A Landlord’s Tax Planning DisasterMake Text Bigger
This morning I have been reviewing all of the information provided by a client who booked a Tax Planning Consultation with us. The first step is always for my Executive Assistant to complete a thorough Fact Find and to obtain copies of Tax Returns, a property schedule, proof of identity and residence and other relevant information, which she then curates for me to review in one session.
The first thing that made me raise my eyebrows is that an overview document prepared by our client stated that he had recently formed an LLP with a view to incorporating his business and saving Stamp Duty in due course. That alone is a ‘No:No’ because it could very easily fall foul of HMRC’s General Anti Avoidance Rules “GAAR” without there being a commercial reason for the restructuring other than avoiding tax. Thankfully, I think that point could be addressed, because he is already beyond normal retirement age has made his children Members of the LLP, so it could be argued that he was ‘succession planning’.
What really horrified me though was that his advisers had not considered that he has over £200,000 of retained personal rental losses which can be offset against future personal rental profits.
Personal being the keyword here.
HMRC’s manual PIM1030 makes it quite clear that personal rental losses CANNOT be offset against Partnership profits. The following (which I have put into blue italic text) is an extract from that HMRC manual, to which I have also bolded the most relevant sentences.
Jointly owned property: partnership
A customer may jointly own properties which are let out as part of a partnership business. This might occur where:
- they are in a trading or professional partnership which also lets some of its land or buildings (but see BIM41015 about the inclusion of rents from the temporary letting of surplus business accommodation in the trading or professional profit),
- more rarely, they are in a partnership which runs an investment business which does not amount to a trade and which includes, or consists of, the letting of property.
A partnership rental business of either type is treated as a separate business from any other rental business carried on by the individual partners on their own account. Each partner’s share of the profits or losses arising from the partnership rental business can’t be added to or subtracted from any individual rental business profits or losses. If customers are in more than one partnership, each is dealt with as a separate rental business and the profits of one can’t be set against the losses of another.
The above is an extract from HMRC manual PIM1030 – link >>> https://www.gov.uk/hmrc-internal-manuals/property-income-manual/pim1030
If he had sought my advice before forming an LLP I would have recommended him to do nothing at all until such time as his accumulated personal rental losses are fully utilised. A consequence of forming the LLP is that he will now pay tax on his share of profit allocation and he will not be able to offset that Partnership profit allocation against his personal carried forward rental losses.
As yet, I have no specific details of the basis upon which the Partnership was formed and assets/liabilities were transferred into it, but given the appalling standard of advice I have been privy to so far, and reading between the lines of the overview notes he provided, it would not surprise me in the slightest if the transition to LLP status has also resulted in the crystallisation of capital gains and a created a liability for Stamp Duty to be paid. I sincerely hope I am wrong in that regard. I have asked him to send me the opening balance sheet of the LLP I explained will be happy to delve deeper into this for him.
My advice to him was that, at the very least, he should be asking his professional advisers for a copy of their professional indemnity insurance policy and considering a claim for the costs of their advice and formation/implementation of the LLP strategy, plus the costs of unwinding it and corresponding with HMRC, plus any other losses, costs and fines he may have already or could incur subsequently as a result of their negligence. I have also advised him to appoint another firm of accountants.
So why does The Property118 Tax Team recommend LLP’s?
The short answer is; if our clients have carried forward rent losses, we don’t.
However, when used correctly, Limited Liability Partnerships “LLP’s” can be an excellent structure for landlords, not just for tax planning but also for the evolution of rental property businesses generally. For example, many landlords wish to eventually leave a legacy to the next generation. They also wish to consider succession planning, which is something all business owners should do. Do you want to be tied to your business until the day you die or would you like to think you can take more of a back seat when you reach retirement age?
One of the key advantages of LLP’s is HMRC accept that it is perfectly legitimate for taxable profits to be allocated disproportionately to ownership between individual Members (not Corporate Members’ though).
You can read more about this in HMRC’s own internal manuals, which are designed to provide guidance for tax inspectors but are also accessible to the general public – please see the link below.
An example of how this might work is your favour is as follows:-
Let’s say that Mr X has a property rental business in his own name at the moment, which produces real profits of £100,000 a year but taxable profits of £200,000 after factoring in the restrictions of finance cost relief. Let’s also assume that he also has an income of £150,000 from other profession or trading company but his wife has no earnings and neither do his three adult children who are studying at University but are already showing an active interest in the property business and getting more involved when they can.
In this scenario, I think it would be fair to say that income tax, inheritance tax and legacy planning are already very much ‘on the mind’ of this man.
By transferring the beneficial ownership of his property rental business into an LLP, his opening ‘Capital Account Balance’ would be the value of his properties minus the liabilities, i.e. his mortgage balances. This can be achieved without remortgaging and reliefs exist to ensure that CGT and Stamp Duty doesn’t fall due either.
His wife and his children can then become Members of the LLP, because they all have an active interest in the business. The opening value of their Capital accounts is £nil, because they haven’t contributed anything to the business at that stage.
The purpose of the restructure goes far beyond tax planning, because succession planning is also an important consideration.
Twelve months elapse from the transition having occurred
The business produced the same profits as before, i.e. £100,000 of real profit and £200,000 of taxable profit after factoring in the restrictions on finance cost relief.
Previously, the tax that the man would have paid would have been as follows:-
£45,000 of tax on the real profit
A further £25,000 of tax on the additional £100,000 of disallowed finance costs, after factoring his his 20% tax credit.
Total tax £70,000.
The above would represent 70% of the real cash profit of the rental property business being paid in tax.
However, under the new structure, now that his wife and his three children are taking an even more active role in the rental property business, the taxable profits are allocated differently. The man takes none of them, and instead allocates £50,000 of taxable profit each to his wife and his three children.
As they don’t have any other taxable income, they can utilise their full £12,500 nil rate band and pay only 20% basic rate tax on the other £37,500 each, i.e. £7,500. The restrictions on finance cost relief do not bite because none of the Members to whom profits have been allocated are higher rate tax payers.
The total tax ordinarily payable under the new structure is just £30,000. However, his wife and his children also get a 20% tax credit on the £25,000 of finance costs allocated to each of them, so that reduces the total tax by yet another £20,000, leaving just £10,000 of tax payable.
That’s a whopping tax saving of £60,000 in the first year alone!
To put this another way, the net effective tax rate on the real profit of the business is reduced from 70% to just 10%.
Yet another way of looking at it is that a reduction in tax from £70,000 to just £10,000 is a saving of nearly 86%.
So whose money is it now?
After paying the tax, the Capital Account values of the wife and the three children now stand at £47,500 each. A well drafted LLP Members agreement can determine that drawings against capital accounts are at the discretion of the Senior Partner, i.e. the person with the highest value capital account, or indeed until the death of the founder of the business. The Senior Partner could, of course, allow drawings to be taken by other Members if he chooses to do so. He might, for example, agree to this is their efforts result in the profitability of the business being increased as a direct result of their efforts.
Assuming no other drawings are taken by his wife and children, save for the money needed to pay their tax bills, the LLP bank account would have accumulated £90,000. That’s £60,000 more than would previously have been the case without this structure, in other words, more than double the amount!
The Senior Partner could, if he wished to do so, withdraw and spend all of the £90,000 of cash at bank. This would be recorded as a debit against his capital account, the outcome of which is that his capital account would reduce.
Over time, and assuming he lives long enough, it is quite feasible for the founder of the business to reduce the value of his capital account to zero. Meanwhile, the capital accounts of his family Members would be growing very nicely indeed. A further benefit of this is that when the founder eventually passes away the net value of his estate for Inheritance Tax purposes will also be significantly lower that it would otherwise have been. This is because his property rental business would have been transferred to the next generation in the optimally tax efficient manner, and completely within the legislation and spirit of HMRC’s rules.
Landlord Tax Planning Consultancy is the core business activity of Property118 Limited (in association with Cotswold Barristers).
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There will never be an optimal ‘one-size-fits-all’ business structure for tax purposes. The presentation below provides a useful overview of some of the options you might like to discuss with us.
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