What is the 80/20 rule for contractors?

The 80/20 rule means that most traditional pty limited company contractors will be assessed as being a PAYG employee. This removes the traditional full benefits of an umbrella company: using a low salary, expenses and dividends to reduce their tax burden. The financial ramifications are significant as it can reduce net retention by 10-20% depending on circumstances.

There is a Personal Services Business Self Assessment Checklist on the ATO website to work out if the 80/20 rule applies. But the simple explanation is that if you only work for one client during a tax year then you will be assessed as a Personal Services Business and the PSI (Personal Services Income) rules will apply.

In actual definition the rule states you need to earn 80% or more of your income from one client during a tax year. For the typical contractor this means you'll be assessed as PSI if you work more than 176 days for any one client (assuming you do the standard total of 220 billable days a year and that your billable rate is the same throughout).

How to reduce Australian tax under 80/20 rule

The main effect of the legislation is it removes the attractiveness of a personal pty ltd company for contractors. Running a limited company involves a significant amount of administration and carries heavy obligations if the taxes or accounts aren't filed on time and correctly. These reporting obligations are increased with the Personal Services Income rules whilst also dramatically limiting the allowable expense deductions. This leaves two other options for payment - PAYG and umbrella companies.

Having contractors paid through Pay As You Go was the Australian governments preferred outcome with the "Alienation of Personal Services Income Act 2000". It requires the least administration of any solution, but it also results in the highest levels of taxation. As a PAYG contractor you really get the worst of both worlds - you are taxed like a permanent employee but receive none of the associated benefits like sick leave, holiday pay, training and development, etc.

Being paid through an umbrella company offers a number of benefits. The best Australian umbrella companies have professional assessors who can advise whether the 80/20 ruling applies. Even if it does, they will enable contractors to process a degree of expenses and utilise salary sacrifice on common purchases like cars and laptops to reduce the tax burden. They make the administration exceptionally easy by handling all aspects of invoicing, payment and tax reporting. The contractors only responsibility is to send in their timesheets.