Personal services income - are you treating it correctly?

Personal services income - are you treating yours correctly?

Sally Preston

Do you earn income, either directly or through your business structure, that you generate mainly from your efforts and skill? This type of income is called Personal Services Income" ("PSI") and if this is you, then you need to keep reading.

Who may earn this type of income? Well, an accountant, lawyer, doctor, financial planner, management consultant, business coach, electrician, architect, and so on.

“PSI is defined as income that is mainly a reward for an individual's personal efforts or skills (or would mainly be such a reward if it was the income of the individual).”

It is worth noting that only individuals can have PSI. It can be earned directly by a sole trader or indirectly through an interposed entity (Personal Services Entity or "PSE").

Did you know that there are laws in place that prevent individuals from reducing their tax by diverting the income generated to an interposed entity such as a company, partnership, or trust? The laws also restrict the deductions that are available to claim against the income.

How would this be a problem? Well say, I was operating a consulting business through a company. The company would bill the client and then pay tax at the company tax rate, probably 25%. If I only wanted to spend 50% of the profits then I may only pay a dividend for this amount, I could then keep the other profits having only paid 25% tax on the profits. This seems fine right? Well, the tax law doesn’t like this as, if you were an employee, 100% of the profits would be recorded in your own name. Plus, any expenses you claimed against the income would be restricted to those an employee can claim. If the tax law allowed this, then wouldn’t all people who would otherwise be an employee, set up a company and contract to their employer and manage their tax that way?

Another example would be if I included a discretionary trust in my structure. It may be that the company still invoices the client but dividends are paid by the company to the trust. The trust then distributes the profits between me and my spouse. Now if I was an employee I would have reported all my salary and wages in my own name as it related to the services I provided, and not provided by my spouse.

So, the tax laws come in to treat the income like that of you as an employee unless you meet certain tests.

These rules are mutually exclusive to the rules surrounding employee’s vs contractors. So, if the tax law considers you an employee for PAYG withholding purposes of a business, then you are not subject to the PSI rules as you are already receiving the income as an employee.

So, assuming the income derived is not in the capacity as an employee, how do these rules work?

Well, first of all, income generated from a business structure, is not considered PSI.

Income is more likely to be generated from a business structure if your business has substantial income-producing assets, several employees, or both.

While you should consider your particular circumstances, the following factors will help you determine whether your income is generated by a business structure:

the extent to which the income depends on a particular individual's personal skills, efforts or expertise.
the number of arm's-length employees or other people (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
the nature of the activities carried out
the size of the operation.

After considering these factors, if you determine that your income is generated from a business structure, then that income is not PSI.

So, if your income is not so much from your efforts as it is from the people or assets in the business, then the income is not “income mainly from your personal exertion”. In this context take the word “mainly” to mean more than 50%.

When assessing whether the income generated by an entity is PSI, we iook at the substance of the arrangements in place, including the contracts with the customers.

It may also be that the entity has more than one owner providing the services. For example, when two lawyers join to own a company providing legal services to the public, then each discrete amount of income received by the entity under each contract entered into with the client is examined to determine which test individual's personal effort and skills mainly generated that income. This can be done by an analysis of contracts and invoices.

Personal services businesses

Even if it is mainly from your personal exertion there are some tests that may be passed that mean your business is considered a “personal services business” and is not subject to the deduction restrictions under the PSI rules, unless the anti-avoidance rules are applied.

Now passing these rules does not mean the income is not technically PSI, it means that it may not be subject to the restrictions within the PSI rules.

The tests

An individual or an entity would be considered a personal services business where:

they meet the results test for at least 75% of their PSI

less than 80% of their PSI is from the same entity and its associates (the 80% rule) and they satisfy one or more of the other PSB tests

For an entity, the above applies to each test individual. That is an individual that may be considered to have generated income mainly from their exertion. So, for one business entity, more than one individual may need to look at the above tests.

Results test

This is the first test to look at to determine if you, as a sole trader, or your entity if that is what you operate though, passes the test to be considered a personal services business and therefore not subject to the PSI rules.

The results test is satisfied if at least 75% of a test individual's PSI in an income year meets all the following 3 conditions:

the income is for producing a result; and
the sole trader or personal services entity (“PSE”) is required to supply the plant, equipment and tools of trade needed to do the work that produces the result, and
the sole trader or PSE is, or would be, liable for the cost of rectifying defects.

Let’s break these down:

1. Producing a result

In contracts that are for producing a result, payment is usually made for a negotiated contract price to achieve a specified outcome. This may be calculated by reference to an estimated number of hours applied to an hourly rate.

What is important is that it is for a specified outcome and not just for doing work. The condition will not be satisfied merely because the contract states that the contract is for producing a result. Consideration should be given to the substance of the arrangement between the sole trader or personal services entity and the service acquirer and what the sole trader or the PSE is actually being paid for.

2. Tools and equipment

The sole trader or entity must supply any plant and equipment or tools of trade needed to do the work that produces the result and which a service acquirer would expect the sole trader or PSE to provideor which the sole trader or PSE is contractually required to provide. Minimal usage of the tools or equipment of others will not of itself disqualify the taxpayer from meeting this condition.

3. Liability for the cost of rectifying defects

The sole trader or entity would be liable for the cost of rectifying any defects in the work.There is no requirement that they actually perform the work which rectifies the defect, so long as they are liable for the cost of rectifying any defect in the work performed.

The main consideration is whether they are exposed to commercial risk. So where a right to claim for damages exists in respect of faulty or negligent performance of contractual obligation. A requirement to have professional indemnity insurance is an indicator that the sole trader or PSE is liable for rectification where the indemnity insurance is part of the contractual arrangements between the parties. However, the fact that a person may be subject to disciplinary action by a professional body for misconduct is not sufficient to satisfy the rectification element of the test.

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So, if all the above conditions are passed for at least 75% of the income, then the results test is satisfied for that person.

If, however, this test is not satisfied then less than 80% of their personal services income, is from the same entity and its associates (the 80% rule); and they satisfy one or more of the other Personal Services Business tests.

The other tests are:

The unrelated clients test

This is where the income is generated from providing services to 2 or more entities; where those entities cannot be associates of each other or associated with the sole trader or PSE; and the services must be provided as a direct result of making offers or invitations (for example, by advertising) and those offers must be made to the public at large or a section of the public.

The employment test

This is where the sole trader or entiy engages one or more entities that perform at least 20% (by market value) of the principal work. Note that a test employee in the entity is not counted, and any individual engaged to perform principal work counts towards the employment test even if they are an associate of the sole trader or test individual. Other types of entities engaged to perform principal work only count towards the employment test if they are not an associate of the sole trader or entity.

The business premises test

This test always requires that, at all times during the income year, the sole trader or PSE maintains and uses business premises:

where the main activities conducted their gain or produce PSI
of which they have exclusive use
that are physically separate from any premises that they (or any associate) uses for private purposes; and
that are physically separate from the premises of the service acquirer (or any associate of the service acquirer).

Personal services business determination

A sole trader or PSE can apply for a personal services business determination from the Commissioner (ATO), in respect of each test individual, under any of the following circumstances:

they could be reasonably expected to meet the results, employment or business premises tests
unusual circumstances prevented the results, employment or business premises test from being met
the unrelated clients test was met, or could reasonably be expected to be met, but unusual circumstances prevented the 80% rule from being satisfied or
unusual circumstances prevented the unrelated clients test and 80% rule from being met.

Application of Part IVA of the ITAA 1936

The general anti-avoidance provisions of Part IVA of the ITAA 1936 may still apply to cases where the PSE is considered to be conducting a PSB and the PSI rules do not apply. The ATO may seek to apply Part IVA where there are factors indicating that the dominant purpose of the arrangement is to obtain a tax benefit by diverting, alienating or splitting an individual's PSI or retaining profits in the lower taxed PSB.

Tax ruling, TR 2022/3 outlines the ATO view on how this may be applied. It states that in deciding whether the PSB and test individual has engaged in income splitting to gain a tax benefit, the following considerations may be relevant:

whether the salary or wages paid to the test individual is commensurate with the skills exercised or services provided, and with the income received by the PSB for those services
whether the PSB distributes income to associates and does not distribute income to the test individual who provided the actual services, and
whether the salary or wages paid to associates by the sole trader or PSB is not commensurate with the skills exercised and services provided, and the income received by the sole trader or PSB is for services performed by the test individual.

An example of a situation where there may be income splitting to which Part IVA could apply would be where an independent contractor (conducting a PSB through an interposed entity) is paid less than the contracted price for their work and the profit made as a result of paying less than the contracted price is distributed to the contractor's relatives who are on a lower marginal tax rate or accumulated in the interposed entity and taxed at a lower marginal rate of tax

Examples from the ATO ruling

Example: Not personal services income - income from a business structure

Jim is an electrician who operates a partnership with his wife, Jane. Jane does not perform any of the electrical work but performs some of the administrative work. Jim undertakes the work required by clients and engages 3 full-time employees who undertake electrical work for him. The partnership owns 2 vans equipped with the necessary tools and equipment that are used by Jim and his employees. The partnership has generated goodwill, having a trade name and approximately 150 regular clients. The income is derived from the business structure of the partnership and is not PSI.

Example: Personal services income - not business structure

Chris, Adrian and Simon are accountants who provide their services as principals through CAS Accounting Firm; not as individuals, but rather in their capacity as trustees for their respective family trusts. A service entity, CAS Services, provides office accommodation, all staff requirements, IT equipment and other services as required for CAS Accounting Firm to operate. In the past 3 years, CAS Accounting Firm has established a wide customer base. Chris, Adrian and Simon each receive income from CAS Accounting Firm only in their capacity as trustees of their family trusts.

Applying the general guidelines for determining whether income from a practice company or trust is from a business structure, Chris, Adrian and Simon (as trustees) are principal practitioners. As CAS Accounting Firm has 3 principal practitioners (Chris, Adrian and Simon) and no other practitioners (principal or non-principal), the following various factors are applied to determine if the income is generated by a business structure:

Chris, Adrian and Simon operate a small firm.
The firm has established a wide customer base.
The services provided are accounting services that can only be provided by qualified accountants.
The accounting services provided by Chris, Adrian and Simon require a high level of knowledge and skill, as well as substantial training and qualifications.
The income-producing activities of the firm are dependent on the exercise of the personal skills, efforts and expertise of Chris, Adrian and Simon.

CAS Accounting Firm has established a wide customer base which suggests that it enjoys a measure of goodwill and its operations are quite extensive. On the other hand, it does not have substantial income-producing assets or employees, so its income is dependent upon the rendering of the personal skills of each of Chris, Adrian and Simon. The income of CAS Accounting Firm is therefore mainly derived from the personal efforts or skills of Chris, Adrian and Simon, rather than from a business structure. Chris, Adrian and Simon are considered to be test individuals and each has their own PSI to which they will have to separately apply the PSB tests to see if the PSI rules will apply.

Example: Not principal work - employment test not met

Glenn is a house builder, who provides building services as a sole trader. Glenn contracts with a major company to build houses. While Glenn does the physical building work, he pays his wife, Nan, to perform the tasks of contract administration, keeping track of costs, recording times worked, recording agreed or automatic variations and making progress payment claims on clients. Such contract administration activities are not part of Glenn's principal work, as they are not integral to and part of the principal work.

These types of activities are to be contrasted with work that is integral to and part of the principal work. For example, the work associated with building a brick wall includes the mixing of the sand and cement, the laying of the bricks and the cleaning of the brickwork. It would not include clerical or administrative activities.

As Glenn does not engage Nan to perform any principal work, he does not meet that element of the employment test.