When we plan our clients tax affairs one of the most crucial elements is asking the client, what, exactly, is your intention? Obviously, the answer is to make money. But it’s how you intend to make your money that directly informs what form of business you should operate as.
This is best shown in a property business.
Scenario 1 – intention to sell
Let’s imagine that your intention is to buy a few properties cheaply, have some of them done up and then sold on at a gain – even if this means renting out the property for a time period before selling. The real intention here is to make capital gains on the property. Such gains are subject to capital gains tax for individuals / partnerships (at a rate of either 18% or 28% depending on if you’re a basic or higher rate tax payer) but are subject to corporation tax for limited companies (at a rate of 20%). So, the question is, if this is the intention, which form of business should you operate as?
All individuals are given a capital gains tax free allowance which for the 2013/14 tax year are £10,900. This means that you can have capital gains up to this point without paying a penny in capital gains tax as an individual. So, if you sold the property and made a gain of £8,000 you wouldn’t be liable for any tax. Any gains over this amount are however taxable.
If the properties are owned as a partnership equally you then get an additional £10,900 allowance based on every partner in the business. If the business has two partners, and each partner also has a spouse / home partner that they wish to bring into the business venture on an equal basis, this equates to £10,900 x 4 = £43,600 per year capital gains which would be tax free!
Each partner would however be taxable on any profits made in the rental business. One saving grace of rental income is that, as of writing, they are exempt from national insurance contributions. However, if the partners are all higher rate tax payers then they are looking at up to 50% income tax charges on their share of the profits.
Otherwise if the venture operated as a limited company then there would exist NO capital gains tax allowances and ALL gains would be immediately subject to a 20% corporation tax charge.
Scenario 2 – intention to rent
Now let’s imagine the intention is to build up a steady portfolio of houses to rent out. They might be sold at some point but the main focus is to build up the portfolio and make profits.
Here, the main focus from a tax planning point of view is keeping the tax on the profits to a minimum. Consequently a limited company model would be a better way to go as each shareholder can potentially charge a small salary to the company reducing taxable profits and extract any remaining profits as a dividend.
Of course, most lending institutions would not lend directly to the limited company to purchase a house without a personal guarantee from at least one of the directors but effectively this is no different from a lending institution lending to an individual or a group of individuals directly.