Profits, freeholds and pensions

Michael McCabe and Stephen Marsden look at the best way of managing and making profit from an office

Solicitors earning sufficient profits who have been able to fund their pensions to a satisfactory level and are happy with the amount of tax that they pay can afford to relax and ignore this article.

On the other hand, what follows will be relevant to to the many solicitors who:

l have unused pensions relief;

l are concerned at the level of their practice rent;

l have capital locked up in the freehold of your office but are concerned at the ability to realise that capital, or;

l have used all available pension relief and would like to save additional tax on income.

This article will examine:

l why renting offices is potentially a waste of money;

l how solicitors can release capital locked up in a freehold through the use of pensions, and;

l how, if a practice is a reasonably stable one, solicitors could earn a return on capital of up to 36% annually through owning the freehold via pension funds.

Solicitors and property

Solicitors either rent premises or own them.

In some cases, some of the partners might own the property, with the firm paying a rent to those partners.

In many cases, the partners would intend that all of the partners have a share in the freehold.

However, many young partners do not earn a sufficiently large share of profits to raise the funds required to buy a share in the freeholds.

There are many wonderful offices, which are full of character and are listed, but which are completely impractical for the running of a modern legal practice.

Some young partners see a share in such properties as a potential millstone, as they see limited scope for appreciation in the value of such buildings.

This has created a situation where many elder partners, who are looking to retirement and much of whose personal capital is tied up in freehold premises, find they are unable to realise their capital, as there is no market for their share in the property.

One possible solution might be to transfer the freehold premises into the partners' pensions.

However, current Inland Revenue rules prevent partners' pension funds from acquiring premises from related parties (that is to say, the partners themselves).

A number of firms have been advised by accountants and financial advisers that a transfer of this type is not possible.

Solicitors might be encouraged to hear that there is a possible solution whereby their existing freeholds may be transferred into a vehicle created specifically for this purpose and into which their pensions may invest.

By this method, the partners gain benefits and tax savings, without falling foul of Revenue rules.

A possible solution

The solution provides:

l The opportunity to raise capital to be repaid from future tax free profits.

l Avoidance of capital gains tax - retirement relief is being phased out over the next three years and many partners older than 50 may use the remaining allowance while it is still available.

l Effective succession planning, by providing an affordable way for junior partners to acquire a share in the firm.

l A way of enhancing greatly the retirement plans of all partners in the firm.

Self-invested personal pensions (SIPPS)

Self-invested personal pensions (SIPPS) are a method of taking control of the investment element of pensions.

They are a vehicle whereby the decisions as to investment or the appointment of investment managers are taken by the investor.

Investments may be in property, managed funds, equities or other approved investments.

In general, a SIPP provides greater flexibility, not only over investment choice, but also over contributions.

They involve the payment of fixed annual fees rather than a percentage of the fund.

This can result in significant savings.

Take the example of a firm with eight partners, fee income of 1.2 million, and profit of 50,000 per partner (400,000).

Assume that the partners are paying 7% of their fee income in rent and occupy a premises worth 800,000.

They wish to acquire premises for 800,000.

The partners have individual pension arrangements.

Some may have retirement annuity contracts, while others have personal pensions.

It is assumed that all partners have some unused pension relief.

The partners will decide to buy either property owned by themselves or by a third party.

Specialist financial and tax advice should be taken if the property is already owned by some or all of the partners.

It is likely that a large proportion of the cost will be borrowed.

Many partners in law firms will be nervous of approaching their own bank, because firms often experience difficulty when approaching their bank with unfamiliar proposals.

Most high street business bankers will look at professional firms from a standpoint where their lending criteria are fixed and to some degree inflexible.

However, some of the larger banks are familiar with and comfortable with this type of lending.

Peter Fearns, regional director for the North of England division of the Royal Bank of Scotland, comments: 'This is a complex area and underwriting loans of this kind requires specialist knowledge.

As a bank, we need to be certain that the advice given by all professional advisers is suitable and that the tax implications have been dealt with satisfactorily.

It is of paramount importance that bankers fully understand this type of loan, its proposed structure and potential benefits to the business or individuals concerned.'The deposit will be provided by the partners, either by transferring existing pension funds into a SIPP or by making an additional contribution.

Assuming that, in the example, the eight partners wish to acquire the property equally and will put a deposit of 30%.

l Cost of property: 800,000

l Deposit: 240,000

l Borrowing: 560,000

l Deposit per partner: 30,000

The funding of the deposit per partner depends on their existing pension arrangements.

If they already have sufficient personal pensions, then a transfer could be made from existing funds.

If each partner were to make additional pension contributions, they would need to find 18,000, the other 12,000 being paid through tax relief.

The property will be owned by the pensions and rent will be paid into the pension funds.

Charges such as mortgage interest, maintenance and management charges will be paid by the pensions.

Any excess will be retained in the partners' pension funds and invested in other tax-free investments for the partners' retirement.

Many firms set a benchmark for establishment costs at 10% of income.

In recent years, there have been many firms that own their freeholds distorting their figures by paying a notional, rather than commercial, rent.

In difficult times, this has the effect of maintaining profit.

However, it can have a detrimental effect when the firm is successful.

For instance, take the example of a firm which in the last year earned 133,000 per partner.

The partners own the freehold and they pay a notional, rather than a commercial, rent.

The partners are earning significantly more than the earnings cap and have around 42,000 of income, which cannot be relieved by pension contribution allowance.

Each of the partners could be significantly better off if they were to increase the amount of rent they pay.

If the rent were increased by the equivalent of 10,000 per partner, the excess would ultimately be paid into their pension funds.

The rent is a deductible expense in the partnership and the payment into the pension fund will not attract any income tax on the part of the partner.

In effect, the partners will each have saved 4,000 in tax.

The endgame - realising investment on retirement

By the time a partner reaches retirement, his pension portfolio would consist of interest in freehold property as well as other, more conventional pension assets.

On retirement, the partner would normally elect to take 25% of the total value of investments as a tax-free cash lump sum.

In addition, they have the following options in respect of the remaining investments:

l A pension drawdown income may be taken from investments, which may include rent from freehold property;

l Interests in freehold property may be sold with the proceeds used to provide a drawdown pension as above.

In the case of this being sold to incoming partners, specialist advice is needed to avoid contravening Inland Revenue rules; or

l The retiring partner may use the residual funds to purchase an annuity if a guaranteed income is preferred.

Under proposals that may take effect later this year, this must occur by the time the partner reaches the age of 80, instead of 75 as under the current rules.

Michael McCabe is a director of Premiertec Consulting, which specialises in advising lawyers on management and performance issues.

Stephen Marsden is a partner of the J Rothschild Partnership and is a specialist retirement benefits adviser