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PSI Income and Your Small Business: What You Need to Know

  • Small Business

Are you a small business owner, sole trader, or freelancer who earns income primarily from your personal skills and expertise? If so, understanding Personal Services Income (PSI) regulations and their impact on your tax obligations is crucial. In today’s fast-paced business world, getting to grips with PSI could open doors to tax benefits, helping you keep more of your hard-earned money in your pocket. So, are you ready to dive into the world of PSI and discover how it applies to your specific business structure?

In our latest article, the Shoebox team has put together a guide to help explore the ins and outs of PSI, what it means for tax obligations, and how it affects various business structures such as sole traders, companies, partnerships, and trusts. Keep on reading to check out how to use the PSI Decision Tool from the Australian Taxation Office to help you determine if your income falls under PSI rules. By the end of this blog post, you’ll have a solid understanding of PSI and how to navigate its complexities to ensure compliance and financial success.

Understanding Personal Services Income (PSI)

Is my income classified as personal services income or business income?

To determine if you are eligible for Personal Services Income (PSI), you need to evaluate the nature of the income you are receiving. If a considerable portion of the income from a contract is due to your personal labour, skills, or expertise, it may be classified as PSI.

In the context of PSI, it is also important to differentiate between a Personal Services Business (PSB) and a Personal Services Entity (PSE), as your tax obligations can be influenced based on these classifications. PSI rules apply to individuals, companies, partnerships, and trusts, including income that a personal services entity (PSE) gained.

Some common industries where PSI is typically received include:

  • Professional services
  • Information technology consultants
  • Engineers
  • Construction workers
  • Medical practitioners

It is essential to understand the difference between Personal Services Business (PSB) and Personal Services Entity (PSE), as well as how these classifications impact your tax obligations and the role of personal services business determination in this process.

Navigating tax classifications can sometimes feel like you’re lost in a maze, but don’t fret! We’re here to guide you through the differences between a Personal Services Business (PSB) and a Personal Services Entity (PSE) and how to identify PSI so you can fully grasp your tax opportunities and obligations.

Identifying PSI and non-PSI sources

Differentiating between PSI and non-PSI income sources is essential in accurately assessing your tax liabilities. PSI income is primarily derived from personal skills, expertise, or labour, while non-PSI income is obtained from other sources, like the sale of an item. For income to be classified as PSI, more than 50% of your income should come from the resources and time spent on specific skills, expertise or labour.

One of the key tests the Australian Taxation Office(ATO) uses to determine if your income is PSI is the Unrelated Clients Test, which focuses on the diversity of your client base over the financial year. For instance, if you are a freelance graphic designer who worked with five different clients this year, and no single client contributed to over 80% of your income, you would pass the Unrelated Clients Test.

Familiarising yourself with the criteria for PSI classification and wrapping your head around these rules can put you on a path to a smoother tax filing process, potentially saving you from unnecessary stress. We understand that this can seem a bit complex, but don’t worry — if you ever have a question about your business structure and tax, we are here to help guide you.

How PSI affects tax obligations

Personal Services Income (PSI) affects income tax obligations by applying specific rules and limitations on deductions, depending on the business structure and income source. If PSI rules apply, there are specific regulations in place to ensure the income is properly allocated to the person earning the income rather than being diverted to other individuals or entities. These rules can affect your deductions, income tax liability, and how PSI is reported in your income tax return. 

For example, if you’re a freelance photographer who bought a new camera to use in your business, understanding how PSI rules apply could affect whether or not you can claim the cost of the camera as a tax deduction. Failing to adhere to PSI rules can lead to penalties, but it can also allow you to claim additional deductions and reduce your overall tax burden. Comprehending the impact of PSI rules on tax obligations aids in ensuring compliance and avoiding potential penalties or complications with the ATO.

Personal Services Business (PSB) vs. Personal Services Entity (PSE)

So, what is the difference between a PSB and PSE? Well, distinguishing between a Personal Services Business (PSB) and a Personal Services Entity (PSE) is a critical step in understanding the finer points of PSI rules.

A PSB is a type of entity that has satisfied at least one of the four PSB tests within a given income year, which means the PSI rules do not apply to them. Understanding how an entity achieves PSB status is essential to ensuring you comply with regulatory standards. On the other hand, a PSE refers to the entity that is the recipient of personal services income and is, therefore, subject to the PSI rules. If you’re working as a sole trader or freelance, gaining a firm grasp of whether you operate as a PSB or PSE can provide a clear roadmap to assessing your tax obligations accurately.

Stay tuned as we delve further into the PSB tests and the role PSEs play in the PSI guidelines in the sections to follow.

The Impact of PSE on PSI Rules

Personal Services Entities (PSEs) are subject to PSI rules, which can restrict the amount of deductions they can claim and have specific implications on tax obligations. If you’re a small business owner, it’s crucial to understand how these rules impact the allocation of your income and expenses. 

Here’s a scenario to consider: In cases where various individuals are generating PSI through a different structure like a company, partnership, or trust (also known as a “personal services entity”), it is necessary for the entity to request a PSBD for every single person involved. Other regulations might also come into play. Specifically, the general anti-avoidance rules for income tax may apply under circumstances where the ATO perceives the primary aim of your business structure is to secure a tax benefit. Recognising the subtleties of PSI rules regarding PSEs can be pivotal in navigating your tax obligations effectively.

Navigating the PSI Rules: Key Tests and Requirements

A thorough understanding of the key tests and requirements, such as the Results Test and the 80% Rule, is necessary for effective navigation of PSI rules. These tests can help you determine whether your income falls under PSI rules and how it affects your tax obligations under normal tax rules.

In this section, we will explore the following tests that play a critical role in determining the applicability of PSI rules and their impact on your business and tax obligations:

  1. Employment Test
  2. Business Premises Test
  3. Results Test
  4. 80% Rule

Employment Test

The employment test looks at the nature of the work you perform and the circumstances under which you perform it. Essentially, if your work arrangement is similar to that of an employee, it’s likely that your income will be treated as PSI. Understanding this test helps in categorising your employment status appropriately, thus guiding you on how to manage your tax obligations.

Business Premises Test

This test assesses whether your business premises are distinct from your personal residence and any associated clients. The business premises should be used exclusively for work, showcasing a high level of business activity to the general public. Meeting the requirements of the business premises test means the PSI rules do not apply, giving you more freedom in your tax management.

Meeting the Results Test

The Results Test evaluates whether income is generated based on results achieved, which can impact PSI rules applicability. This test assesses the outcomes of an individual’s activities rather than the activities themselves. By meeting the criteria for the Results Test, the PSI rules will not apply.

The Results Test involves answering several questions, such as:

  • Whether payment is only due after the contracted result has been achieved
  • If it is incumbent upon you to provide the tools and equipment necessary to complete the work
  • Whether you are responsible for the costs of any flaws and are obligated to rectify any errors or flaws.

Understanding the 80% Rule

The 80% Rule states that if 80% or more of PSI comes from the same client or a client and their associate, PSI rules apply. This rule is crucial in determining whether your income is subject to PSI rules, and being aware of this rule and its consequences when assessing your income sources is important for tax compliance and determining how PSI rules apply to your specific situation.

Tax Deductions and PSI: What You Can and Can’t Claim

As a PSI earner, there are specific deductions that are and are not available to you. PSI rules often limit the types of deductions that can be claimed against PSI income, depending on the business structure and specific contracts. The rules surrounding these deductions depend heavily on whether over 50% of your income comes from your personal labour or skills. In this section, we will explore the constraints and sanctioned deductions for PSI-related expenses, offering insights into managing your tax obligations effectively and maximising your deductions within the PSI rules framework.

Restricted Deductions:

When over 50% of your income is derived from your personal skills or efforts, there are certain limitations on the deductions you can claim. Restricted deductions include:

  • Rent, mortgage interest, rates, or land tax for your home office
  • Certain travel and entertainment expenses
  • Capital expenses (large costs that improve the value of your asset)

Being familiar with these restrictions helps to avoid penalties and ensure you are compliant with PSI rules.

Permitted Deductions:

On the flip side, PSI earners can claim deductions for expenses directly connected to their PSI income like:

  • Advertising and marketing costs
  • Business-related travel (excluding certain restricted travel expenses)
  • Professional fees, and necessary business subscriptions

To navigate tax time seamlessly, it’s pivotal to differentiate between restricted and permitted deductions, making a note to document all your expenses meticulously to abide by PSI rules.

PSI Rules for Different Business Structures

A solid awareness of how PSI rules apply to various business structures is crucial for an accurate assessment of your tax obligations and a smooth navigation through the complexities of PSI regulations. In this section, we will discuss how PSI rules apply to:

  • Sole traders
  • Companies
  • Partnerships
  • Trusts

Sole traders and PSI

As a sole trader, you will find that the PSI rules apply directly to your individual income. While navigating PSI rules, you have to adhere to the limitations on deductions imposed on personal services income.

For instance, if you are a personal fitness trainer or yoga instructor operating as a sole trader, while you can claim deductions on the equipment used for client sessions, you cannot claim deductions on rent or mortgage interest for a home studio. Understanding these nuances can help streamline your tax management process, ensuring you claim only permissible deductions.

Companies, partnerships, and trusts

As we discussed earlier, companies, partnerships, and trusts must correctly attribute PSI to the individual responsible for earning it. This not only ensures compliance with PSI rules but also facilitates optimal tax management by enabling the correct individual to claim applicable deductions.

Imagine a scenario in a partnership where a single partner leads a substantial project. The income generated from this endeavour should rightly be attributed to them, opening up avenues for pertinent deductions during the tax season.

Navigating the complex landscape of PSI rules can be a tough nut to crack. Feel free to reach out to the team at Shoebox for professional guidance and to make tax management a breeze.

Using the ATO’s PSI Decision Tool

The ATO’s PSI Decision Tool is a valuable resource for determining if you have earned Personal Services Income (PSI) and how it affects your tax obligations. The tool is designed to assist individuals in ascertaining whether the PSI rules are applicable to them or not.

Before you start using the tool, ensure you have details such as the specifics of the services you provide, your business structure, and information about your clients at hand. Basic steps to use the tool include entering relevant details about your income and answering a series of questions to help determine your PSI status.

Using the ATO’s PSI Decision Tool offers the following benefits:

  • Allows for a quick and straightforward determination if your income falls under PSI rules
  • Offers valuable insights into the implications of your tax obligations
  • Helps you make informed decisions about your business operations
  • Ensures compliance with tax regulations.

Keep in mind that the tool is designed to give a preliminary understanding, and it’s always beneficial to consult with a professional for tailored advice. Navigating the complex world of Personal Services Income (PSI) can be challenging, but with the right knowledge and tools, you can effectively manage your tax obligations and ensure compliance with tax regulations. It’s all up to you now. With this guide, you can now confidently navigate the PSI rules and make informed decisions about your business operations. Remember to always consult with a tax professional for personalised advice and guidance, and keep up-to-date with the latest PSI rules and regulations to ensure your financial success.