WORKING FROM HOME: DON'T LOSE PRIVATE RESIDENCE RELIEF!

Working from home is increasingly popular, but could it affect your Capital Gains Tax (CGT) private residence relief when you come to sell?

Private residence relief is perhaps one of the best well-known tax reliefs allowing a person to sell his or her (main) home without triggering a liability to CGT. As with most reliefs, its availability is contingent on certain conditions being met.

The relief applies to the disposal of a person’s main residence. As the MPs’ expenses scandal highlighted, where a person has more than one residence, he or she can choose which one is the main residence for the purposes of the relief. This does not have to be the one in which most time is spent and a person can chop and change which property is regarded as his or her main residence, although only one property can be the `main’ residence at any one time.

Relief is provided from CGT on the disposal of all or part of a property that is, or has at any time in taxpayer’s ownership, been his or her only or main residence, together with land enjoyed with the property as a garden up to the permitted area.

No Relief for Exclusive Business Use

Private residence relief is not available in respect of any part of the property that is used exclusively for business use. The key word here is exclusively and relief is only denied in respect of that part of the property that is used exclusively for business use. Where there is exclusive business use, any gain arising on the sale of the property must be apportioned and the proportion relating to exclusive business is charged to tax.

Example

Julia runs a marketing business from home. Her home has eight rooms and she uses one exclusively as an office. On the sale of her property, she realises a gain of £50,000. One eighth (£6,250) would be charged to CGT. To the extent that her annual exemption (£10,100 for 2010/11) remains available, this would shelter the gain with the result that no CGT is payable.

The same considerations apply if a person is employed but works from home and sets aside a dedicated area exclusively for work.

Protecting the Exemption

As noted above, relief is only lost where there is exclusive business use of part of the property. To protect the exemption, all that is necessary is to ensure that any part of the home that is used for business purposes is also available for private use. For example, a room used as an office from which to run the business during the day could also be used by the taxpayer’s children to do their homework in the evening.

By ensuring that rooms used for business are also available for domestic use, it is possible both to work from home while ensuring that private residence relief remains available for the whole property.

Income Tax Dilemma

While non-exclusive business use is a `good thing’ from the perspective of protecting full entitlement to private residence relief, the same cannot be said from an income tax angle. Relief for expenses is available to the extent that they are incurred wholly and exclusively in relation to that business.

Where a room is used exclusively for business, a greater deduction is permitted. Where there is non-exclusive use, the permitted deduction is reduced as costs must be apportioned between business and domestic use.

Practical Tip

If part of the property is used exclusively for business, all is not lost from a CGT perspective. Depending on the amount of any gain arising in relation to the business part, it may be possible to shelter the gain with the annual CGT exemption (£10,100 for 2010/11) with the result that it is possible both to use part of one’s house exclusively for business and to sell the house without paying any CGT, while enjoying the maximum possible deduction for expenses in the process.

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Query: Could you tell me please if a Discretionary Will Trust only applies to married couples? We are an unmarried (or common law) couple who wish to use a Discretionary Will Trust if possible but cannot see where this is defined.

Mark McLaughlin replies:

A Discretionary Will Trust is broadly a trust written into a Will, with trustees (who are normally the deceased’s personal representatives) and beneficiaries who usually include the surviving spouse (if there is one), family members, close friends, etc. With increasing property prices in particular resulting in more people having to consider inheritance tax (IHT) for the first time, Discretionary Will Trusts are being used by many married couples to achieve potential IHT savings. The reason for this can be summarised as follows:

Individuals domiciled in the UK are generally liable to IHT on worldwide assets (non-domiciled individuals are also liable, but on chargeable UK property). Their estates on death are subject to IHT at 40%, to the extent that their IHT allowance or ‘nil rate band’ (£263,000 for 2004/05) is exceeded.

There is an exemption from IHT for gifts or legacies between spouses domiciled in the UK. This means that if all estate assets of the first to die are left to the surviving spouse, there is no IHT liability. However, the surviving spouse’s estate is correspondingly increased, and the nil rate band of the deceased spouse is effectively wasted.

If a Discretionary Will Trust is set up it is possible, for example, for an amount up to the nil rate band to be left to the trustees, with selected potential beneficiaries (e.g. wife/husband, children and other family members). The trustees have discretion over how the trust capital and income is dealt with. However, it is quite common for an individual to write a ‘letter of wishes’ at the same time as his/her Will, requesting that the trustees consider exercising their discretion in favour of a particular beneficiary, usually the surviving spouse.

The intended effect is generally that the trust fund is available to the surviving spouse if required (subject to the trustees’ discretion), without enlarging his or her estate for IHT purposes. The available nil rate band of the first to die is also used. By applying the IHT nil rate band in this way, a significant tax saving can be achieved (up to £105,200 for 2004/05, i.e. the nil rate band of £263,000 multiplied by the 40% ‘death rate’ of IHT).

There is nothing to stop an unmarried couple making Discretionary Will Trusts. In fact, they can be quite useful, e.g. if there is some uncertainty when making the Will over who should benefit from the estate on death. A transfer of trust capital to beneficiaries after three months but within two years following death is treated for IHT purposes as having been made by the Will, although there may be possible capital gains tax implications. However, under present law, the above IHT exemption for gifts and legacies between spouses requires the couple to be married (although as a result of the Civil Partnership Act, registered same-sex couples are soon to be treated the same as married couples, with the necessary legislation expected to be introduced in Finance Act 2005). This means that if you remain unmarried and leave assets to your partner in the Will there may be a liability to IHT on death, but only to the extent that the estate value exceeds your available nil rate band. On the first death, the nil rate band is potentially used by a legacy to the surviving partner and is not wasted due to the surviving spouse exemption, which is an IHT objective of Discretionary Will Trusts.
Finally, a word of caution: Discretionary Trusts, whether created in lifetime or on death, involve potentially complicated legal and tax issues (e.g. Will Trusts involving the family home). Appropriate professional advice is essential.

Query:

I am approaching the end of the first tax year with my limited company. Out of necessity, I have been transferring as much money as possible each month from the company account into a personal bank account. I have been taking a nominal salary and paying NI on this each quarter, as well as paying VAT each quarter. I have the following questions:

1) Will the money I have been transferring out each month be considered as dividends for tax purposes?

2) If so, is it true that whereas money left in the company account attracts 19% tax, the dividends will attract 40% as I am a higher rate taxpayer?

3) I have taken out about £100,000 in this way - is it possible to borrow this money short term to put back into the company account for the year end?

4) How will the tax man view all this?

Mark McLaughlin replies:

With reference to your numbered questions:

1) There are certain requirements and formalities relating to company dividends from private companies. For example, the company must have sufficient distributable profits from which to pay the dividend. Otherwise, the dividend is unlawful. As the company is approaching the end of its first year, no final accounts will be available. Do you have any information (e.g. management accounts) to indicate that the company has made sufficient profits to cover the ‘dividends’ paid?

Assuming that the company has sufficient profits to pay dividends, is there any paperwork to support the treatment of the company’s payments as dividends? If the payments cannot be evidenced as dividends, the Inland Revenue could argue that the payments are actually additional earnings, and seek tax and National Insurance Contributions accordingly.

If the monies were withdrawn ‘on account’ of dividends, are the payments described as dividends in the company’s accounting records? Dividends fall into two categories, interim and final. The ‘dividends’ in your case would appear to be interim. The dividends are not effectively paid until they are declared (there should be written evidence of this) and the payments are recorded in the company’s books. Interim dividends are declared by the directors, assuming that the company’s constitution (i.e. its Memorandum and Articles of Association) allow it. Are you a director? Until the payments to you are properly declared, they are not strictly dividend payments as such, but are probably loans, which can have tax consequences for you and the company. Specific professional advice is recommended on the tax implications of company loans to shareholders and directors.

For the record, it is a criminal offence to backdate dividends. In addition, the dividends would be rendered void.

2) Dividends are distributions of company profits. Those profits will suffer corporation tax, with the post-tax profits generally being available for distribution as dividends. Single companies with taxable profits under £300,000 generally pay tax at 19% (for Financial Year 2004). In your hands, the dividends are received net of 10% tax. If you are already a higher rate taxpayer, you are liable to pay 32.5% tax on the gross dividend (i.e. an additional 22.5%). This equates to 25% tax on the net dividend received. Taken together, the tax payable both by the company (e.g. 19% on the profits out of which the dividend is paid) and yourself (25% on the net dividend) gives rise to an overall tax rate of almost 40% (for 2004/05) - 39.25% to be precise.

3) Companies are generally prohibited from making loans to directors. There are certain exceptions, such as in relation to small loans, but unless the business is that of a money lending company the amount you are considering treating as a ‘loan’ is not permitted. The Inland Revenue are aware of company law regarding loans, and could argue that the £100,000 extracted from the company was not a loan on that basis, but possibly ‘disguised’ remuneration. Of course, all this assumes that you are a director, but I suspect from your query that this may well be the case.

4) As mentioned, without the necessary formalities and paperwork to demonstrate that the payments were dividends, the Inland Revenue is unlikely to accept that they were. You may then need to convince them that the amounts were paid on account of dividends. A dividend could be voted or declared to cover the amounts drawn, but until then the withdrawals would probably be treated as loans, which carry a potential tax cost. Alternatively, there is a possibility that the Revenue could argue that the payments were actually remuneration, particularly in view of the small salary you have received from the company. The withdrawals would then be subject to tax and National Insurance contributions.

In summary, dividends need to be dealt with correctly, if they are to be treated as such. Professional help with the formalities and paperwork is recommended, at least until familiar with the procedures.

Mark McLaughlin
© 2005 Mark McLaughlin