Personal Service Income vs. Sole Trader Income: Key Differences

The tax season is stressful for everyone, but it’s especially so for the self-employed. Many Australian taxpayers find themselves grappling with the complexities of Australian taxation laws, trying to navigate the differences between personal services income (PSI) and sole trader income tax rules. 

This is why we’ve put together this comprehensive guide, which will demystify income taxes for freelancers and consultants. We’ll explore how PSI differs from sole trader income, what types of earnings are excluded from PSI, and how to navigate the PSI rules effectively. 

By the end of this article, you’ll have a clear understanding of PSI and be equipped with the knowledge to handle your taxes with confidence.

What is Personal Service Income (PSI)?

Personal Service Income (PSI) is a specific type of income recognised by the Australian Taxation Office (ATO); it is generated from an individual’s personal skills or efforts. This concept is crucial for many Australian taxpayers, particularly those working as contractors, consultants, or in professional services.

PSI is income that you earn primarily through your personal efforts or skills. This is in contrast to income earned by using certain types of equipment, selling goods, or employing others. For example, if you’re a freelance writer, graphic designer, or IT consultant working independently, you are likely earning PSI. 

It’s important to note that PSI is not limited to sole traders or independent contractors. You might also earn PSI through a company, partnership, or trust (known as a Personal Services Business, or PSB) 

You should clearly understand whether your income is classified as PSI because it affects how you report your earnings and the deductions you can claim. Essentially, PSI rules are closer to employee income, which can have significant implications for your tax planning and obligations.

Personal Services Income vs Sole Trader Income – what’s different?

Navigating the differences between PSI and sole trader income can be confusing. We’ve put together a table to help you clarify how your income is classified and the ways this impacts your tax obligations. 

A key difference lies in the tax treatment. PSI is subject to specific rules that may limit deductions and restrict income splitting, aiming to align the tax treatment more closely with that of an employee. Sole trader income, when not classified as PSI, is generally subject to standard business income rules, which often allow for a broader range of deductions and more flexibility in tax planning.

For example, if you are a freelance graphic designer working independently, your income would likely have to be classified as PSI. In this case, you may have limited ability to claim deductions for home office expenses or split income with a spouse. 

In contrast, if you are a sole trader running a retail store, your income wouldn’t typically be considered PSI. This would give you more flexibility to claim business-related tax deductions.

What income is not considered PSI?

PSI includes primarily income you might earn through personal efforts or skills. Meanwhile, the categories of income listed below are not considered PSI. 

Income from selling goods

If your business primarily sells goods rather than services, this income is generally not considered PSI. For example, revenue generated by a retail store or an online e-commerce business falls outside the PSI category.

Income from using equipment or assets

If you derive a substantial part of your income from using assets or equipment rather than personal services, it may not be classified as PSI. This could include income from renting out heavy machinery or vehicles.

Income from a team effort

When you generate income by working together with a team rather than using your own skills, it may not be considered PSI. For instance, a construction company with multiple employees working on projects would likely not have its income classified as PSI.

Passive Income

Income that doesn’t require active efforts, such as dividends from investments, rental income from properties, or interest from savings accounts, is not considered PSI.

Employment Income

If you receive regular salary or wages as an employee, then your income is not classified as PSI. PSI rules are designed for independent contractors and similar arrangements, not traditional employment relationships.

Income from High-Capital Businesses

Businesses that require significant capital investment and generate income primarily from this investment rather than personal services are generally not subject to PSI rules. This might include businesses like hotels or manufacturing facilities.

Commission-Based Sales

If you are a salesperson working on commission, your income is likely not PSI. This is especially true if you sell products rather than services. 

Classifying PSI and non-PSI components of your income can be complex. You might have one or both types of income, falling under different taxation rules. If you are unsure, it’s a good idea to get guidance from a tax professional or contact the ATO directly. 

How personal services income (PSI) rules apply

The ATO applies PSI rules to income classified as such. The first step is to determine whether your income is considered PSI or not. There are several tests and assessments you can use to do so. You need only pass one test for the PSI rules to not apply.

Income Test

The income test evaluates whether 50% or more of your income is used to produce a result, the income is likely PSI.

Unrelated Clients Test

The unrelated clients test checks if 80% or more of your business’s income comes from one client (or associates of that client) in an income year. If so, it is 

Employment Test

The employment test considers whether you engage others to perform at least 20% of the principal work.

Business Premises Test

The business premises test looks at whether you maintain and use business premises exclusively for personal services work.

If your situation meets the criteria for PSI, the next step is to determine whether you can be classified as a Personal Services Business (PSB). This is done through the Results Test or by obtaining a PSB determination from the ATO.

Results Test

The results test is a crucial factor in determining whether you’re operating a PSB. You are considered a PSB if: 

1. You’re paid to produce a specific result or outcome.
2. You provide the tools and equipment necessary to do the work (if applicable).
3. You’re liable for the cost of rectifying any defective work.

If you pass the results test, you’re considered to be operating a PSB, and the PSI rules don’t apply to your income. You can either self-assess or request the ATO to provide you with a status determination. 

What to do when the PSI Rules Apply

If the PSI rules apply to your income:

1. You must attribute the PSI to the individual who performed the work.
2. Certain deductions may be limited or disallowed, such as rent, mortgage interest, rates, and land tax for the individual’s residence.
3. You cannot split the PSI with other individuals or entities.
4. Superannuation contributions may be limited.

What to do when the PSI Rules Don’t Apply

If the PSI rules don’t apply (i.e., you’re operating a personal services business):

1. You can treat the income as ordinary business income.
2. You have more flexibility in claiming deductions.
3. You may have opportunities for income splitting or retention within a company structure.
4. Standard business tax rules apply, including the ability to claim a broader range of deductions.

It’s important to note that even if the PSI rules don’t apply, you still need to ensure you’re complying with other relevant tax laws and regulations. For this, you may need the help of a tax professional. 

How to report PSI on your tax return

It’s crucial that you correctly report PSI on your tax return to ensure ATO compliance. The process varies depending on your business structure. Here’s a general guide on how to report PSI; however, you may follow different steps depending on your unique situation. 

Step 1: Determine Your PSI Status

Before reporting, ensure you’ve correctly determined whether your income is PSI and whether you qualify as a personal services business.

Individual Reporting

• If you’re an individual (sole trader), report your PSI in the “Business and professional items” section of your individual tax return.
• Use the Business and professional items schedule to provide details of your income and expenses.
•  Ensure you only claim allowable deductions under the PSI rules.

Entity Reporting

• If your PSI is earned through a company, partnership, or trust, the entity must first attribute the income to the individual who performed the services.
• The entity reports the PSI on its tax return but cannot claim deductions for amounts attributed to individuals.
• The individual then reports the attributed amount on their personal tax return.

Step 2: PSI Worksheet

Complete the PSI worksheet. This helps you calculate the net PSI amount and determine which deductions you can claim.

Step 3: Separate PSI from Other Income

If you have both PSI and other types of business income, you need to separate these on your tax return. Report PSI separately from other business income.

Step 4: Record Keeping

Maintain detailed records of your PSI, including invoices, contracts, and expenses. Good record-keeping is essential for accurate reporting and potential ATO audits.

Step 5: Seek Professional Advice

Given the complexity of PSI rules, you may want to consult a tax professional to ensure you’re reporting correctly and maximising your allowable deductions.

Remember, the specific steps for reporting PSI can vary based on your individual circumstances and business structure. 

FAQ

What is the 80% rule for PSI?

The 80% rule for PSI states that if 80% or more of your personal services income comes from one client (or associates of that client) in an income year, you’re likely subject to the PSI rules. This rule helps determine whether your income is primarily from personal services or if you’re operating more like an independent business with multiple clients.

Is it better to be PSI or PSB?

In general, you are better off classified as a Personal Services Business (PSB) compared to PSI rules. This is because PSBs have more flexibility in claiming deductions and structuring their taxes. That said, the better classification depends on your specific circumstances. 

If you are unsure, consult a tax professional or ATO to help you determine your classification. 

Do sole traders earn personal services income?

If you are a sole trader, you might have personal services income, but not all sole trader income is necessarily PSI. It depends on the nature of the income and whether it’s primarily earned from the individual’s personal skills or efforts. If your income as a sole trader meets the PSI criteria, it will be subject to PSI rules. However, sole traders can also have non-PSI business income.

Final Thoughts

Navigating PSI rules can be complex, but understanding these rules is crucial for proper tax compliance. Whether you’re a freelancer, consultant, or running a small business, knowing how PSI applies to your income can help you make informed decisions about your business structure and tax planning.

Remember, while this guide provides a comprehensive overview, tax laws can be complex and subject to change. Always check the latest ATO information and, if necessary, chat with a tax specialist before making any tax-related decisions. 

If you’re looking for help managing your tax compliance, including PSI considerations, Lawpath offers a range of legal and business solutions. Visit Lawpath today to explore how we can support your business journey and help you navigate PSI intricacies with confidence.