Alan Pink suggests a structure for a property development business.
Let’s assume that your aim in acquiring or developing property is to sell the resultant buildings; so we’re not talking about how to plan for property that you intend to buy and improve in order to let out at an enhanced rent.
The key point is that profits from selling development or trading properties are chargeable as income and not as capital gains; so that if an individual makes a profit, the rate of tax (including self-employed National Insurance contributions (NICs)) on that profit could be as high as 47%. And this is where the advantage of trading through a limited company seems overwhelming – a ‘no-brainer’.
Companies pay a flat 19% currently, with a 25% rate on all but small profits promised from 2023, and this is obviously something that we must factor into our planning. But, of course, this is still an awful lot better than 47%. This top rate applies if an individual’s total income for the year is more than £150,000 and, of course, it is in the nature of development profits that they come in big lumps all at once, so the likelihood of any substantial development pushing a person’s income over this threshold has got to be high.
Halving your tax rate on profits is surely the obvious choice. And yet, as so often in this untidy world of ours, things can get a lot more complicated than that, as I’ll explain.
Smaller developments
For a start, the ‘one size fits all’ answer does not apply because the tax considerations change dramatically as the actual level of profits changes.
Let’s look at an example of a development which is large enough to be worthwhile, but not large enough to need the extra formality of a limited company.
Example 1: A family affair
Brian buys a fairly rundown house in Stoke, which was clumsily converted into two flats some years ago by a DIY merchant. He buys the two flats and the freehold for a combined figure of £1 million, including stamp duty land tax. He’s done his sums carefully and has worked out that, after £100,000 reconversion costs back to a house, and £50,000 for a ‘wash and brush up’, he can sell the resultant improved property for £1.35 million. So the anticipated profit is £200,000, which isn’t bad, if you think about it, for a maximum of three months’ work.
Brian’s wife Wendy, and his two children, aged 18 and 20, have no income of their own, and Brian is a property developer who is not expecting any other profits this year. So he structures the venture as a four-way partnership, and when the expected profit comes in, this is divided equally between the four partners, giving a profit share of £50,000 each. This is within their basic rate bands for income tax, and the total tax and NICs is, therefore, just over £40,000; only slightly more than corporation tax at 19%, and noticeably less than corporation tax at 25% (when it applies).
So, developments giving rise to smaller anticipated profits are one possible exception to the conclusion that a limited company is the ‘obvious’ structure through which to do a property development. But it’s by no means the only exception.
Any planning for structuring a property development venture of any kind needs to start at the end, so to speak. What is the destination of the profits? Is your plan to spend those profits on private living expenditure, buying your own home, paying off a home mortgage, improving the home, or the like? Or is it the aim to keep the profits and use them to provide more income in the future?
This is the fundamental question that you need to answer before deciding how to structure your property development business. To sum up the position very briefly, if you’re likely to be retaining the profits in one form or another, the limited company structure is likely to be the more sensible one. If you’re planning to spend the proceeds privately, it may not be. Let’s have a look at an example.
Example 2: Large property development
George is a hardworking entrepreneur, whose income from various businesses takes him into the top rate of income tax: 45%. His wife Jenny is a city lawyer who’s also a top rate taxpayer. Their company, George Jenny Developments Ltd, is set up to undertake a large one-off property development project and realises a profit of £4 million.
By this time, the 25% corporation tax rate has come in, and so there is a £1 million tax liability on the profits. George needs the remaining £3 million to pay off his mortgage, and so he pays dividends to himself and Jenny (who are the shareholders) of £3 million. At a top income tax rate on dividends of 38.1%, they end up with income tax liabilities of about £1.14 million, leaving £1.86 million after tax to pay off some of the mortgage with.
So, was the limited company the right structure for this particular property trading business? In total, HMRC has had £2.14 million out of the £4 million profit, which equates to an overall tax rate of about 53.5%. If George had simply bought the land in his own name and sold it, he would have had an income tax charge (with NICs) of 47% and would have paid HMRC something like £260,000 less.
What this example illustrates quite clearly, I think, is that limited companies can significantly increase the overall tax level if their profits are then all distributed to the shareholders. So the obvious answer is very definitely the wrong answer in a situation like that of George and Jenny.
‘Serial’ developers
On the other hand, all the time corporate profits can be kept within the limited company ‘envelope’ in which they have been made and charged to corporation tax, the overall effective rate of tax is substantially less, and it’s undoubtedly true to say that the majority of property development ventures, particularly the larger ones, are dealt with through limited companies.
So, here’s a structure which has a lot going for it, for the sort of person who does one development after another:
Profits paid Intercompany
up as dividend financing loans
The basic idea behind this structure is that the profits from one development will be ploughed back into the next development, and so on. This could, of course, all be done within a single limited company, and it often is so. But sometimes, the developers are concerned with limiting any risks that might attach to past developments, and this is where the structure shown in the diagram comes into its own. When a development profit is made in the first company, marked SPV1 (special purpose vehicle 1), it is paid up as a dividend to the holding company, and, as a result, SPV1 is now an ‘empty company’.
If, perhaps in a long time to come, some kind of problem arises with what SPV1 has done, there is nothing there for creditors to attack. The holding company receives the dividend tax-free because it’s part of a group of companies, and then lends the money down to finance the second development carried on by SPV2, and so on. The important point to note from the tax planning point of view here, is that none of these cash flows (after the original inflow of profits to the SPV company) is taxable.
Practical point
Ultimately, no doubt, the process of making development profits and ploughing them back into another development will end, and at this point, the shareholders have the option of selling or winding up the group and paying capital gains tax at the comparatively favourable CGT rates of 10% or 20%, or alternatively investing the reserves in another activity, typically property investment.
