16:40 PM, 17th January 2020, About A year ago
If you have children or grandchildren over 13 years of age and it is your intention to leave your property business as a legacy for them, why not consider involving them now?
There are certainly inheritance tax planning advantages of doing so and if they are over the age of 18 there could also be income tax advantages too.
The example below shows how one landlord (we will call him Mr X for the purposes of anonymity) managed to reduce his income tax bill by a staggering 85% by using this strategy.
Mr X had a property rental business in his own name, producing real profits after finance costs of £100,000 a year. However, his taxable profits were £200,000 after factoring in the restrictions of finance cost relief.
He also has an income of £150,000 from other profession or trading company but his wife who is 20 years younger than him has no earnings. Neither do his three adult children from his first marriage, who are studying at University but are already showing an active interest in the property business and getting more involved when they can.
Income tax, inheritance tax and legacy planning were very much ‘on his mind’ when he booked his tax planning consultation with Property118
By transferring the beneficial ownership of his property rental business into an LLP, his opening ‘Capital Account Balance’ was the value of his properties minus the liabilities, i.e. his mortgage balances. This was achieved without remortgaging. Furthermore, reliefs were available to ensure that CGT and Stamp Duty didn’t fall due either.
His wife and his children then became Members of the LLP, because they all have an active interest in the business. It is not necessary for all Members of a partnership to be able to deal with every aspect, but they must do something. The opening value of their Capital accounts was £nil, because they hadn’t contributed anything to the business at that stage.
Twelve months after the LLP was formed
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. That is now expected to increase as a result of greater family involvement.
Previously, the tax that Mr X would have paid would have been as follows:-
£45,000 of tax on the real profit (i.e. £100,00 after finance costs).
PLUS, a further £25,000 of tax on the additional £100,000 of disallowed finance costs, and that’s after factoring the 20% tax credit.
Total tax £70,000.
The above represents 70% of the real cash profit of the rental property business being paid in tax.
However, under the new structure, now that the wife of Mr X 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%.
REMEMBER – Members of an LLP pay tax on profit allocated, not on drawings!
This is an extremely important point for both IHT and income tax planning purposes.
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 if profitability of the business is 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!
Mr X 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, which is great for IHT planning purposes.
Over time, and assuming he lives long enough, it is quite feasible that Mr X might 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 Mr X 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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