Late last year, the Chancellor announced that the 0% starting rate of corporation tax (CT) for small companies would be abolished from April 2006, and all such companies would pay CT at 19% on all their profits up to £300,000.One of the reasons for this change of heart was the way that small companies were being used to reduce their tax bills by property investors.
Consider the following case study:
Say you own half a dozen properties, which produce gross rents of £60,000 a year, and a rental profit of £40,000 after expenses. Depending on your circumstances, you will be paying income tax at 40% on at least part of this profit – let’s say, on £10,000 of it. You set up a company to manage the rentals. It does not own the properties – it charges you a fee for managing them, in the same way any other letting agency or estate agent might.
A typical “arm’s length” property management fee is between 10% and 15% of the rents received, so if we take 15%, the company will charge you £9,000 for collecting your £60,000 rents. This reduces your income tax by £3,600 (£9,000 times 40%). The company pays no CT because its profits are below the £10,000 threshold. It will probably cost about £600 per year to run the company (accountant’s fees, etc.) so you have saved £3,000.
Getting the money out of the company requires a little more ingenuity; is it still worth it if the company is paying CT at 19%?
If you are a basic rate taxpayer, the answer is probably no – the difference between the basic rate of income tax (22%) and CT at 19% will probably be swallowed up by the cost of running the company. If you pay tax at 40%, it is still worth considering.
On the figures we used above, you still save £3,600 income tax. The company pays CT at 19% on its profits of £8,400 (£9,000 fees, less £600 running costs), so the CT due is £1,596. Taking the running costs into account, the saving is now £1,404 (income tax saved = £3,600, less CT due £1,596 and running costs £600). If you want to get the money out of the company, you have a choice; you can pay yourself dividends, but as a higher rate taxpayer your effective rate of income tax on these will be 25%. Looking at our company again, it will have cash of £6,804 after paying its expenses and its CT. If you pay that out as a dividend, £1,701 income tax will be due, so you will have saved nothing.
If, however, you liquidate the company after running it for at least two years, business asset taper relief will reduce the capital gain you make on the shares by 75%. On 2005/06 figures, this would mean that a gain of up to £34,000 will be covered by your annual exempt amount for CGT (£34,000 reduced by 75% = £8,500), so there will be no further tax to pay. Which goes to show that although a property management company can still save you some money, it would be pretty borderline unless your rentals were approaching the £100,000 per year mark. Above those levels, however, it is still worth considering.
A word of warning – the strategy of liquidating a company to get the cash out free of tax is “provocative” (that is tax adviser’s jargon for “it makes tax inspectors very cross”) – you can’t do it too often, and you must have advice from a tax specialist to avoid getting into trouble with the taxman!
Property Tax Tip
If you have lived in a property and also let the property out, then you will be able to benefit from Private Letting Relief. This generous relief can reduce your taxable gain by a maximum of £40,000.