Transform Your Tax Strategy: PSI to PSB Explained
If you’re like most people, the concept of Personal Services Income (PSI) might feel like it’s shrouded in mystery. But understanding PSI is essential, especially if you’re self-employed and your work primarily involves your personal skills or you’re building your own business. So, let’s break down what PSI is and how it affects you.
Before all else, let’s get a clear idea of what Personal Services Income is.
Simply put, PSI is a term the Australian Tax Office (ATO) uses to describe income earned through your personal skills, knowledge, or efforts. It’s the money you make directly from the work you perform yourself, rather than from selling goods or investments.
Income is classified as PSI if more than 50% of what you earn from a contract is a direct reward for your personal efforts or skills.
PSI can apply across various industries and professions, including –
Professional services (e.g., consultants)
Information technology (e.g., IT specialists)
Engineering
Construction trades
Medical practitioners
Why does the PSI rule exist?
The main reason behind the Personal Services Income rule is to prevent individuals from using complex business structures to reduce their tax burden. Essentially, the ATO wants to ensure a level playing field, where everyone pays the correct amount of tax on income earned from their personal skills.
Let’s say you’re a graphic designer working directly with clients, and you earn $100,000 in a year. Normally, this income would be taxed at your personal income tax rate.
However, some individuals set up a company or trust and direct the earnings there instead. In this case, if the company earns the $100,000, it might be taxed at a lower company tax rate. The individual could then pay themselves a smaller salary (subject to less tax) and leave the rest of the money in the company, effectively reducing their overall tax liability.
The ATO created the PSI rules to close this loophole. By ensuring that income derived from personal skills is taxed as personal income, the ATO prevents individuals from using business structures to avoid paying their fair share of tax.
How does the PSI rule affect you?
If you’re a freelancer, contractor, or consultant, the PSI rules could have a significant impact on how your income is taxed. Here’s how it works –
Imagine you’re a consultant who gets paid primarily for your personal advice or services. Instead of receiving payments directly, you set up a company, like “Ashley’s Consulting Co,” to collect the income.
The ATO looks at this arrangement and says, “Hold on, the clients are paying for your expertise, not the company’s.” In this case, the ATO may classify this income as PSI, meaning it needs to be declared as personal income on your tax return, regardless of the business structure used.
If your income is classified as PSI, you face certain tax restrictions:
You can’t claim expenses like rent for a home office or payments to an associate (such as paying a spouse for admin tasks).
The income must be reported as personal income by the person who performed the work, so you can’t split the income with other entities (like a spouse, trust, or company).
To avoid these restrictions, you’ll need to qualify as a Personal Services Business (PSB).
What is a Personal Services Business (PSB)?
A Personal Services Business (PSB) is a status that a sole trader or a personal services entity (like a company or trust) can qualify for to bypass certain restrictive tax rules associated with Personal Services Income.
Why apply for PSB status?
If you qualify as a PSB, you’ll —
1. Have freedom to claim business deductions.
If you qualify as a PSB, you can claim a broader range of business expenses, such as travel, advertising, and home office costs. Without PSB status, the PSI rules limit your deductions because they treat your income similarly to a regular employee’s salary, restricting your ability to write off many business-related expenses.
2. Have flexibility in income distribution.
As a PSB, you can structure your business as a company, trust, or partnership and distribute income to other shareholders or beneficiaries. This allows for tax planning by spreading income across multiple entities. Without PSB status, income must be attributed to the individual who performed the work, preventing you from splitting the income for tax benefits.
3. Avoid attribution rules.
PSB status helps you avoid the ATO’s special ‘attribution rules,’ which require PSI to be taxed in the hands of the person who provided the service. These rules prevent income splitting and limit deductions. Being recognized as a PSB means you’re treated more like a business, giving you greater control over how income is handled and reported.
4. Enhance your business credibility.
Qualifying as a PSB demonstrates that you’re genuinely running a business rather than acting as an employee under a business structure. It signals to clients and the ATO that you meet criteria like working with multiple clients and operating independently.
5. Have more flexibility in retirement contributions.
As a PSB, you have the option to make superannuation contributions through your business entity, offering more flexibility and potential tax benefits when saving for retirement.
When you earn PSI, you need to determine whether you qualify as a PSB.
If you do, you’re exempt from the PSI rules, allowing you to claim broader business deductions and structure your income in more tax-efficient ways.
If you don’t qualify, the PSI rules will apply, limiting your deductions and requiring the income to be taxed as personal income.
How do you qualify for PSB status?
One – Results Test
This is the main way to check if you’re a PSB. You pass the test if your income is based on achieving a specific result (not just hours worked), and you provide your own tools/equipment for the job. Plus, if there’s a mistake, you would be the one fixing it at your own cost.
Two – 80% Rule
If you don’t pass the results test, you can still qualify if less than 80% of your income comes from a single client or its related entities. This helps show that you’re working with multiple clients, not just one employer-like relationship.
Three – Other PSB Tests
Unrelated Clients Test: You have multiple clients who are not connected to each other, showing a diversified client base.
Employment Test: You hire other people to help you complete your work.
Business Premises Test: You have a separate office or workspace specifically for your business activities.
What if you don’t have PSB status?
If you can’t self-assess as a PSB, you might apply for a special determination from the ATO, called a PSB Determination (PSBD), to still get the PSB status for that income year.
If you don’t have a PSBD, the PSI rules will apply, meaning you can’t claim certain business deductions.
Additionally, the income is considered your personal income, and you can’t split it with other entities (like a company or trust).
Why should you care about PSI?
The PSI rules mean you –
One: Can’t use your company or trust to pay less tax on income you earned by yourself.
Two: Must include that income on your personal tax return, possibly paying a higher tax rate than if it stayed in the company.
At its core, PSI is about keeping the playing field level. It ensures that those earning from their personal skills aren’t simply funnelling income through a company to dodge higher taxes. Instead, it’s taxed as if it’s coming directly to you — because it is.
If you’re grappling with PSI rules or finding your footing as you transition to self-employment, don’t leave your taxes to chance. The right tax strategy can make all the difference in your financial future. Reach out to us at FRE.DM Wealth. With Michaela Rankin’s extensive experience in Australian taxation, we’ll help you navigate these complexities with confidence, ensuring you’re not just compliant but making the most of every financial opportunity. We’ll guide you to a future of financial abundance — taxed right, from the start.
Your journey to wealth starts with the right foundation, and we’re here to help you build it.
