Contractors trading through a limited company are typically employed by their own business, so in order to claim more home office expenses than HMRC’s minimum rate, they should create a rental licence. That’s the advice of James Abbott, owner and head of tax at contractor accountant Abbott Moore.
“Limited company contractors differ from contractors working as sole traders and partnerships, because they are employees,” explains Abbott. “And as employees, HMRC rules say they can only claim £3 per week for the use of their home as an office.”
However, according to Abbott, contractors can charge rent to their limited company at commercial rates that are substantially more than HMRC’s employees’ rates. To do so, they need to put a commercial rental licence in place between themselves and their limited company. This rent can reduce the contractor limited company’s corporation tax liability, but need not increase a contractor’s income tax charge if properly calculated.
Self-employed and partnerships calculate office costs differently from employees
“Contractors working as sole traders and in partnerships can calculate specific deductions based on household costs, floor area used for business and the hours that space is used for business purposes,” says Abbott. “HMRC publishes detailed guidance on how to perform these calculations.”
He continues: “Employees traditionally find it harder to claim expenses than the self-employed, so in theory contractors employed by their own businesses can only claim £3 per week or if the marginal cost, that is to say additional costs incurred solely for business reasons are more than that, they can claim the actual amount..”
But contractors employed by their limited company can turn the relationship between themselves and their company into one of landlord and business tenant. This is where a form rental licence comes in, as it allows them to use the same method of calculating home office expenses as sole traders and partnerships.
Contractors can charge rent through a rental licence and save on tax
“Any contractor homeowner can create a written rental licence between themselves and their contractor limited company, as long as it carefully sets out the commercial arrangement specifying how much rent the company pays,” explains Abbott. “Contractors who rent can do the same, but should first check that their lease agreement allows them to sub-let, which many do.”
The rent should not be excessive and the amount should have a commercial basis. However, for many contractors it makes sense to charge less than commercial rates, and that issue becomes important when assessing the income tax implications.
The process can be very straightforward. “Most contractor accountants will be able to supply a pro forma rental licence for their contractor clients,” continues Abbott, “so there is generally no need to incur additional legal costs.
“As with many contractor accounting issues, the important part of the process is to clarify in writing the commercial arrangement between contractor and limited company, and to identify that proportion of cash moving from the limited company bank account into the contractor bank account as rent, not expenses or dividends.”
Contractors charging rent – how it works
According to Abbott, in practice the contractor creates a written rental licence and charges their company rent. Rental income does not attract National Insurance Contributions (NICs), but could attract income tax.
The contractor then calculates the costs of their home office using exactly the same guidance used by sole traders and partnerships. Any profit could be liable to income tax, but the objective it to set a level of rent that covers the contractor’s expenses and minimises the potential income tax liability. Crucially, the contractor’s limited company can offset the cost of the rent against corporation tax.
If the contractor is married or in a civil partnership, they would normally share rental income with their spouse or partner, assuming the home is jointly owned. Abbott explains the mechanics: “Let’s say the contractor is charging £1,000 a year in rent and, using HMRC’s guidance, calculates home office expenses of £800, giving a profit of £200.
“Each spouse would receive £500 rental income per year, and charge £400 of home office expenses. Each would show a £100 profit, and it is only this profit that is taxed as income on their personal tax return, not the entire rental income.”
Contractor warnings – rates, capital gains and tax returns
But there are other factors to take into account before setting out on this course of action. Abbott warns contractors that business rates could apply to a contractor’s home if they make structural alterations to accommodate the business. Also, if there is a stream of clients and suppliers regularly visiting, neighbours may start complaining, which could attract the local authority’s attention and the imposition of business rates.
Any contractor homeowner can create a written rental licence between themselves and their contractor limited company, as long as it carefully sets out the commercial arrangement specifying how much rent the company pays
James Abbott, Abbott Moore LLP
Capital gains tax can be another issue. “A contractor’s home is generally considered to be their principal private residence and thus attracts no capital gains tax when sold,” says Abbott. “But if the contractor claims their study is used exclusively for business, they lose capital gains tax exemption and so, when selling their property, they would face a tax charge for that part of the building.”
Abbott suggests a way round this is to also use the office as a spare bedroom, as many contractors already do, by leaving a spare bed in the office and specifying in the rental licence exactly when the room is available to the business. That would demonstrate that the office was not used exclusively for business.
Finally, Abbott recommends that contractors do the maths with their accountant before charging rent and sharing the income with a spouse. He explains that in some cases the additional accountancy costs to prepare a spouse’s tax return, or if rental income takes the contractor into the higher rate tax band, could mean the corporation tax saving may not cover those costs.
“Charging rent can save some contractors money on their tax bills,” notes Abbott. “But it is essential to have the right paperwork in place and to confirm with a tax professional that the contractor will benefit financially.”