Consultants and professionals often set up separate entities to run the businesses through. They choose either a trust, partnership or private company. The lower tax rate of a company is appealing, as is the potential to distribute income to a spouse in a lower tax bracket, rather than being subject to the top marginal tax rate as an individual high-income earner.
Running a business through such a structure can also lead to a wider range of deductions being available, depending on circumstances. So, to prevent taxpayers from paying their full share of tax there is set of rules in place for income derived in this way, which the tax law calls “personal services income”.
The personal services income (PSI) rules apply to income that is earned mainly from the personal efforts or skills of a person.
It does not matter whether the income is earned by the individual in their own name or through an entity such as a business. The rules do not apply to income earned from being an employee.
A business structure
This can be a confusing concept. It does not mean that you conduct a business through an entity such as a company or a trust.
The term “business structure” is used to define a business (operated through any structure) that is large enough for it to be concluded that the income of the business is not being earned from the individuals in the business. Rather, the income is being earned by the “business structure”. This can still apply to quite small businesses.
The results test
This is an important test. If you pass the test, the PSI rules do not apply to you. An individual passes the results test if in relation to at least 75% of the individual’s PSI:
- it is for producing a result, and
- the individual is required to supply the equipment or tools of trade needed to perform the work, and
- the individual is liable for rectifying any defect in the work.
Unrelated clients test
This test is passed if:
- the PSI is gained from providing services to two or more entities that are not associates, and
- the work has been gained by making invitations to the public or a section of the public.
Broadly, this test is passed if:
- one or more entities are engaged (other than associates) to perform work, and
- those entities perform at least 20% by market value of the principal work. The test is also passed if an apprentice is engaged for at least half the income year.
Business premises test
Broadly, this test is passed if business premises are maintained:
- at which the PSI is mainly gained, and
- of which there is exclusive use, and
- that are physically separate from premises the individual or associate uses for private purposes, and
- are physically separate from premises of customers or associates of customers.
Personal services determination
The ATO can give you a ruling that the PSI rules don’t apply to you in certain circumstances. For example, there could be “one-off” changes in your circumstances that cause you to fail the PSI tests. You can apply to the ATO to have the PSI rules ignored by the ATO. If the ATO rules in your favour, this is called a “personal services determination”.
Ariss and Commissioner of Taxation  AATA 2958
This recent case serves as a timely warning for consultants and other service providers who are splitting income with their family members.
All the income derived from an IT consultant’s skills, but split between the consultant and his wife, via a third party trust arrangement, was assessable to the consultant, as his ‘ordinary income’ and as ‘personal services income’.
The Taxpayer failed each of the personal services business (PSB) tests. Accordingly, the Tribunal concluded that the Taxpayer was not carrying on a PSB and the fees paid to the Trustee were assessable directly to the Taxpayer as PSI.
The Tribunal considered that the taxpayer was carrying on a business as a ‘sole trader’, using his own intellect, skills and expert knowledge.
This case is a reminder of the importance of seeking appropriate advice when it comes to business structuring, and ensuring that the substance of your ongoing activities align with your tax planning.
Ariss raised the question of whether trust distributions are ordinary income and/or personal services income, and also:
– whether Part IVA applies to a tax-avoidance scheme
– the entitlement to certain tax deductions
– entitlement to deductions for income attributed to spouse
– whether deductions for payments to a related person are an unreasonable amount
– entitlement to deductions for payments made to an associate
– entitlement to deductions for personal superannuation contributions
– entitlement to tax deduction for travel expenses that were reimbursed
– whether the opportunity is lost to amend assessments which are ‘out of time’
– limited amendment period
– whether there is a beneficiary under a trust
– whether any person entered into or carried out a scheme for the sole or dominant purpose of the individual obtaining a scheme benefit
How we can help you decide if the PSI rules apply
The ATO have a PSI Decision Tool on their website. However, the information required can be confusing.
To answer the questions in the PSI decision tool you may need:
• details of contracts or written agreements with your business’s customers during the income year
• invoices from work performed during the income year
• records of payments to any employees or subcontractors.
After answering a series of questions, the tool will produces a report with:
• guidance on whether your income is PSI and if the PSI rules apply to you
• a summary of the responses you have provided
• information about what your result means for your tax obligations.
This information is only general in nature; it does not take into account your personal or business situation or objectives; it is not intended to replace professional advice and should not be acted upon. For professional advice based on your individual circumstances, please do not hesitate to contact us.