannot be reported through Single Touch Payroll.

Moreover, Alienated PSI payments do not form part of “ordinary time earnings”, so they are not subject to superannuation guarantee, and they are generally not subject to Workcover either.

In A Nutshell

If you work for yourself, or for a business that was owned or partly owned by you or your associate and you’re providing your specific skill set, knowledge and your time as opposed to selling a physical product, then income you/your business earns is “your personal income”, regardless of whether it is income of another entity.

There are a series of steps that you need to go through to check if your PSI Income may or may not be subject to PSI rules. If you need help on checking if PSI rules apply to your income reach out to the business accountants at Fullstack for comprehensive guidance and advice today.

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