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Case Study 5 – Roger – the cost of incorporation
· NIC is due on trading income.
· Property investment is not a trade.
· As property investment it is not a trade, no NIC is due.
· NIC is one of the main drivers behind operating a business through a limited company.
· One of the other main drivers for using a company is when profits push a sole trader above the standard 20% tax bracket.
· With companies only liable to tax at 20% (and lower from April 2017), regardless of how large profits are and individuals liable to 40% tax above just £42,385 (2015/16) rising to £50,000 by 2020/21, there are significant tax savings to be made by operating as a company, once profits exceed the 20% personal tax threshold.
· Such savings only apply if the profits are retained in the company.
· The added administration & non tax cost of operating as a company also needs to be considered.
· Incorporation may be the Holy Grail from an income tax perspective but it comes at a CGT/SDLT cost unless there are specific exemptions.
· In the long term, the additional CGT costs from operating as a company mean that landlords should not automatically assume that incorporation is the 100% certainty that some commentators are suggesting.
Before considering incorporation of a property letting business, we must first consider some of the reasons why any business may choose to incorporate.
National insurance contributions (NIC) play a decisive role for trading businesses. This is because a self-employed sole trader is subject to income tax AND NIC on profits whereas, if that sole trader begins to operate via a limited company (i.e. he incorporates) he can extract profits out of the company without paying any NIC.
Until 06/04/2016, no personal tax is payable on dividends unless the individual is liable to tax above the 20% standard rate. This means that with the ‘right’ remuneration strategy, a limited company could pay a small salary (in the region of £8,000) plus a net dividend of £31,000 (total income £39,000) to the company owner without any income tax or NIC being paid.
Granted, the company would be liable to Corporation Tax (CT) at 20% on the profits prior to the payment of a dividend. This means that the company would have to generate profits of almost £47,000 before being able to pay £39,000 ‘tax free’ to the director/shareholder.
Let us assume that Roger is operating a trading business, a hairdresser, with £50,000 taxable profits in the 2015/16 tax year. He will pay 40% tax once his taxable income exceeds:
· £42,385 until 05/04/2016;
· £43,000 from 06/04/2016 to 05/04/2017 and
· £45,000 from 06/04/2017.
· Anticipated to be £50,000 from 06/04/2020.
Table 1 below compares a sole trader to a limited company (operating ‘a low salary/balance as a dividend’ strategy) where profits are £50,000.
Tax year / 2015/16Individual / Income / Tax/NIC / Company / Income / Tax/NIC
Profits / 50,000 / 50,000
Total tax & NIC / 12,853 / Total tax (no NIC) / 9,063
Tax/NIC ratio / 25.7% / 18.1%
Income retained / 37,147 / 40,937
Saving by operating as a company / 3,790
· Via the company, the total (personal & company) tax payable would be just over £9,000.
· This compares to almost £13,000 tax and NIC if operating as an individual (a saving of almost £4,000).
It should be noted that the change in the taxation of dividends applying from 06/04/2016 will mean that personal tax will now be payable if adopting the ‘low salary, balance as a dividend’ remuneration strategy outlined above, even if the individual is not liable to 40% income tax.
Table 2 highlights how the taxation of dividends will change from 06/04/2016:
Dividend taxation2015/16 & earlier / 2016/17 onwards
Income tax rate / Tax due on net dividend / Tax due on net dividend
20% / 0% / 7.50%
40% / 25% / 32.50%
45% / 30.60% / 38.10%
The first £5,000 of a dividend from 06/04/16 will be tax free.
The strategy still remains very tax efficient compared to operating as a sole trader because of the NIC savings. In some instances, where the dividend to be paid out is quite small, the new dividend taxation rules may even result in additional overall savings compared to 2015/16.
The majority of the savings in table 1 relate to NIC.
HMRC do not regard any property investment business as a trade, regardless of how large the portfolio is or how much profit it makes. As it is not a trade, no NIC would be payable by a sole trader property investor. With there being additional issues associated with operating as a company:
· Generally, it is easier to obtain a BTL mortgage as an individual rather than as a company.
· Also, as it more complicated to operate as a company rather than as an individual (and, hence, more expensive).
It raises the issue: ‘Is it really worthwhile for a property investor to operate as a limited company compared to a ‘regular’ trader?’
A company really comes into its’ own when profits push the sole trader into the 40% tax bracket. This is because CT is charged at the following rates:
· 20% until 31/03/2017.
· 19% until 31/03/2020
· 17% from 01/04/2020.
This is regardless of whether profit is £3,000 or £30,000,000.
This compares very favourably to the personal tax rates indicated above.
Keeping the numbers real, imagine if, in addition, to his £50,000 hairdressing profits Roger receives £30,000 rental profits (total taxable income £80,000).
If he was a sole trader property investor he would be liable to 40% tax (no NIC) on those profits (£12,000) leaving him with just £18,000.
Contrast this to him having a separate property investment company. He is happy with his current lifestyle which means that he only requires the £41k salary and dividend he has been drawing from his hairdressing company previously (just keeping him below the 40% tax bracket).
Consequently, once the 20% CT, i.e. £6,000, has been paid on the £30k rental profits, he leaves the remaining £24k in the company. This could be available to put towards expanding the property portfolio or towards paying off an existing mortgage.
Overall he is £6,000 per annum better off operating via a company than as a sole trader.
With CT rates reducing in the coming years, the tax savings are likely to amount to over £50,000 in less than 8 years.
This is the case whether he draws the money out of the business or leaves it in. This is because sole traders are taxed personally on the business profits whereas a director/shareholder is taxed personally on the drawings from the company.
These savings arise because he leaves the rental profits in the company.
What would happen if Roger decided he wanted to extract all the rental profits from his property investment company?
From table 2 we know that in 2015/16, Roger will be liable to 25% income tax on the £24,000 dividend he wishes to extract from his property investment company (already being a higher rate taxpayer via his hairdressing). 25% of £24,000 is £6,000 in tax, leaving Roger with £18,000. This is exactly the same as if he had operated the property investment business as a sole trader.
As the interest and administration costs will be higher via company ownership, the logical course of action is to only operate as a limited company, if you are a 40% taxpayer, and if you do not need to withdraw the profits from the company.
In the above, the choice is quite clear for Roger. He can use the £6,000 in tax savings to good effect in expanding the property business or reducing its outgoings OR he can pay it to the tax man.
Consequently, where all post tax profits are being extracted for personal use, the insignificant savings to be made by operating as a property investment company rather than as a sole trader are, at this present time (2015/16), outweighed by additional non tax related costs associated with a company.
Where business profits exceed £47,000 (2015/16), and the business owner is happy to restrict himself to withdrawing just sufficient profits to keep within the 20% personal tax bracket, operating as a property investment company is likely to be beneficial with immediate effect rather than waiting until the loan interest restrictions commence in April 2017.
The restriction in loan interest relief commencing in 06/04/2017 for non corporate residential landlords is a tax/NIC game changer in determining whether a property investment business should be operating as a limited company.
We have seen from case study 1 (Michelle) that when interest relief is restricted to 20% this could turn a 20% taxpayer into a 40% taxpayer (with the nasty implications to the entitlement to child benefit) and we have seen from the earlier workings in this case study that there are tax savings to be made from operating as a limited company.
Unfortunately, there is a tax down side to operating as a limited company. This relates to capital appreciation. Everything stated above is about income tax & corporation tax due on rental income. However, some landlords do not make any rental income profits or very small ones (under the current loan interest regime). Their goal will be to benefit from the increase in value in the property between purchase and sale.
If Roger’s rental income came from two average priced houses that he purchased in September 2014 in the London boroughs of Southwark and Hackney, he would have paid £543,111 and £580,480* respectively. A year on and the properties are now valued at £582,215 and £629,821, increases of just over £39k and £49k each.
* Figures obtained from Land Registry House Price Index September 2015.
Let us assume that Roger has had enough of letting properties. He has had a couple of bad tenants and instead of £30,000 of rental profits in 2015/16 he is only just breaking even. He decides to sell up and concentrate on his hairdressing business.
If he had been operating his property investment business via a company, it would have been the company disposing of the properties and it would have been liable to tax as follows:
Southwark / Hackney / JointPurchase / Sep-14 / 543,111 / 580,480 / 1,123,591
Disposal / Sep-15 / 582,215 / 629,821 / 1,212,036
Gain / 39,104 / 49,341 / 88,445
Company
Indexation* / 0.0077 / 4,182 / 4,470 / 8,652
Taxable Gain / 34,922 / 44,871 / 79,793
Tax rate / 20% / 15,959
Retained gains / 72,486
*Indexation gives relief for inflation and is only relevant to companies (which do not receive an annual CGT exemption as individuals do). Therefore, if Roger had been operating as an individual, he would not have been entitled to the indexation relief that reduced the gains by £8,652. Instead, he obtains an annual CGT exemption which, for 2015/16 stands at £11,100. This would result in the following tax liability:
Southwark / Hackney / JointPurchase / Sep-14 / 543,111 / 580,480 / 1,123,591
Disposal / Sep-15 / 582,215 / 629,821 / 1,212,036
Gain / 39,104 / 49,341 / 88,445
Individual
Annual exemption / 11,100
Taxable / 77,345
Tax rate / 28% / 21,657
Retained personal gains / 66,788
On the face of it, the company produces a better result by almost £5,700.
However, it has to be remembered that the gains are still in the company. If Roger wants the money personally he will have to pay additional personal tax in order to get his hands on it. It could be extracted by way of a dividend or salary, as discussed above, or, more likely, as the company no longer has a purpose, the company will be liquidated and the retained company gains will be extracted as a capital distribution taxed as follows:
Retained gains / 72,486Annual exemption / 11,100
Taxable / 61,386
Tax rate / 28% / 17,188
Retained personal gains / 55,298
Now the additional tax cost of operating via the company is almost £11,500 (£66,788 compared to £55,298). There is a double whammy! Tax is paid in the company with further tax paid by the individual to get the money out of the company.
But earlier we saw that Roger could make income tax savings of £6,000 P/A if he operated as a limited company (so long as he left the money in the company). Clearly, there are opportunities to save tax in the right circumstances going down either the personal or corporate ownership route.
If Roger sold one property now and another after 5 April 2016 to obtain the benefit of a 2nd annual CGT exemption, the tax benefit of personal ownership becomes even greater.
Similarly, could Roger have purchased the properties with his wife, Sophie, to gain an additional CGT annual exemption (or two, if properties are sold over two tax years)? This would have been particularly valuable if Sophie had only been a basic rate taxpayer. This would have meant that, at least, a portion of the gain would have been taxable at 18% rather than the 28% that is appropriate for taxpayers liable to tax above the 20% basic rate.
Even if he had not actually purchased the properties with Sophie, he could still consider transferring a half share to her on a no gain/no loss basis for CGT purposes so that half of the gains on ultimate disposal would be attributable to her. However, in such a situation, one would need to consider if the Stamp Duty Land Tax (SDLT) costs outweighed any CGT savings to be made.