By Louise Misiewicz
Updated and relevant for tax year 2019/20
You entrepreneurs tax questions answered
In this article we attempt to answer the following questions about entrepreneurs relief:
– Is entrepreneurs relief available on flipping a house?
– What rate is entrepreneurs relief?
– How many times can you claim entrepreneurs relief?
– Do sole traders get entrepreneurs relief?
– How does Entrepreneurs Tax relief work?
– What is a trading company for entrepreneurs relief?
Whilst you are reading this article you may wish to read our page on the subject of “buy to let tax for UK landlords” where we discuss all the different types of tax that you need to be aware of. Read Here for more (opens in a new tab)
Different types of property tax to pay when flipping a house
I hear a lot of horror stories where investors think that they will get Capital Gains Allowances and pay just 18% tax on the profit made. Sadly, there is a criterion that must be met to ensure that CGT is paid rather than income tax.
Capital Gains Tax (CGT)
This is where you pay tax on properties that you have purchased, refurbed, rented and sold. The tax rates for properties sold after being rented out is 18% for basic rate taxpayers and 28% for high rate taxpayers.
Income tax is paid when you purchase, refurb and flip a house. Please note that the property would not have been rented. The tax you pay will be based on your total income. The tax rates are 20% for basic rate taxpayers. This is increased to 40% for high rate taxpayers. This is further increased to 45% for additional rate taxpayers.
What is the entrepreneur’s relief when calculating Capital Gains Tax?
Entrepreneurs Relief (ER) is available to a person who closes down all or part of their business. This could be a sole trader or limited company/partnerships. Entrepreneurs Relief reduces the tax you pay from 45% for significant profits down to 10%. It is available typically where the following can be met:
- The person claiming ER has at least 5% of voting shares in the business which is being part or fully closed down.
- The person claiming the ER has owned the shares in the business for at least 12 months. From April 2019 this will increase to 24 months
- The business on which ER is being claimed is a Trading business (ie not rental, bank interest or stocks and shares trading income) or it is the holding company of a trading group within the last 12 months. Again from April 2019, this period will increase from 12 months to 24.
- The person claiming ER works in the business (ie is not a “sleeping partner”).
How to claim Entrepreneurs’ Relief
To claim Entrepreneurs’ Relief you have to meet the relevant qualifying conditions throughout a period of 1 year. This period is referred to in this helpsheet as the ‘qualifying period’. It ends with the date when you disposed of the asset, or an interest in the asset for which you want relief, or the date when the business ceased. If that year was earlier.
As HMRC help sheets show You can claim relief, subject to the conditions set out below, on a disposal of assets (including disposals of interests in these assets) which fall into the following categories:
- assets (with the exception, in some circumstances, of goodwill) used in the business. This is comprised of a disposal of the whole or part of your business. See ‘Qualifying conditions’ below. The qualifying business assets include business premises. Items not included within this category are shares and securities.
- assets that were in use for your business or a partnership. These items would have been disposed of within the period of 3 years after the time the business ceased. This category excludes shares and securities.
- one or more assets consisting of shares in, or securities of, your ‘personal company’. See below for more details. The shares must be disposed of either
- (i) while the company is a trading company. alternatively, where you hold shares in a holding company of a group. The group of companies must be a trading group or
- (ii) within 3 years from the date it ceased. Either a trading company or a member of a trading group. See Example 3 below
- assets owned by you personally but used in a business carried on by either:
- (i) a partnership of which you are a member, or
- (ii) by your personal trading company. Again this may also be by a company in a trading group. These holding companies which are your ‘personal company’. See below for more details. The disposal will only qualify as long as it is associated with a disposal of either your interest in the partnership or of shares/securities in the company. Qualifying disposals which fall into this category are referred to as ‘associated disposals’.
What assets are included in the entrepreneur’s relief calculation?
References above to ‘business’ includes any trade or profession. These do not include the letting of property. The exception to the rule is furnished holiday lettings in the UK or European Economic Area (EEA). See page UKPN 2 in the UK property notes for guidance on furnished holiday lettings in the UK or EEA. We talked about holiday lets in another article.
A trading company is defined in TCGA 1992, s 165A(3) as a “company carrying on trading activities whose activities do not include to a substantial extent activity other than trading activities”.
It has always been understood that HMRC will regard any activity as not being substantial if it comprises less than 20% of the company’s activities.
A business closes down and the shareholder takes the profit into their name. The amount of income tax charged in this is just 10%. Please note that the persona also receives an annual Capital Gains Tax allowances.
Special purpose vehicle (SPV) — limited company
I would advise that people set up a limited company as a special purpose vehicle (SPV). The reason for this advice is because:
- A limited company limits the financial risks to the limited company, not your personal assets
- As a limited company, you are not tying yourself financially to any joint venture partner
- There is a perceived enhanced reputation by using a limited company
- It is more tax efficient to have a limited company that is only taxed at 20% compared to a maximum of 45% income tax as an individual.
Download our tax-efficient property investment guide for 2018 here
Entrepreneurs relief to mitigate Capital Gains Tax (CGT)
You can claim entrepreneurs relief when you sell a property within a limited company that has paid corporation tax.
So, how much tax do you pay? You will pay 10% tax by making use of entrepreneurs’ relief rather than 18%/28% CGT.
Here is the process of setting up a limited company:
1 – Agree who are going to be the investors. They agree to put in £1 shares each
2 – Agree the amount of money that is to be loaned to the company
3 – Set up a limited company
4 – Set up a limited company bank account
5 – Ensure that bookkeeping is neat and tidy by using online software such as Xero
6 – Carry out the business/property transaction, making sure you get invoices for all the money that you spend
7 – The company is taxed at 20% of any profits made
8 – Payback any loans made
9 – The company is closed down and remaining cash is distributed to the shareholders
10 – Shareholders are taxed at 10% entrepreneurs relief on closing down the limited company, after receiving the CGT allowance.
Example of entrepreneurs’ relief
1 – John and Jim agree to set up ABC Limited with £1 equity each
2 – They both agree to put in an additional £49,999 each as a loan
3 – An agreement is formed and signed
4 – ABC Limited is born on 3rd January 2015
5 – Bank accounts are set up so that one person issues a payment to be made and the other person has to authorise it. This ensures financial control of the money within the business. It also ensures that the two agree how the money is spent in advance
6 – Jim agrees that he should look after all the paperwork
7 – They buy a property for £100,000 and sell it for £150,000. The business has made a profit of £50,000
8 – At the end of the financial year, 2nd January 2018, they work out that the profits are £50,000 as above and their accountant informs them that the 19% tax of £9,500 needs to be paid nine months later. This means that the business will have £140,500 (£2 equity plus £99,998 loan + £50,000 profit less £9,500 tax bill) left in the bank after the tax has been paid
9 – The company pays back the two loans of £49,999 (each). This leaves the company with £40,502 (£40,500 profit after tax and £2 equity shares)
10 – The balance of £40,502 is split between the two brothers. Each gets £20,001 (£20,000 share of the profits plus £1 equity)
11 – Jim and John do their self-assessments after closing the company down and they claim entrepreneurs’ relief at 10%. Tax is calculated as follows:
£20,251 profit plus the £1 equity
(£1) less the equity involved
(£11,300) less Capital Gains tax allowance
£8,950 taxable profit
£895 tax to pay (10% of the £8,950)
Please note to qualify for entrepreneurs relief the following must apply:
– you’re a sole trader or business partner
– you’ve owned the business for at least one year before the date you sell or close it
– you sell or dispose of your business assets within three years of selling or closing the business
HMRC’s concerns about entrepreneurs relief
HMRC have expressed concern about the use of this process. They view it as aggressive tax planning. HMRC believe it is unfair to other taxpayers. As they cannot make the same type of arrangement. For this reason, if you are closing down your company via a Members’ Voluntary Liquidation (MVL), HMRC will look carefully at the reasons for closure, and attempt to identify whether moneyboxing has taken place.
One of the problems facing HMRC is the ability to define ‘excessive’ retention of funds in each case. Working capital requirements vary greatly between businesses. There is a danger that directors simply erring on the side of caution with their working capital. This is rather than deliberately trying to gain a tax advantage, could be wrongly accused.
HMRC have introduced a safeguard to charge taxpayers income tax whereby a shareholder becomes involved in a similar trade within two years of that closure.
Targeted anti-avoidance rule (TAAR) against flipping properties in limited companies
In order to meet the needs of some financing companies where they must have the property development in its own limited company. You may find that you fall foul of TAAR if you repeat opening and closing of companies performing similar jobs within 2 years of one another.
Following a mechanism of opening and closing similar types of businesses will likely be in contravention of the 6 April 2016 changes to law using TAAR (targeted anti-avoidance rules). These rules now in full force are to combat phoenixing as the government describes it (which in essence is approaching a business transaction with a view to avoiding tax rather than the business transaction itself). A distribution from a winding-up will be taxed under income tax rules (up to 45% tax), rather than Capital Gains Tax (up to 28% tax) or Entrepreneurs Relief Tax (10% tax) where four conditions are met:
- The company is a close company (which it will be in your instance)
- The individual holds at least a 5% share (which you will have)
- Upon receiving a distribution, the individual continues to be involved, directly or indirectly, with the carrying on of the same or similar trade or activity to that of the wound up company; and
- The main purpose, or one of the main purposes, of the arrangements as a whole, is to obtain a tax advantage.
It is likely for many property developers that the structure of continuing similar business ventures after closing down each company means that the first 3 bullet point conditions will be met by most. It will then be down to interpretation of the intent of the developer to determine the fourth which means discussions with HMRC who may rule that although an individual intent is to run 1 business of development, in order to meet the needs of lenders they had to run several businesses and that this falls foul of TAAR (and causes all profits to be taxed under income tax which is the highest level of tax chargeable).
Step by step guide to avoiding TAAR
1 Set up a holding company where you are the 100% shareholder
2 Set up individual development/flip companies beneath the holding company (ie have the holding company own 100% of the development/flip company) for each project/lender and conduct the necessary work within them
3 On completion of the development (and securing of the profits), pay corporation tax due and pay the remaining profits as a dividend to the holding company (no further tax will be taken from the dividends unless you extract the money from the holding company to your personal name as either a wage or a dividend)
4 Re-use the development/flip limited company for further developments where possible
5 Extract from the holding company no more than £8,164 in salary (17/18 tax year) and £36,836 in dividends (17/18 tax year). This will result in a personal tax bill (assuming no other income such as bank interest lands in your personal name) of £2,387.70.
This solution results in a flexible plan that keeps all limited companies in operation and allows you to remove profits from the flip company up to a holding company. This then allows you to determine how to use the profits made without it necessarily landing in your personal hands and therefore in your personal tax return. When you do extract money to your personal name you can manage carefully and through just one limited company what you personally take keeping administration to a more minimal level.
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