How Directors Can Claim
Home Office Expenses
Company Directors: Claiming Expenses
IN A previous article, we looked at some of the problems facing company directors and other employees when trying to claim tax deductions for business expenses.
As readers may recall, the basic problem is that the expenses generally have to be incurred wholly, exclusively and necessarily for the purposes of the director’s employment. This highly restrictive test contrasts rather unfavourably with the position for sole traders or partnerships who only need to show that expenses have been incurred wholly and exclusively for the purposes of their business.
Salary v Dividends
One of the most important areas where the difference in the two tests has a major impact in practice is when it comes to claiming a tax deduction for the business use of the proprietor’s home.
Example Part 1
Alex is a sole trader with a successful business. She rents office premises for her business but, for the sake of convenience, she also works a great deal from home in the evenings and at weekends. As a result, Alex is able to claim tax deductions for both her business premises costs and for a suitable proportion of her household running costs.
Alex’s house contains six rooms (excluding bathrooms, kitchen and hallways) and she uses one of the rooms as her study where she does her work when she’s at home. If Alex used her study exclusively for business purposes she would therefore be able to claim one sixth of her household running costs, including mortgage interest, council tax, heat and light, insurance and general repairs. However, Alex also uses her study privately and only around 50% of her use of the room relates to her business. She can therefore claim 50% of one sixth of her household running costs, or one twelfth.
(It is actually just as well that Alex does not use her study solely for business purposes, as exclusive business use of part of her home would lead to a partial loss of her Capital Gains Tax exemption on the property.)
So, if Alex has total annual household running costs of £24,000, she can claim a £2,000 deduction for ‘use of home’, saving her £840 (42%) in Income Tax and National Insurance if she is a higher-rate taxpayer.
Many sole traders or partners like Alex are able to make significant tax savings by claiming a ‘use of home’ deduction: even when they also have dedicated business premises. For these self-employed business proprietors there is nothing to stop them claiming some or all of the running costs for each and every property that they use for business purposes.
For company directors (and other employees), the position is not so simple. Before they can claim a ‘use of home’ deduction, they need to show that the business use of their home is ‘necessary’ for the performance of their duties of employment.
Example Part 2
A little while later, Alex is advised to form a company and transfer her business into it in order to reduce the top tax rate on her business profits from 42% to 20%.
In general, this is probably a good move but, sadly, it does mean that Alex can no longer claim a deduction for ‘use of home’.
Why not? Because it is not necessary for her to work from home part of the time: it is only a matter of convenience. As far as HMRC are concerned, they would expect Alex to stay at her business premises in the evenings – no matter how late she works and regardless of the risk to her personal security – and to make a special journey to her business premises if she wishes to work at weekends (with no tax deduction for the cost of the journey as it represents ‘home to work travel’).
Clearly, this situation is totally unfair: Alex has not altered her behaviour in any way and yet she is being denied relief for what was previously a perfectly valid tax deduction. Nonetheless, we have to accept that this is one of the drawbacks of transferring your business to a company.
What Company Owners Can Do
So what can Alex do to restore her tax relief?
Her first option is to make her ‘use of home’ necessary. She can achieve this in one of two ways:
- The simplest method would be to give up her business premises. If she had nowhere else where she was able to do her work then clearly, her ‘use of home’ becomes necessary and the appropriate deduction may be claimed. This would generally be the position for any company director running their company from home where there are no other business premises available to them.
- The second way to make your ‘use of home’ necessary is to make it a contractual requirement of your employment as a director. You make it a term of your employment contract that you will be required to work from home some or all of the time (as appropriate).
Making your ‘use of home’ a contractual necessity is a reasonably well-established method for retaining the relevant tax deduction, especially in the case of directors or other employees working for larger companies with many other employees. It may, however, be more risky in the case of a small company where there are no, or very few, other employees apart from the directors. Furthermore, where the director does not already have sufficient salary to cover the ‘use of home’ expenses, the ‘contractual necessity’ method may actually create an overall tax cost instead of a tax saving!
For the director of a small company, it may therefore be better to adopt the second option: the company rents part of the director’s home from them.
Example Part 3
Alex decides to rent her study to her company for £4,000 per annum. She therefore now has rental income of £4,000, but is also able to deduct one sixth of her £24,000 household running costs as expenses of her rental business. This leaves her with a rental profit of zero. Although she will need to report her rental business on her tax return, there will be no tax to pay.
Meanwhile, the company may claim a Corporation Tax deduction for the rent it is paying to Alex, thus effectively restoring the tax deduction for her ‘use of home’. (I’m ignoring her partial private use of the study for now: I’ll come back to that point later.)
The rental method described above is probably a better way to get effective tax relief for the director’s ‘use of home’ in the case of most small companies. Why? Because it does not require the payment of additional salary to the director.
Under the rental method, Alex has no taxable net income and the company may claim a deduction of £4,000: yielding a saving of £800 (at 20%).
To claim a direct deduction as a ‘necessary’ expense of her employment, Alex would need some taxable employment income. Here’s the catch though: the most tax efficient way for a small company director to pay themselves is generally to take a salary equal to no more than the personal allowance (£7,475 for 2011/12) and to take any further sums as dividends.
But Alex cannot set her ‘use of home’ deduction against her dividends, so to get a tax deduction she will need an additional £4,000 of salary. She won’t suffer any Income Tax, as she will be deducting her ‘use of home’ costs, but she will be stuck with additional National Insurance of £480 (at 12%). The company will also suffer an additional £552 in employers National Insurance (at 13.8%).
Between them, Alex and her company will therefore suffer a total of £1,032 in National Insurance. Even after factoring in the Corporation Tax relief for Alex’s extra salary and the National Insurance paid by the company, there is still an overall net tax cost of £122.
Hence, for small company directors paying themselves a minimal salary equal to the personal allowance, we can see that a direct claim for ‘use of home’ is actually counter-productive and the rental method should be adopted instead.
The director does not have to confine the rent charged to the company to the same level as the relevant proportion of their household running costs. They could, in fact, charge anything up to a full market rent.
Any charge in excess of the relevant costs will, however, lead to a taxable rental profit in the director’s hands. Rent-a-room relief will not be available, since the rental is for business purposes rather than residential.
Nonetheless, this remains a tax efficient method for extracting company profits and is a good alternative to dividends in most cases. Although the director will have some tax to pay on the rental profit, this is generally compensated for by the company’s Corporation Tax relief on the additional rent: in fact, it is more than compensated for where the company’s profits exceed £300,000!
There are two potential drawbacks to the rental method. Firstly, there will be a partial restriction in the director’s Capital Gains Tax exemption on their home and this is unavoidable where the rental method is used. In practice, this could end up costing more than the tax savings which have been yielded, although the method often still remains worthwhile in many cases, especially where the director has no intention of selling the house or the gain can be covered by the director’s annual exemption (remember that a couple owning the property jointly would enjoy a total of £21,200 exemption at current rates).