Sarah Bradford explores the ‘pros’ and ‘cons’ of using a family investment company to hold rental properties.
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A family with a sizeable rental portfolio is likely to have a significant amount of wealth tied up in that portfolio. They will, understandably, have concerns about how they can pass the properties on to the next generation without incurring a significant inheritance tax (IHT) liability, while continuing to operate in a tax-efficient manner.
Recent changes to the rules governing the deductibility of interest and finance costs incurred by unincorporated landlords on residential lets has resulted in an increase in corporate landlords. A limited company can deduct interest costs in full and, even with the corporation tax changes applying from 1 April 2023, is likely to pay tax at a lower rate than an unincorporated landlord.
However, if the aim is to protect the properties from IHT, a simple limited company will not do the trick. While trusts are often the first port of call for IHT mitigation, a family investment company (FIC) is an alternative worthy of consideration.
What is an FIC?
An FIC is a bespoke private company whose shareholders are family members. It allows shares in the company to be passed to successive generations, rather than passing on fractional shares in properties – generally a more straightforward option. Using an FIC enables parents to retain control over assets and to accumulate wealth in a tax-efficient manner while planning for the future.
There is no ‘one-size-fits-all’ – the bespoke nature of an FIC means that it can be tailored to the needs of the family. For example, the parents may form an FIC and gift some shares to their children. This is done at the outset before the shares have any value. An ‘alphabet’ share structure offers flexibility, both in terms of any dividend payouts and also any variation in the rights available to different shareholders. For example, if the parents wish to retain control of the company, voting rights could be confined to the shares owned by the parents.
Once the FIC has been created, the parents will generally introduce funds into the company. This may be in the form of loans or in return for preference shares. The funds are then used to purchase properties, which are held in a company. Where the parents lend money to the FIC, they should be able to withdraw the funds tax-free.
The parents will be directors of the company and, assuming they hold all the voting rights, they will have control over the assets held by the FIC.
Setting up an FIC is more complex than setting up a standard limited company, and professional advice should be sought at the outset. The company will need a bespoke constitution (i.e., articles), so it will not be possible to buy an ‘off the shelf’ company. To protect wealth, specific clauses can be incorporated to deal with particular situations (e.g., to prevent an ex-spouse from retaining shares should a child divorce). Due to its bespoke nature, set-up costs will be higher than for a standard limited company.
As with any company, there are associated company law requirements; the company must file accounts and an annual confirmation statement with Companies House.
If the parents already own properties that they wish to hold within the FIC this can be done, but it is both more complicated and more expensive; putting the properties into the FIC may trigger both SDLT (in England) and CGT bills. As the disposal is to a connected person, any CGT liability would be computed by reference to the market value of the properties. Incorporation relief (where available) will allow capital gains to be held over.
Taxation of rental profits
Any rental profits made by the FIC will be liable to corporation tax. From 1 April 2023, the rate depends on the level of the company’s profits. If the company does not have any associated companies, it will pay corporation tax at the small profits rate of 19% if its profits do not exceed £50,000, and at the main rate of 25% if its profits exceed £250,000. Between these limits, the company will pay tax at the rate of 25% as reduced by marginal relief, resulting in an effective tax rate of between 19% and 25%.
By contrast, for 2023/24 the basic rate of income tax is 20%, payable on the first £37,700 of taxable income; the higher rate is 40%, and the additional rate is 45%. However, unlike an individual, a company does not have a personal allowance. The lower corporation tax rates allow for the tax-efficient accumulation of wealth as the share taken by the taxman is lower.
The company is able to deduct interest and finance costs in full in calculating taxable profits. Where the rental properties are residential this is a distinct advantage, particularly in a climate of rising interest rates. Interest relief restrictions are available to unincorporated landlords who let residential property but not to corporate landlords.
If the FIC realises a gain on selling a property it holds, the gain will be liable to corporation tax rather than CGT. Even if the company pays corporation tax at 25%, the rate will be lower than the 28% payable on residential capital gains by individuals taxable at least at the higher rate. Unlike individuals, the gain does not need to be reported and the tax paid within 60 days. For commercial properties, however, the corporation tax rate may be higher than the CGT rate. Unlike individuals, companies do not benefit from an annual exempt amount (£6,000 for individuals for 2023/24).
As noted above, an FIC is generally used as a vehicle for passing wealth to the next generation in a tax-efficient manner. Consequently, the family may wish to leave the profits to accumulate in the company. However, should they wish to extract them, it is likely that further tax liabilities will be payable. Depending on the extraction method, there may be National Insurance contributions to pay too.
It will generally be tax-efficient to extract profits as dividends to the extent that they are required outside the FIC. Use of an alphabet share structure enables dividend payments to be tailored without falling foul of company law requirements. For 2023/24, all individuals are entitled to a dividend allowance of £1,000. Thereafter, dividends are taxed at 8.75% where they fall in the basic-rate band, at 33.75% where they fall in the higher-rate band and at 39.35% where they fall in the additional-rate band.
Inheritance tax
The main reason for considering an FIC is usually the potential IHT benefits it can offer. If the children subscribe for their shares when the FIC is created, there will be no transfer of value. In the event that shares are given to family members, provided that the donor survives seven years, they will fall out of the charge to IHT. The FIC is not subject to the IHT charges applicable to a family discretionary trust.
As wealth builds up in the FIC, it will accumulate to all shareholders, not just to the parents, removing the need for them to be passed on. However, if the parents pass on their shares on death, IHT may be payable.
Anti-avoidance
Care should be taken not to fall foul of the various anti-avoidance provisions that could potentially apply.
Professional advice should always be taken in advance.
Practical tip
Families looking to build up a significant property portfolio could consider using an FIC as a vehicle for building up wealth and passing it on in a tax-efficient manner.
