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If you’re a self-employed professional, a freelancer, or operate through a small business, you’ve likely come across the term “PSI” – Personal Services Income. In Australia, PSI rules are designed to ensure that income is taxed appropriately when it’s earned primarily as a reward for your personal skills and efforts. In this article, we’ll break down what PSI is, why the regime exists, how it is determined, and what tests you need to be aware of if you’re running your own business. Let’s dive in and demystify the PSI regime together!
What Is Personal Services Income (PSI) in Australia?
Personal Services Income (PSI) is income that you earn as a result of your own personal skills, expertise, and efforts. Rather than being generated from a traditional business operation – where profit is made through a sale of goods or services independent of who provided them – PSI is typically received when you personally provide the service. Whether you’re operating as a freelancer or running a small business through a company, partnership, or trust, the PSI rules come into play if the majority of your income is a direct reward for your personal labour.
Simply put, if more than 50% of the income from a contract is for your personal input, that income is likely considered PSI. This means that even if you structure your business using a personal services entity (PSE), the income might still be treated as if it were earned by you directly. For more background on business structures, you might be interested in learning about operating as a sole trader and how it differs from other business forms.
Why Does the PSI Regime Exist?
The Australian Government introduced the PSI rules mainly to combat tax avoidance. By ensuring that income earned through your personal skills isn’t diverted to other entities to access lower tax rates or unjustified business deductions, the regime helps maintain fairness in the taxation system.
Under these rules, income that is determined to be PSI is taxed at your individual marginal rate rather than through the potentially lower company tax rate. This discourages individuals from using complex entity arrangements simply to reduce their tax liabilities. The Australian Taxation Office (ATO) provides extensive guidance on how the PSI rules work, giving you a solid resource if you need more detailed information.
How to Determine Whether Your Income Is PSI
The key feature of PSI is that it reflects payment primarily for your personal skills or efforts. In practice, if more than 50% of the income from a contract is attributable to your labour, then that income is classified as PSI. It doesn’t matter if the income is received through your personal services entity – the underlying principle remains the same.
This assessment is crucial because if your income qualifies as PSI, the tax treatment and allowable deductions are quite similar to that of an employee rather than a traditional business. With limited deductions available compared to a general business structure, it is particularly important to determine your PSI status accurately. Many professionals find it useful to consult a legal advisor to navigate these rules, so you’re not caught off guard during tax time.
How to Avoid PSI Rules Applying to Your Business
If you want to avoid PSI being applied to your income, you need to pass one of the Personal Services Business (PSB) tests. These tests are in place to demonstrate that your business operates in a way that is distinct from merely providing your personal labour. Let’s look at the four key tests one by one:
Results Test
To pass this test, you must show that:
- You are paid to achieve a specific result (rather than for your time).
- You supply the tools and equipment needed to complete the work.
- You are responsible for fixing defects in the work you deliver.
Example: A freelance web developer hired to build a complete website, using their own tools and responsible for fixing any bugs post-launch, is more likely to pass the Results Test than someone paid hourly to provide website support.
Unrelated Clients Test
This test is passed if you’ve earned income from two or more unrelated clients during the income year and sourced this work through advertising or public tenders.
Example: An IT consultant who secures work from multiple clients via LinkedIn outreach or a personal website would likely satisfy this test.
Employment Test
If you employ others to help deliver your services, you may pass this test. Specifically, if at least 20% of your principal work is outsourced, or you have an apprentice employed for at least six months, you may qualify.
Business Premises Test
This test focuses on whether you operate from a separate business location used exclusively for generating PSI.
Tip: Even a home office may qualify if it is clearly segregated and used only for your business activities.
What Happens If Your Income Is Classified As PSI?
If your income is classified as PSI, the tax implications can be significant. It will be taxed at your personal marginal tax rate instead of through a business structure. Plus, you can only claim deductions that would be available to an employee.
Examples of allowable deductions:
- Home office expenses (proportional)
- Work-related travel
- Professional indemnity insurance
You generally cannot split income among family members or claim large business deductions. If the ATO deems your PSI incorrectly declared, penalties may apply.
Service Entity Arrangements and Income Splitting
Many professionals use companies, partnerships or trusts to distribute income in a tax-effective way. However, if your income is considered PSI, these strategies may be restricted.
Even if you pass a PSB test, income splitting remains tightly controlled. The ATO closely examines these arrangements, particularly where they appear designed primarily for tax minimisation. Make sure your business model reflects genuine commercial operations.
Legal Tips for Structuring Your Business to Meet PSB Tests
To minimise the risk of PSI classification, it helps to structure your business in a way that demonstrates independence and scalability. Consider the following:
- Review and formalise client contracts – see our guide to contracts.
- Develop your terms and conditions to clarify deliverables and responsibilities.
- Use a freelancer or contractor agreement when engaging others to help you meet the Employment Test.
- If working from home, read our tips on starting a home-based business.
Compliance Tips and Best Practices for PSI
- Maintain records: Keep detailed documentation of client engagements, invoices, and project outcomes.
- Review contracts regularly: Ensure your agreements accurately reflect a business-to-business relationship, not an employment-like one.
- Monitor PSI risks annually: Re-assess whether you pass a PSB test each financial year.
- Get expert help: Consider a legal or accounting review before tax time to stay compliant.
Planning for the Future
Even if your income currently falls under PSI, that doesn’t mean it always will. As your business grows, your structure may evolve to pass one or more of the PSB tests.
Growth strategies to consider:
- Diversify your client base to satisfy the Unrelated Clients Test
- Hire or contract others to help you scale your services
- Set up a dedicated office or workspace to demonstrate separation from personal activity
Planning ahead helps you build a sustainable, scalable business that complies with the PSI regime and takes advantage of tax efficiencies where available.
Key Takeaways
- PSI applies when income is mainly earned from your personal efforts.
- It is taxed at your personal rate and restricts your ability to split income or claim business deductions.
- You can avoid PSI applying by passing one of the four PSB tests.
- Carefully structuring your business and contracts can help reduce PSI risks.
- Getting legal advice and staying on top of ATO guidance is critical.
Conclusion: Navigating PSI with Confidence
Understanding whether your income is PSI is key to managing your tax obligations and avoiding compliance issues. With the right business structure, legal documents, and planning, you can position your business for growth while staying compliant.
At Sprintlaw, we help small business owners and self-employed professionals build strong foundations—from setting up the right structure to drafting clear client agreements.
Need help navigating PSI or structuring your business? Get in touch with our team for a free, no-obligations consultation. Or call us on 1800 730 617 or email team@sprintlaw.com.au.
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