There are advantages and disadvantages of being self employed or a contractor. If you are self employed you have a much wider range of tax deductions available to you. For tax reasons many people would prefer to be self employed or a contractor, or to contrive things somehow so while in practice they are somebody's employee they are considered self employed for tax reasons.

There are disadvantages also. Employees get sick leave, workers compensation, superannuation and other perks. For this reason although your boss would prefer to call you a contractor it might be in your best interests really to call yourself an employee.

To stop people abusing the system in either direction, there are tests applied to see if you can classify yourself as a contractor or not.

To set yourself up in a partnership, company or other entity and then call yourself a contractor, even though for all intents and purposes you are an employee is called alienation of personal services income. You provide a personal service, you earn income from that personal service, and you try to have that money paid into a trust or company or something for tax reasons instead of to yourself - alienation of personal services income.

New rules designed to counter the alienation of personal services income started from 1 July 2000. Under this legislation earnings from work will be taxed in the same way for personal services income regardless of whether the income is earned directly by an individual or through a company or other entity. If caught by the new rules there will no longer be any point setting up a company or other entity in an attempt to get more tax deductions or to split or retain income if the income you are trying to alienate is just your income from your regular employment (this of course is not designed to affect investment income, you can still benefit from using a family trust or some other structure to control investments and genuine business income).

Where an individual is treated as having earned personal services income (PSI) there will be a limit on the type and amount of income tax deductions that can be claimed. In general, if you are found to be earning PSI you will be limited to the same tax deductions to which any employee would be entitled.

If you want to be able to claim the full range of tax deductions that a business operator is entitled to receive, you want to be classified as a personal services business. To be classified as a personal services business you need to pass any one of three tests:

• The unrelated clients test

• The employment test

• The business premises test

The unrelated clients test says that a business must provide services to two or more unrelated clients that are neither associated to each other or to you. The services must be available to the public at large or a section of the public.

Services offered through labour hire companies and other such businesses that arrange to provide services directly for clients do not pass this rule.

NB: For the purposes of this test, Government departments and agencies are not treated as associates of each other.

An 80% rule also applies to this, if 80% or more of your income comes from a single client you may need to seek a personal services determination.

The employment test means you must have at least one employee that carries out at least 20% of the market value of your work for the year. The actual wording is a little broader than this and refers to "entities" instead of employees.

One of the employees could be an apprentice.

The business premises test is about having a seperate premises from your residence that is used exclusively to produce your personal services income.

The wordings of these tests are a bit broader than I have put here, I am only trying to express the "gyst" of the rules, though there are a few little clauses and wordings that may change things a little for some specific taxpayers. I urge you of course to seek out a more authoritative source of information if the alienation rules may affect you and you lie in a grey area for these tests.

Personal services income (PSI) is payment that is received mainly for an individual's personal skills or effort. This does not include income that is payment for the receipt of goods or the use of an income producing asset.

For example a truck driver is paid for his truck, not for his driving as such. His income is not personal services income.

A fish breeder is paid for fish, not for his breeding skills. His income is not personal services income.

A backhoe operator is paid for the supply and use of the excavator and is not personal services income.

A computer programmer is paid for his skills in producing computer programs. A child minder is paid to provide a child minding service. Both of these would be considered personal services income and thus there is no point trying to hide behind a company, trust or partnership to call yourself a contractor, even if in some other sense you are a contractor (ie non-entitlement to leave etc).

Payments to others engaged to perform work are tax deductible, but if that person is an associate the other person being paid must perform a part of the principle work for which the contractor earns personal services income.

Principal work is work that is essential to generating the contractor's personal services income and is central to meeting obligations to the contractor's client. It excludes administrative work.

So if you are contracted to provide a personal service like computer programming, bricklaying or similar, you can't get your spouse (or any other associate) to do the invoicing or some other kind of administrative work and pay some of your income into their name, thus splitting the income and potentially reducing your total tax liability if he or she is in a lower tax bracket.

Where superannuation payments are made deductions can be claimed for contributions provided you satisfy the general deductibility rules for self-employed people.

Contributions made to an associate's super are deductible if they perform part of the principle work relating to the contractor's personal services income. These contributions are limited to the amount which satisfies your obligations with respect to the superannuation guarantee (ie 8% of ordinary time earnings in 2001-02).

If you do some personal services work from home and wish to claim expenses for this you are limited to the usual deductions available to an employee doing the same. This means you can only claim a portion of electricity and phone calls relating to using a room in your home as a home office or study. You can not claim a portion of rent, mortgage interest, rates or land tax as a deductible expense.