Income splitting has historically been used by professionals and small business owners as a way to manage their tax.
The ATO have highlighted that they will be cracking down on misuse of Income Splitting and Personal Services Income (PSI).
Income splitting generally involves directing income that would normally be paid to an individual into a company or trust. From there, the income can be distributed to other parties, such as family members.
The motivation is to take advantage of lower marginal tax rates. However, where certain criteria aren’t met, the ATO may consider this tax avoidance.
Last year, the ATO released new Practical Compliance Guidelines regarding Income Splitting which clarifies what is acceptable and what could trigger compliance action.
PSI & PSB
Personal Services Income (PSI)
Personal Services Income (PSI) is income that is generated from an individual’s personal effort, skills or expertise, rather than from selling goods or leveraging assets.
It is commonly earned by contractors and professionals such as:
- Engineers
- IT Specialists
- Lawyers
- Accountants
- Doctors
If the ATO determines income is PSI, it will generally be taxed to the individual who earned it, even if it is paid through a company, trust or partnership. Diverting that income to others to reduce tax can be treated as tax avoidance, with penalties applying.
Personal Services Business (PSB)
A Personal Services Business (PSB) is an exception to the PSI rules. If you meet certain criteria that demonstrate you are operating a genuine business, rather than simply structuring your labour income through an entity, the PSI rules won’t apply.
To qualify as a PSB, you must meet one or more of the following tests:
- You are paid to achieve a specific result, supply your own tools, and fix defects at your own cost.
- You earn PSI from two or more unrelated clients.
- You employ or contract others to perform at least 20% of the principal work, or have one or more full-time equivalent employees (excluding admin staff) for a significant part of the year.
- You operate from separate business premises (not your home or a client’s premises).
Meeting these criteria helps demonstrate that you’re running a legitimate business, not just redirecting income to minimise tax.
Even if an arrangement technically complies with the legislation, the ATO can still apply anti-avoidance provisions under Part IVA of the Income Tax Assessment Act 1936. This gives the ATO the power to cancel tax benefits where a scheme is entered into primarily to obtain a tax advantage.
Historically, there has been uncertainty about when Part IVA would be applied to income splitting arrangements, particularly in family business scenarios, such as where a spouse performs administration or bookkeeping duties.
The new Practical Compliance Guidelines aims to provide greater clarity by outlining low-risk and high-risk arrangements.
Low risk vs high risk arrangements
Low risk
- Income is taxed to the individual who earned it.
- You are appropriately compensated for your work.
- Family members are paid fairly for genuine work performed.
- Profits retained in the business are for legitimate commercial purposes.
Low-risk example
A contractor engineer operates through a company. They earn income from multiple unrelated clients, pay themselves a commercial salary, and retain profits only for genuine business reasons. All income is ultimately taxed to them, and they meet the PSB tests. This is considered low risk.
High risk
- Income is distributed to individuals who did not earn it.
- You underpay yourself while profits accumulate without a clear business reason.
- Family members receive substantial payments for minimal involvement.
- Business profits are retained but used for personal purposes (e.g. private borrowing).
High-risk example
An IT consultant operates via a discretionary trust. They take a small personal income, leave significant profits in the trust, and distribute income to family members who did not perform the work. This diverts PSI away from the person who earned it and is considered high risk.
The ATO has confirmed that taxpayers will have until 30 June 2027 to transition to a low-risk arrangement without facing retrospective compliance action. After that date, normal compliance rules apply. The ATO can review prior years, amend assessments, and impose penalties where inappropriate income splitting occurred.
How to reduce your risk:
1. Assess your current structure
Engage with your advisor to review your arrangements against the new Practical Compliance Guidelines. Ensure you fall clearly within the low-risk zone, including any distributions to a spouse or family member.
2. Maintain clear documentation
If profits are retained in a company or trust, keep up-to-date documentation explaining why. With advanced data-matching tools and AI-driven compliance systems, the ATO is better equipped than ever to identify red flags. Assuming you will go unnoticed is no longer a safe strategy.
The ATO’s updated guidance signals a clear intention to tighten oversight of income splitting arrangements. If you’re unsure whether the new guideline affects you, or whether your structure could be viewed as high risk, now is the time to review your arrangements and take action if necessary.