On 28 August 2024 the Australian Tax Office (ATO) released a draft guideline (PCG 2024/D2) that could change the way small businesses handle personal services income (PSI). If you run your business through a company or trust and provide services yourself, this is something you need to know about. It’s important to understand how the ATO sees your income arrangements, so you can avoid being flagged for review.
What Is Personal Services Income (PSI) and the PSI Rules?
PSI is income you earn mainly from your personal efforts or skills. If you’re a consultant, contractor, or similar professional, your income is likely considered PSI. The “PSI rules” came into existence on 1 July 2000 and set out how this PSI should be taxed, especially if you run it through a personal services entity (PSE) like a company or trust.
The ATO uses these rules to determine if your PSI should be attributed directly to you or if it can stay within your business entity. If your business qualifies as a personal services business (PSB), the PSI rules don’t apply, but the new draft guideline (PCG 2024/D2) clarifies that the ATO may still look into your tax arrangements under Part IVA (anti-avoidance rules).
Low-Risk vs. Higher-Risk Arrangements
The ATO is concerned about businesses that use income-splitting or profit-retention strategies to reduce their tax bills. Based on this, the ATO will categorize businesses into two types of risk: low-risk and higher-risk.
- Low-Risk Arrangements: If the income from your business is mostly paid to you as salary and taxed at your personal rate, you are considered low risk. For example, paying yourself a fair salary for the work you do, rather than paying family members or keeping profits inside the business, is seen as low risk. The ATO is less likely to review low-risk businesses.
- Higher-Risk Arrangements: If you’re splitting income with family members or keeping profits inside the business without a good reason, the ATO could see this as a red flag. Businesses doing this may face more scrutiny. For example, if you’re paying your spouse or children who don’t actually work for the business, or you’re holding profits in the company to pay the lower company tax rate without a reasonable reason, you’re considered higher risk.
What This Means for You
Even if your business qualifies as a PSB under the PSI rules, the ATO can still apply Part IVA anti-avoidance rules if it believes your arrangement is designed to reduce your tax unfairly.
For small businesses, this means reviewing your tax arrangements to ensure they’re in line with ATO expectations. Here’s what you should focus on:
- Pay Yourself a Fair Salary: Make sure the income you take from your business reflects the work you do. This reduces the risk of being flagged for review.
- Avoid Unnecessary Income Splitting: If you’re sharing profits with family members who don’t contribute to the business, this could attract attention from the ATO.
- Don’t Retain Profits Without a Good Reason: If you’re holding profits in the business, there needs to be a legitimate business reason—like purchasing equipment or expanding services. The ATO may question retained profits if there’s no clear purpose.
Keep Good Records
One of the best ways to protect your business from ATO scrutiny is to maintain proper records. This includes contracts, invoices, payment schedules, and detailed records of any income and expenses. If the ATO asks questions, having everything clearly documented will help show that your arrangements are legitimate.
Why It Matters
Getting flagged by the ATO for a tax review can be costly, time-consuming, and stressful. If the ATO finds that your income arrangements are designed to avoid tax, you could face penalties and have to pay back taxes.
But don’t panic—most small businesses will not face any issues as long as they follow the basic rules. The key is to keep things simple, fair, and well-documented.
What You Should Do Next
If you think your business might fall into the higher-risk category, it’s a good idea to talk to your client manager now. They can help you make sure your arrangements are compliant and give you peace of mind. If you want to review the Guideline yourself you can find it here.
Remember, the ATO’s draft guideline is not final yet, but it’s always better to be prepared. We will provide an update on the Draft Guideline as it becomes final.
Author: Darren O’Malley
*Correct as of 26 September 2024
*Disclaimer – Kreston Stanley Williamson has produced this article to serve its clients and associates. The information contained in the article is of general comment only and is not intended to be advice on any particular matter. Before acting on any areas in this article, you must seek advice about your circumstances. Liability is limited by a scheme approved under professional standards legislation.
