Should I put my rental property into a company?

Should I put my rental property into a company?

This is one of the most common questions we get asked and unfortunately the answer is never a yes or no. In the following article, we will focus mainly on UK resident Landlords. And set out some of the differences available to Landlords.

The simplest way is when an individual invests directly, an option that has proved popular in the buy-to-let sector. However, acquiring and managing a property portfolio can require substantial funds, which an individual may not be able to access on his own.

Therefore, various investment vehicles are on offer, allowing investors to pool their resources and share in the profits from the rental assets held on their behalf. Most people are familiar with the limited company as a vehicle which can be used to invest in real estate on behalf of its shareholders.

The company is taxed separately from its shareholders. There are, therefore, two layers of tax involved:

Alternatively, investors can use a partnership structure which is transparent for tax purposes. Investors are taxed as profits and gains arise, irrespective of whether any of those profits and gains are paid out.

There is no ‘one size fits all solution to the question of which type of ownership structure to adopt. Each structure has its own attributes that may cater to certain types of investors but not others. Each investor must decide which option suits him best concerning his commercial objectives and the tax considerations involved.

Individual

Individual landlords resident in the UK are subject to income tax on rental profits at the following rates:

• 20% for basic rate taxpayers.
• 40% for higher rate taxpayers; and
• 45% for additional rate taxpayers.

Individual landlords are also liable to pay Class 2 National Insurance contributions (NIC), calculated at a flat rate. This compares favourably to sole traders who are subject to an additional Class 4 NIC charge calculated by reference to their profits.

For capital gains, individual landlords benefit from an annual allowance (£12,300 for the tax year 2022–23). Gains on property disposals over this amount are taxed at the following rates:

Company

The most common type of company is the limited liability company with an ordinary share capital.

This type of vehicle is typically preferred since the company is liable for all the business debts. The shareholders’ liability is limited to unpaid amounts on their share capital. The company has its own legal personality separate from shareholders and is taxed separately.

A UK resident company is subject to corporation tax at 19%. This rate is now set to increase to 25% from 1 April 2023.

Unlike individuals, the corporate rate applies equally to rental profits and capital gains. The lower tax rate for companies does not necessarily translate into a lower rate overall – this will depend on the ultimate shareholders and the level of profits retained in the company.

Apart from limited liability, there are other advantages to adopting a corporate vehicle to operate the property business.

A company has share capital which makes it easier to allocate fractional interests in the underlying property portfolio, which continues to be held by a single entity (the company), whose ownership rights are not disturbed. It is even possible to create different classes of shares to cater to different investors’ requirements.

It is also possible to create subsidiaries which do not themselves hold any real estate but whose purpose is to provide operational support for the business. For example, a separate company may offer property management services to other corporate group members.

The following factors need to be borne in mind by individual landlords who are considering whether it is worth incorporating the business:

• While a corporate vehicle does provide limited liability to its shareholders, this can be effectively sidestepped if the owners are asked to provide bank guarantees to secure funding.

• A company must follow various reporting obligations, such as filing returns with Companies House and following certain procedures under the Companies Act 2006 (CA 2006) and related legislation.

• A company director has a duty to act in the company’s best interests and must not use his position to gain a personal advantage. Special rules govern cases where there is a conflict of interest, such as when the director is also a partner in a firm that provides professional services to the company.

• A consequence of having a legal personality is that the assets and liabilities of the business belong to the company and not to the owners. It is not uncommon for small business owners to be unaware of this distinction and to treat the company’s coffers as their own personal piggy bank. However, in law, the company is constrained regarding what it can pay out to shareholders. In particular, a company must have sufficient distributable reserves before it can pay an income distribution or dividend

While corporate landlords are subject to a favourable tax rate, it is important to note that the overall rate depends on the extent to which profits and gains are repatriated to its shareholders. Accordingly, there are two tiers of taxation – one at the corporate level and one at the shareholder level.

For other shareholders receiving a dividend, the position is as follows:

• Individual shareholders are taxed at dividend rates. In particular, any amounts above £2,000 are taxed at the following rates: 7.5% for basic rate taxpayers, 32.5% for higher rate payers and 38.1% for additional rate payers.

• Corporate shareholders are not generally subject to tax on dividends.

• Exempt investors, such as pension schemes, do not pay tax on dividends which count as part of their investment income. However, the dividend will have been paid out of taxable profits – had the pension fund invested directly, such profits would have been tax-free. Thus, for exempt investors, a company is not a tax-efficient vehicle.

Partnerships

Various types of partnership vehicles are available in the UK:

• general partnerships established under the Partnership Act 1890, where all partners are jointly and severally liable for the debts of the business;

• limited partnerships established under the Limited Partnership Act 1907, which offers a form of limited liability to partners who have no active role in the business; and

• limited liability partnerships (LLPs) established under the Limited Liability Partnership Act 2000, a corporate vehicle allowing limited liability to all its partners (called ‘members’).

(In the following text, the terms ‘partners’ and ‘members’ are used interchangeably.)

Note that the partners or members of a partnership need not be restricted to individuals. A partnership can have companies, trustees or overseas entities in its membership. It is even possible for one partnership to invest in another. This is not uncommon where the partnership is structured as an investment fund.

In general, a partnership does not have its own legal personality separate from its partners or members, the LLP being the exception. However, all partnerships are tax transparent, with the tax assessed directly on the partners.

The result of ‘looking through’ the partnership is that each investor is effectively treated as running his own separate property portfolio and is responsible for paying the tax for his share of the profits and gains.

Rental profits are calculated in two stages:

• First, the profits are calculated as if the partnership were a single person running the business.

• Second, each partner is allocated his share of the profits in accordance with the profit-sharing ratio for the period in question.

The calculation method depends on the member whose tax liability is being computed. The partnership is deemed to be an individual when calculating the liability of an individual partner and a company when calculating that of a corporate member. This ensures that reliefs and exemptions available to only one type of member cannot be passed on to another.

The profit-sharing ratios agreed between the partners are not set in stone. One would typically expect these ratios to follow the partners’ respective capital contributions, but this need not be the case. The allocations may be made on whatever basis suits the members, and the ratios can change yearly. This is subject to the proviso that the annual partnership return is conclusive as to whether a person does or does not have a share in the profits or losses and what that share is.

For CGT purposes, each partner is regarded as owning a fractional share of the partnership assets, and gains on the rental properties are taxed accordingly.

CGT issues also arise when there is a change in the capital sharing ratios – this is a particular issue when new members are added to the partnership or an existing member exits. HMRC Statement of Practice D12 governs the tax position:

• No immediate tax charge arises if the assets are not revalued in the partnership accounts. Instead, the base cost of the various properties is re-allocated to reflect the fact that there has been a change in the members’ respective interests in the fund. This translates into a higher or lower tax charge when assets are disposed of for cash outside the partnership.

• However, tax is payable if a revaluation accompanies the re-allocation. This reflects that there is indeed a profit recorded in the accounts, albeit a ‘paper profit’.

In the absence of evidence to the contrary, the capital ratios generally follow the income-sharing ratios, but this need not be the case. The two can be kept distinct – for example, those investors seeking income can be allocated a higher proportion of the rental profits while investors seeking capital growth may be allotted a higher capital share. It is even possible to change income and/or capital sharing ratios from year to year.

If you would like to discuss the above with our tax experts you can contact us here.

All information provided in this article is for informational purposes only and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional accountant. It should in no way be considered as advice provided by Hawthorne Tax Consultancy or any of its principals. All information is deemed to be correct at the time of writing.