This is an absolutely crucial question if you’re not going to lose an unacceptable chunk of any development profits that you might make to the taxman. Perversely, our tax system is such that the amount you pay HMRC can be vastly different, depending on which business structure you choose to put the development through. The best way to illustrate what we mean is by giving a number of scenarios, all based on real life situations.
Our first example questions the almost universal assumption that putting a property development through a limited company saves tax.
Mr Laurel is a 40% taxpayer, with other income after just over £50,000. He undertakes a property development which realises a £50,000 profit, and he does this in his own name, rather than through a limited company. The £50,000 profit is duly charged to tax at 40%, and self employed national insurance at 2%, with a resultant overall “tax” charge, therefore, of 42%. HMRC gets £21,000.
Now let’s turn to Mr Laurel’s business rival, who puts an exactly equivalent development through Hardy Limited meaning that the shareholder of Hardy Limited has a personal tax bill on the dividend of about £12,650.
In total, then, over £25,000 has been paid on this development profit because of it being passed through a company – compared with, £21,000 in the case of Mr Laurel who simply did the development in his own name.
The reason the company makes sure a poor showing, from the tax planning point of view, as compared with the sole trader in that example could be said to be the fact that the proceeds of the business are all paid out to the individual via the company. It’s a fact that is being increasingly recognised, that, due to recent changes in the way companies are taxed and the dividends they pay are taxed on their shareholders, introducing a company “between” the business and an individual, so to speak, actually increases the amount of tax that you pay overall, in most situations rather than, as is the general vague idea that most people hold, being reduced.
Now let’s look at a more complex situation, which is not only more complex but also arguably closer to the reality for a high proportion of property developers.
In the Laurel and Hardy example we’ve given, let’s suppose that Hardy Limited doesn’t pay out its post tax profits of £37,500 as a dividend. Instead, it retains the profit in question and uses as the basis for another development. They say that a tax deferred is a tax saved, and so if you take this simplistic view of things, you’ll see that Hardy Limited has a considerable advantage over Mr Laurel. It has £37,500 of its £50,000 profit left after tax, which it can then invest in more developments, and so on. Mr Laurel, the 42% “tax” payer, only has £29,000.
That’s quite a significant apparent saving in tax, if one takes the “tax deferred is tax saved” approach. What makes this situation so peculiarly complex is that deferring tax isn’t, of course, saving it in any true sense of the word. If you’re going to pay the tax at some point, you have to bear in mind the tax that you’ve merely postponed, in assessing the relative merits of the company versus sole trader structure.
Limited Liability
Of course aspects than other than tax may well come into your thinking, indeed no doubt they should. A limited company does bring with it a certain protection from liability if things go badly wrong financially for any reason. A sole trader, on the other hand, is fully exposed and can potentially lose everything he has if financial disaster overtakes the development business. But if you want direct personal taxation and limited liability at the same time, there is, fortunately, a way of getting this – yes, you guessed it, it’s the Limited Liability Partnership or LLP. Members of an LLP are given the same effective protection against liability that a limited company gives; but the tax rules that apply are those that apply to individuals, where you’re talking about individual members of the LLP.
Groups and “Special Purpose Vehicles”
In our straightforward example above, where the profit of the first development is ploughed back into other developments, we were envisaging this all happening within a single limited company. But the larger property developers are a bit cleverer than that. Because of liability issues, they tend to organise their affairs more like the following scenario.
Pussycat Holdings Limited is the holding company of a group of property development SPV’s. the first of these to be formed, for the purpose of development of a single block of flats, was Pussycat Developments 1990 Limited. This realised its profit, paid its corporation tax, and then made a dividend of the balance up to Pussycat Holding, its 100% holding company. Holdings then proceeded to lend the money to Pussycat Developments 1991 Limited, which used the money as the basis of another separate development. This second SPV paid its corporation tax, and like the first, paid the rest up to the holding company as a dividend. And so on, and so on. This structure makes use of the fact that dividends within a 100% group are tax free, in order to get a good degree of commercial protection for the profits of the various developments, despite those profits being ploughed back into the development business.
Obviously nothing is ever guaranteed where lawyers are involved. But generally speaking, the fact that the holding company doesn’t trade, in this example, does provide a lot of protection. Let’s imagine that the block of flats in the first SPV company in that example falls down some years later. The costs are obviously huge, both human and financial. But, aside from any personal negligence claim that could be brought against anyone who had been involved in that development, the profits have long since been paid out by the company that did the development, and that company has been dormant, or may even have been struck off the register, for some years. Generally speaking it’s a safe situation if sufficient years have passed and there’s no evidence that the SPV paid up its dividend in order to cheat the creditors. So the holding company/collection of SPV subsidiaries structure is understandably a very popular one for serial property developers.
Tax Free Profit Extraction
But we now come on to our grand finale, which is an example illustrating how you can both realise a profit at the initially lower corporation tax rates, but then enjoy the proceeds that development personally – without paying the additional layer of tax that generally makes an unincorporated business so unattractive. This is a highly plausible structure that we’ve seen in many of our clients’ situations, and which has worked extremely well to minimise their tax.
Charles King the Third has lived and breathed property, both development and investment, all his life. As well as a flourishing building and property development company, he also owns a personally held investment property portfolio worth several million pounds. Charles does like to live the high life, though, and takes significant sums out of the property development business each year in order to fund his lifestyle. Hitherto, he’s obviously had to pay through the nose in tax, on the amount he takes of the property development company in dividends and remuneration. But then he meets a switched on tax adviser. What this tax advise suggests is that he set up a property investment LLP, and introduce his personally held property portfolio into this LLP. The LLP has as its members Charles himself, other members of his family, and a specially incorporated investment limited company member. Profits from the property development company are thereafter channelled via this investment company, which introduces the funds into the LLP. The money in the LLP is then available for Charles to draw out against his capital credit, which was created by introducing the multi million pound property portfolio. As if by magic, Charles finds that he can now draw large sums out of his trading profits without paying income tax.
If we left it like that, we could perhaps be accused of glossing over difficulties, and making the structure look better than it was. Objectors might say, for example, that all Charles is doing is deferring tax, because one day the limited company will have to pay out its profits in taxable form: this is only a deferral.
It can also be pointed out, correctly, that within three years of the initial introduction of his property portfolio into the LLP, there is a Stamp Duty Land Tax charge if he takes out any large lump sum of more than £40,000 a time.
The second objection is far less cogent than the first, because it’s usually relatively easy to avoid going over the £40,000 amount on any individual drawing (which is how we interpret the rules). But, arguably, even if a small amount of SDLT were payable, this wouldn’t take away the overall attractiveness of the idea.
With regard to the “mere deferral” objection, this may or may not be justified by the reality. Bearing in mind that, if Charles property portfolio goes up in value over the years, and providing the LLP agreement has been properly drawn up, he can draw out not just the current value of his portfolio, credited to his capital account on introduction of the properties but also any future increase in their value. It may be, in fact, that he never “runs out of credit” with the structure, and therefore never has to pay the “warehoused” dividends from the company. It should be borne in mind that, from the capital gains tax point of view, when Charles dies and leaves the shares in the property development company to his children, they will be deemed to take those shares on at their market value at the time of Charles’ death. All of the rolled up value, which has rolled up in the company because Charles hasn’t been paying dividends all these years, is effectively “cleansed” at least from the point of view of income tax and capital gains tax. It’s true that inheritance tax is still payable, but then this is common to all scenarios where profits are taken from a trading business and retained long term.