Meg Saksida outlines the tax implications of some common forms of extraction that landlords need to know about.
Taxpayers choose to incorporate their rental business (i.e., transfer it to a company they own) for a number of reasons. Maybe it is the draw of the lower tax rate; maybe it’s the ability to extract the profit through dividends or the ability to retain them and further build up the company. Perhaps it is the thought of future disposals leading to lower gains.
Unlike an individual bearing the punitive 20% or 28% rate, as long as the residence is being used in the trade, a company will only have a standard 19% rate charged on corporate gains. Furthermore, the restriction on mortgage interest deductions is not in point inside a company. Whatever the motivation, now the business is incorporated, how does the landlord best extract the profits?
Retaining profits
While running the property business as an individual, the taxpayer was charged to income tax personally on the entire profit arising in the business and, because of that, the taxpayer was able to enjoy and use all those profits too.
However, following incorporation this charge to tax falls inside the company and only at 19% rather than up to 45%. If the landlord does not wish to use all the profits, they can accrue in the company. This means that 19% is the limit of taxation that is required, and 81% of the profits can build up in the company, allowing further property purchases to be made and the company to grow organically.
Extracting profits
If, on the other hand, the landlord wishes to extract any funds, they could choose from:
- becoming an employee of the company;
- making a loan to the company and receiving interest;
- allowing the company to use a landlord-owned rental property and receiving rent;
- receiving a dividend from the company; and
- taking an interest-free loan from the company.
Each of the above have their own tax impacts.
Becoming an employee
Becoming an employee of the company will mean that the profits extracted will be charged on the landlord to income tax and, depending on the marginal tax rate of the individual landlord, this could be up to 45%. National Insurance contributions (NICs) will also need to be paid by both the landlord and the company, so this is unlikely to be the best alternative for tax purposes. In addition, the NICs employment allowance is unlikely to be available as there is usually only one employee who is also the director.
However, pension payments could be made to the landlord through employment up to the higher of £3,600 or their UK earnings, and tax relief is available on amounts contributed up to £40,000. Employee income is also counted as earnings for pension input amounts, unlike dividends.
Salaries can be paid even when the company is making losses and are an allowable expense against corporation tax.
Loan to the company and receiving interest
The landlord could make a loan to the company and receive interest on this loan. Although there would be no NICs charged, income tax would still be payable on any amounts paid to the landlord at up to 45%. If the landlord has little non-savings income (e.g., if they are retired), the landlord could earn up to the first £5,000 interest taxed at 0%, due to the savings rate band. There is also the personal savings allowance of £1,000 and £500 for basic and higher rate taxpayers, respectively.
Interest can be paid even when the company is making losses and is generally an allowable expense against corporation tax. The company would potentially also need to deduct income tax from the interest payments and make associated required returns if the loan has the potential to endure longer than a year. Excess interest over a commercial rate may also be taxed as a dividend.
Company using a landlord-owned rental property and receiving rent
The landlord could make a rental property, owned privately, available to the company and receive rental income on this arrangement. Again, although there would be no NICs due, income tax would be payable on any net profits generated from the letting of the property.
Rents can be paid even when the company is making losses and are an allowable expense against corporation tax. Although inheritance tax business property relief (BPR) (if available) would not be lost if the asset was being used in the business (at 50% if the company is wholly or mainly trading), business asset disposal relief for capital gains tax purposes will be restricted.
Dividends from the company
If the company makes a dividend payment to the former landlord as a shareholder, although this is still charged to income tax, it is charged at different rates to employment income, loan interest and rent, as explained above. The dividend ordinary rate is 8.75%, the upper rate 33.75% and the additional rate 39.35% (for 2022/23). Before these are charged, however, there is a £2,000 dividend allowance and this is not means tested. Any dividends received inside this allowance are charged at 0%.
The company will only be able to pay a dividend if it has distributable profits, and dividends are not an allowable expense for corporation tax purposes.
Interest-free loan from the company
If there is spare cash in the company, the landlord could extract value through an interest-free loan from the company. The company might then be minded to write off this loan in the future.
Anti-avoidance rules exist for this kind of arrangement for close companies (which an incorporated rental property business is likely to be) both for the landlord and for the company. A close company is a UK-resident company controlled by five or fewer participators (shareholders) or any number of directors who are also shareholders.
(a) Tax implications on the landlord
For the landlord, they would be impacted by the beneficial loan interest rules. If the company makes an interest-free loan exceeding £10,000 to the landlord, or even a loan with interest lower than the official rate of interest (currently 2.25%) a benefit arises, taxable on the landlord. If the landlord was also an employee, this would be treated as a benefit-in-kind associated with the employment and subject to income tax and NICs. If the landlord was not an employee, although the benefit would be calculated in the same way, it would be treated like a dividend.
If the company subsequently writes off or releases a loan to the landlord, the landlord will be treated as having received a dividend, whether the landlord is an employee or not. The value of the dividend will be equal to the amount of the loan written off. If the landlord is an employee, there will also be NICs to pay on the value of the dividend.
(b) Tax implications on the company
For the company, there is a punitive ‘penalty tax’ if the company is a close company and the loan is to a participator in that company. The legislation acts to charge this tax for loans made to any shareholders who own or control 5% or more of the share capital or voting rights or rights to capital on a winding-up in the company. Where these shareholders have received a loan in excess of £15,000 from the company, a tax charge will be incurred in the company of 33.75% of the loan. Unless the loan was repaid before, the tax will be payable nine months and one day after the company’s accounting period ends in which the loan was made.
If the loan is written off, the tax charge is the same as if the shareholder were to have received a dividend. If the loan is repaid or written off, HMRC will pay the tax back to the company nine months and one day after the company’s accounting period end in which the loan was repaid or written off.
Practical tip
Profit extraction can also occur by leaving the value in the company until the landlord dies. If the company is genuinely wholly or mainly trading and not simply holding investments (which rental companies comprising furnished holiday accommodation should be), it could be eligible to 100% BPR, meaning that no inheritance tax will be due on death, and as there is a capital uplift on death increasing the historical cost to market value, there will be no capital gains tax either.
