Lee Sharpe looks at the common conundrum of choosing between typical vehicles for property investors.
This article looks at the key features of evaluating the choice between running a property business personally or through a limited liability company. The article covers general considerations only, and any individual should get advice from a competent professional, tailored to their specific circumstances.
Note in particular that the significant tax hurdles when incorporating a pre-existing letting business have been deliberately ignored, as they are a topic in themselves.
Profit extraction and the double tax charge
The perennial problem with putting a business into a corporate wrapper is that the company is taxed first and then the individual is (usually) taxed when he or she wants to get some of those corporate profits into his or her own bank account. This is commonly referred to as the ‘double tax charge’ and it can apply to capital gains as well as to income profits.
Many readers will be aware that trading businesses used to enjoy a potentially quite significant advantage in terms of tax efficiency – despite the double tax charge – when comparing limited companies to sole traders or similar. One of the key considerations was that a sole trader would be subject to Class 4 National Insurance contributions (NICs), which made profits in a sole trade relatively expensive.
Property investors, however, had no exposure to self-employed NICs, so the argument in favour of incorporating a property business into a limited company wrapper simply did not fly from an NICs perspective. This worsened following the reform of dividend taxation from April 2016. But the imposition of the restriction on finance costs for residential lettings opened up a significant potential tax saving, basically because the restriction does not apply to interest paid by companies.
Example 1: No mortgage interest
Joanne has a long-established property business that yields £45,000 profit annually, with no mortgage costs. Her landlord friends are all incorporating, so she asks her tax adviser whether or not she should, too. Joanne has no other income.
PersonalCompany
£ £
Personal/corporate profit 45,000 45,000
Income tax on profit( 6,500)
Corporation tax on profit( 6,897)
Income tax on salary/dividend( 1,770)
38,500 36,333
Cost of incorporation: 2,167
Her tax adviser explains that, while she can extract around £725 a month in salary from her company tax-free, this does not make up for the fact that the company has to pay corporation tax at 19% on everything else, and then she will have to pay further income tax on dividends to get out the rest of the post-tax profits in the company. This double tax charge makes holding her property business much less attractive through a company.
The above example assumes 2020/21 rates and allowances (which may yet be further updated at the time of writing), a salary of £8,700, and that all net profits are paid out as dividends. Taking more as salary rapidly becomes more expensive: theoretically, Joanne could take out as much as £40,600 in gross salary but the resulting combination of corporation tax, income tax, and employers’ and employees’ NICs would make her about £7,200 worse off under the corporate route.
Example 2: Mortgage interest
Johan has a relatively ‘young’ property portfolio, which is, therefore, quite highly geared. He also has net profits of £45,000 a year but this is after £30,000 of mortgage interest has been paid. His tax adviser explains that, by 2020/21, he will be deemed to be making rental profits of £75,000, pushing him well into the higher rate tax threshold. His tax adviser makes the following comparison:
PersonalCompany
£ £
Personal/corporate profit 45,000 45,000
Add back: interest cost 30,000
Deemed profit for
Income tax only: 75,000
Income tax on profit( 11,500)
Corporation tax on profit( 6,987)
Income tax on salary/dividend( 1,770)
33,500 36,333
Benefit of incorporation: 2,833
Clearly, the restriction of tax relief on mortgage interest is making a huge difference to the net result: without mortgage costs, incorporation is expensive; but with mortgage costs the same corporate outcome is relatively cheap because staying as a sole proprietor becomes so much more expensive.
Other factors on profit extraction
Real-life scenarios tend to be more complicated because landlords often have other sources of income, and it is not always possible to compare ‘like with like’; – the most common issue being that a company may have to pay higher interest rates than an equivalent business owned directly.
However, if a person has sufficient other income that he or she can afford not to have to extract all available profits every year, he or she will not then need to incur the second of the double tax charge. This will allow profits to roll up relatively cheaply in the company, perhaps to fund further business growth or perhaps to accumulate profits until the owner retires and can take income out of the company more tax-efficiently. Paying out accumulated reserves over many years post-retirement, as a kind of pension, is reasonably commonplace.
Wider considerations
The double tax charge also applies for CGT purposes. Residential lettings held personally will, of course, attract capital gains tax (CGT) at as much as 28%. But corporate capital gains are taxed at only the standard rate of 19%, and liquidating the company will cost only 20% CGT (the shares themselves are not residential property).
As things stand at the time of writing (i.e. in 2019/20), a person liquidating a property business they own directly will recover 72% of the gain after CGT, while liquidating a property investment company will yield around 65% after CGT. Of course, the importance of this differential depends on how the value of the property has increased – how much of the proceeds on sale derive from capital gains.
Certainly, in terms of moving wealth between individuals, it would generally be considered more straightforward to transfer a few shares in a company that owns (say) a dozen properties, than to transfer (for example) a 10% stake in a dozen properties owned personally. It may be possible to make good use of the CGT annual exemption when transferring relatively small shareholdings repeatedly over the course of several years and this could, in turn, accumulate to a quite substantial reduction in one’s inheritance tax exposure, given sufficient time and assuming the donor survives what would, in most cases, be a potentially exempt transfer (with a seven-year ‘window’ for making gifts between individuals, such as where transferring wealth to one’s sons or daughters).
Where an individual already has a trading business or similar and is registered for VAT, it may well be better to run the property business through a separate legal entity, to avoid problems with partial VAT exemption (although where rental incomes are relatively modest, it may actually be beneficial to take advantage of the de minimis thresholds in the partial exemption regime to improve overall VAT recovery). This is on the basis that most letting businesses are wholly exempt for VAT purposes, although commercial property lettings (and B&B or holiday lettings) may be treated differently. In particular, individuals who participate in the VAT flat rate scheme should beware that HMRC expects them to account for the flat rate on their letting income, even though the letting itself may be wholly exempt.
One area where corporate landlords need to be particularly careful is in relation to the annual tax on enveloped dwellings (ATED). ATED applies only to dwellings that are worth more than £500,000 and it is possible to claim relief where such dwellings are used in a rental business, but the relief must actually be claimed each year and does not apply where the property is let to a relative or to anyone ‘connected’ with the company – even if the letting is on an arm’s length basis.
Conclusion
The ongoing net income after tax will be a key consideration in the minds of most landlords. The above examples illustrate what some landlords still seem not to have realised; adding back mortgage interest is going to make some landlords into higher rate taxpayers even if their economic profits are comfortably below the higher rate threshold. But it is not so simple as to say that only all property businesses with mortgage interest should incorporate and, while the above paragraphs set out some of the basic issues to consider, advice tailored to a landlord’s specific circumstances is essential.
