Four years after this article was first published an update has been added to show the impact and outcomes of our recommended restructure.
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 that HMRC accept that it is perfectly legitimate for taxable profits to be allocated disproportionately to ownership between individual Members (not Corporate Members’ though) by paying ‘Partners Salaries’. This is very different to a PAYE salary in that it is treated as a profit share in a property investment business rather than having tax and National insurance deducted at source.
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.
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, it would be fair to say that income tax, inheritance tax and legacy planning are 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 as a ‘Partners Salary’ 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 Members Current 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 from the business are at the discretion of the Senior Partner, e.g. 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 the incoming Members work results in the profitability of the business increasing 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 Members current account balances 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 the value of 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.
If/when the children start to earn more money outside the business, or if the profits of the business exceed the basic rate tax bands of all of the Members, that might be a good time to consider incorporation.
Soon after leaving University, all three children were able to obtain a mortgage to purchase their own homes. This was possible as a result of them being able to show their self-assessment returns to mortgage lenders to justify their income from ‘Partners Salaries’ allocated to them.
Each of the children now rent one bedroom in their homes and benefit from the “Rent-A-Room” allowance of £7,500 of tax free rental income. This services a substantial element of their mortgage commitments.
Furthermore, off the back of their fathers business and experience of working with him the children now also manage properties for other landlords. This has proven extremely successful, as has the expansion of the LLP through the refinancing and acquisition of additional properties.
The combination of all these successes pushed all members of the family into the higher rate tax band, resulting in the impact of Section 24 impeding the growth of the business and their ability to arrange further mortgages.
The solution was to incorporate the business, which produced the following opportunities for further growth.
The incorporation of the business involved selling the entire business of the LLP as a going concern to a Limited Company in exchange for shares. The ownership of the business remained the same, so there was no CGT or Stamp Duty payable at the point of incorporation. Also, by utilising a combination of mortgage novation and the Substantial Incorporation Structure there was no immediate requirement to change the existing mortgage arrangements
Landlord Tax Planning Consultancy is the core business activity of Property118 Limited (in association with Cotswold Barristers).
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