Think you have your taxes under control? You might want to think again. If you are a sole trader, freelancer, or contractor, there is a good chance your income falls under Personal Services Income (PSI) rather than Business Income.
This distinction could mean the difference between keeping more of your hard-earned money or handing it over to the ATO.
Confused? You’re not alone. Many Australians assume that as long as they lodge their tax return on time, everything’s fine. But in reality, getting your income classification wrong can cost you thousands in missed deductions or extra taxes.
Sound overwhelming? Don’t stress. Let’s walk through it step by step.
What Is Personal Services Income (PSI)?
Let’s paint a picture. Say you’re a consultant, graphic designer, or tradie. Most of your income comes directly from your skills, knowledge, or labour. That is Personal Services Income, i.e., money you earn because of you, not because of assets, employees, or a larger business structure.
The Australian Taxation Office (ATO) uses specific tests—like the results test and the employment test—to decide if your income counts as PSI. If you’re working mainly for one client and using their tools or systems, chances are you’re dealing with PSI.
What Is Business Income?
Now, imagine you have a bakery. You hired a team, set up shop, and your revenue comes from selling bread and cakes. That is Business Income, i.e., money earned from operating a business, not just from your personal efforts.
Business Income often involves:
- Selling goods or services.
- Using assets or equipment.
- Having employees or subcontractors.
- Operating from a business location.
In short, it is less about you and more about the business as an entity.
Why Does the Distinction Matter?
The classification of your income has big implications for:
Tax Rates – PSI might limit your ability to claim certain business deductions.
Deductions – Business income allows you to claim a broader range of deductions, like expenses for employees, machinery, or renting premises.
Legal Structure – PSI rules may push you to rethink how your business is set up.
Question for you: Are you leaving money on the table because you’re unclear about your classification?
Misconceptions About PSI
“PSI only applies to professionals with fancy degrees.”
PSI covers everything from tradies to freelance photographers. If your income is mainly from personal effort, it could be PSI.
“The ATO rules are impossible to follow.”
While they can feel overwhelming, the ATO provides clear guidance, and a good accountant can help you understand them.
Examples
Let’s look at two scenarios to see how this plays out:
Scenario 1: The Freelance Graphic Designer
You work from home, have one main client, and use their software. Almost all your income comes from your personal design skills. In this case, your income would likely fall under PSI, limiting your deductions (e.g., you can’t claim a deduction for a swanky new home office).
Scenario 2: The Web Design Agency Owner
You have a team of developers, multiple clients, and your income comes from selling website packages. Here, your income is classified as Business Income, allowing you to claim deductions for employee wages, office space, and more.
Tips to Get It Right
Understand the Tests – The ATO’s PSI tests (like the results test) can help you figure out your classification.
Document Everything – Keep track of how your income is earned. This makes it easier to justify deductions and avoid ATO scrutiny.
Seek Professional Advice – An accountant who knows the ins and outs of PSI and Business Income is worth their weight in gold.
What Happens If You Ignore This?
You might think, “This doesn’t apply to me,” but ignoring your classification could mean:
- Overpaying taxes.
- Facing penalties for misclassification.
- Missing out on deductions you’re entitled to claim.
Don’t wait until tax time to figure this out—get on top of it now.
Wrapping It Up
Your income isn’t just numbers on a tax return—it represents your hard work, dedication, and expertise. By taking the time to understand whether you’re earning PSI or Business Income, you’re setting yourself up for success. It’s about more than just avoiding penalties; it’s about keeping more of what you earn and putting it to good use for your future.
So, take control. Consult a tax professional, clarify your income type, and put yourself in the best position to succeed. Your business deserves a solid foundation, and you deserve peace of mind knowing you’re making the right financial choices.
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