One of the most commonly-asked questions in our discussions with professional consultants and small business owners is the definition of employees v. contractors from a tax law perspective.
This conversation is often had with clients who want to minimise their tax and are thinking of earning their income through a company structure (to limit their tax rate to 30%) or splitting their income via a trust to their spouse.
The key thing to consider is whether you are legitimately running a business as a contractor, or are simply an employee. Whether you are considered an employee or contractor under the taxation laws has nothing to do with what your employer calls you. You may be a contractor in your employer’s eyes, but considered an employee under the tax laws. This area of tax law is known as “Personal Services Income”.
Personal services income is income that rewards an individual for their efforts or skills. This could be salary and wages – for example, the income of a doctor, lawyer or accountant, or consultant.
Alienation of personal services income occurs where an individual interposes an entity between their source of income and that individual. This could be either a company or a trust. To be excluded from the application of the personal services income rules, the entity must be classified as a “Personal Services Business” and to do this, there are several tests that must be met.
The primary test: source of income
The first test is to determine the source of the income. There should be no issue if your income is being derived from many different sources, such as with a consultant working for many different clients and invoicing them all directly. Having no more than 79% of income derived from one source should be sufficient to provide immunity from personal services income rules.
Next-level tests: results; business premises; unrelated clients; employment of others
If 80% or more of income is being derived from one source, then the entity must satisfy at least one of these next-level tests to qualify as a personal services business: the results test, the unrelated clients test, the employment test, or the business premises test. These tests are explained as follows:
- The Results Test is satisfied if for at least 75% of income during the year, the income is for producing a result; the individual supplies their own tools of trade; and the individual is liable for the cost of rectifying and defect in the work performed.
- The Business Premises Test is satisfied if the taxpayer maintains a business premise that is separate from their private residence, is used exclusively for business purposes, and is the place where activities are conducted from which the income is gained.
- The Unrelated Clients Test is satisfied if the individual provides services to two or more entities that are not associates of each other, and the services are advertised to the public at large.
- The Employment Test is satisfied if the individual employs one or more persons or entities to perform the work and those persons or entities together perform at least 20% of the work for that income year.
Need more help to know where you stand?
Whilst this is a summary of the main rules and tests applied to the classification of a personal services business, each business must be looked at in-depth to determine its eligibility as there are many variables to the rules. The avoidance of tax, and the application of Part IVA of the Act, has a big role to play in this area and so taxpayers must be certain of their affairs. It can be quite tempting to incorporate, or pay a spouse, and so pay less tax but the consequences if the rules are not met can be disastrous for a taxpayer.
At Billings and Ellis, we have been dealing with these issues for a large number of clients and we can assist you with structuring your affairs so as to minimise your tax legitimately.