Profit Extraction from Limited Company

Should your company pay you rent?

Many company owners own their business premises personally and the company pays them rent.

Paying yourself rental income is often more tax efficient than paying yourself a higher salary. Like salary income, rental income is a tax deductible expense for the business but, unlike salaries, there is no national insurance cost.

But is rental income more tax efficient than dividend income? Sometimes, but not always, as we shall discover shortly.

Of course, there are many reasons why you may wish to pay yourself rental income instead of withdrawing dividends from your company.

For starters, to pay dividends the company must have sufficient distributable profits. There is no such requirement when it comes to paying rent.

Secondly, with rental income it is relatively straightforward to pay yourself a fixed monthly amount throughout the year, for example by setting up a direct debit from your company bank account to your personal bank account.

This could be helpful if you have to personally pay various costs associated with the property, especially mortgage interest.

With rental income there is no requirement to continually do all the paperwork that often accompanies dividend payments, for example holding directors’ board meetings and shareholder meetings.

But will you save yourself income tax by paying rental income instead of dividends?

It all depends on your personal circumstances, for example how much taxable income you have, the amount of tax deductible mortgage interest you have and the company’s corporation tax rate.

Example
Warren, a higher-rate taxpayer, owns a small company that makes profits of less than £300,000 and therefore pays corporation tax at 20%. He personally owns the property out of which the company operates but the company currently doesn’t pay him any rent. He does not have any tax deductible mortgage interest to offset.

During the current 2012/13 tax year he has decided to pay himself a small-tax free salary of £7,605. He also has other taxable income of £500 which uses up the balance of his £8,105 income tax personal allowance.

The rest of his income takes the form of dividends from his company. Some of Warren’s dividends are tax free, being covered by his income tax basic-rate band, but because he is a higher-rate taxpayer, a significant chunk of his dividend income is taxed at an effective rate of 25%.

Let’s say he now decides to get the company to pay him rental income of £12,000. What impact will this have on his net after-tax disposable income?

After paying income tax at 20% on the rental income he will be left with £9,600.

However, the rental income will use up £12,000 of his basic-rate band, which means up to £12,000 of his gross dividend income (£10,800 of his cash dividend income) could now be subject to higher-rate tax. This could increase his income tax bill by up to £2,700 (£10,800 x 25%).

Warren is therefore left with a net after-tax sum of £6,900 (£9,600 - £2,700).

If instead the company had not paid him any rental income, the company would have been left with an extra £9,600 to pay out as dividends (£12,000 less 20% corporation tax) and Warren would have been left with a net sum of £7,200, after paying income tax at 25%.

In total, by getting the company to pay him rent, Warren is worse off by £300 (£7,200 - £6,900).

It all boils down to the peculiar way in which dividends are taxed and means that, if the rental income your company pays you uses up some of your basic-rate band, and this increases the tax payable on some of your dividend income, you could end up out of pocket.

The amount by which you could be worse off is equivalent to 2.5% of your rental income.

Mortgage Interest
Of course, many company owners who personally own their business premises will also have a mortgage on which they personally pay the interest. These interest payments can be offset against your rental income, effectively making some or all of it ‘tax free’.

Most company owners will instinctively realise that it would be foolish not to receive rental income if they also have mortgage interest to pay (or other tax-deductible property expenses). Tax-free rental income has to be better than a taxable dividend!

Nevertheless, let’s compare the two scenarios to find out exactly how much better off Warren could end up. This will also help us answer a more relevant question: Is it tax efficient to increase the rent your company pays you?

Example continued
The facts are the same as before except Warren also has tax deductible mortgage interest of £12,000. This completely offsets his rental income which means he can receive a £12,000 tax-free payment from the company.

If instead he decided not to make the company pay him any rental income, he would be left with an extra £9,600 to pay out as dividends (£12,000 less 20% corporation tax) and could end up with just £7,200 after paying income tax at 25%.

All in all, by paying himself enough rent to cover his mortgage interest, he could be £4,800 better off (£12,000 - £7,200).

The next thing to consider is whether it is tax efficient for Warren to get his company to pay him rent over and above his mortgage interest (and other tax deductible expenses related to the property). In other words, is it tax efficient to pay Warren enough money so that he is making a rental profit?

This is the situation in which Warren found himself in the first example but it’s worth reinforcing the point.

Example continued
The true market rent for Warren’s property is actually £6,000 higher, so he decides to increase the rent the company pays him from £12,000 to £18,000. He is now making a £6,000 rental profit and, after paying income tax at 20%, is left with an additional £4,800.

However, the additional rental income will use up £6,000 of his basic-rate band, which means £6,000 of his gross dividend income (£5,400 of his cash dividend income) could now be subject to higher-rate tax. This could increase his income tax bill by £1,350 (£5,400 x 25%).

In summary, Warren is left with an additional sum of £3,450 (£4,800 - £1,350).

If instead Warren had decided not to pay himself the additional rental income, the company would have been left with an extra £4,800 to pay out as dividends (£6,000 less 20% corporation tax) and Warren would have been left with £3,600 after paying income tax at 25%.

All in all, Warren is better off to the tune of £150 by not paying the additional rental income (the saving is equivalent to 2.5% of his taxable rental profits).

What these examples illustrate is that it is tax efficient to get your company to pay you enough rental income to cover your mortgage interest and other tax deductible property costs.

However, it is not necessarily tax efficient to pay yourself any more rental income if this produces a taxable profit that uses up some of your basic-rate band, thereby increasing the tax payable on some of your dividend income.

So far, we have only looked at the tax position of small companies: i.e. those with annual profits under £300,000. When a company’s profits rise above £300,000, it will start paying corporation tax at an effective rate of 25% (from 1st April 2012) and will therefore enjoy more corporation tax relief on any rent payments it makes.

This can make it more attractive to pay yourself taxable rental income instead of dividends.

Entrepreneurs Relief
APART from saving income tax, there is an additional reason why it may be a good idea to get your company to pay you a rent that is lower than the true rental value of your trading premises: to save capital gains tax.

When you sell your business, you may be able to claim Entrepreneurs Relief which means you will pay 10% tax instead of up to 28%.

Trading premises can also qualify for Entrepreneurs Relief, even if you own them personally. However, you cannot claim Entrepreneurs Relief if your company has paid you a full market rent (although rent paid for periods before 6th April 2008 is ignored).

If your company pays you a rent that is lower than the market rent, or if you owned the property before 6th April 2008, then a partial claim for Entrepreneurs Relief can usually be made.