Employee ownership trusts

Available tax reliefs

Many business owners qualify for “entrepreneurs’ relief” from capital gains tax (CGT), which currently gives a 10% rate of tax on the first £10m of sale proceeds. If a sale is to an EOT, however, the tax relief is even more generous as no tax is paid by the seller. Instead, for tax purposes the EOT is deemed to acquire the shares at the original cost of the seller. In addition:

• if the seller decides to part sell and part gift the business to the EOT, a separate relief is available from any inheritance tax on the gift element; and
• there are income tax reliefs available for bonuses paid by companies owned by EOTs.

Qualifying criteria

To qualify for the tax reliefs a number of criteria must be met. These include:

• the business must be carrying on a trade (so can’t be an investment business) and must continue to trade until at least the end of the tax year of the sale;
• the EOT must acquire and continue to hold a controlling interest (+50%) of the business;
• sellers who retain 5% of more of the shares must not exceed 2/5ths of the total workforce;
• all eligible employees must benefit (with limited exceptions) and the EOT’s assets must be used to benefit all such employees equally – although benefits can be determined to a certain extent by applying objective factors such as length of service, amount of remuneration and hours worked;
• for income tax relief on bonuses, in addition to the above criteria, the bonus must not be a substitute for salary, must not exceed £3600 per year per individual, and directors must not represent more than 2/5ths of the work force.

(Please note the above is a broad summary of the rules as at 1 January 2020 – the rules are detailed and require careful consideration in each case to ensure qualification)

In addition to the substantial tax benefits of selling your company to an EOT as detailed above, there are several other advantages that benefit not just the selling shareholders but other parties too:

No need to find a third party purchaser

Some business owners find it difficult to find a buyer for their business at the time they wish to sell. By using an EOT structure, sellers are often able to achieve full market value more easily, because the business itself funds most of the purchase price (either from reserves or by raising finance (see below for more detail on this)). Selling to an EOT also allows sellers a more certain outcome as there is less likelihood of the deal falling through, particularly if the employees and the proposed trustees know the business well.

Continuity of the ethos built by the founders of the business

Trade sales can often be very disruptive to the workforce and mean the culture can change substantially. Sale to an EOT on the other hand is generally less disruptive because management and the company ethos remain the same, at least in the short term.

Advantages for employees

The company will be run for the benefit of the employees, hopefully providing enhanced job security and making it a more desirable place to work, which in turn will assist with employee retention, engagement and recruitment. Employees that qualify are entitled to income-tax free bonuses of up to £3,600 per annum and to a share of the sale proceeds if the company is eventually sold.

Easier sale process

From the owners’ perspective, the sale process is far easier as they are not having to deal with unknown third parties that may want to do extensive due diligence. The transaction will have more similarities with a management buy-out where the management team understands the company and has a good working knowledge of it so do not require the same level of investigation.

A flexible structure

Although there are certain rules that need to be adhered to in order to achieve the tax benefits, there is a lot of flexibility in the EOT structure:

• sellers can retain a fairly large shareholding, so long as they give a controlling interest to the trust (see below);
• subject to distributable reserves, as much or as little as required can be paid for the business on day one; and
• the board can continue to include the sellers (good for continuity and gives the sellers the added protection of continued involvement at board level if any of the purchase price remains outstanding).

If you have decided to sell your shares to an EOT, one of the first aspects to look at is how best to fund the transaction. Having an independent valuation of the company at the outset will be key, and this should also take into account the affordability of any payment (consideration) structure.

Once the price has, been settled, there are three main ways to fund the acquisition:

Deferred payment

The consideration may be structured in such a way as to allow payment to the seller over a period of time, on a deferred basis. Management/trustees should look to involve an accountant to model the financial impact on the business of the deferred payments to check affordability. Sellers should be aware that other business debts (bank loans etc) may be repaid in priority over repayments due to the sellers, so there is some risk here.

Cash Reserves

The purchase price could be funded in whole or in part by the cash reserves in the company.

Third Party Funding

Finally, there are lenders that will advance to EOTs to enable them to purchase the shares, either directly or by advancing to the company which then gifts the funds to the EOT. Management/trustees should note that lenders usually require security, which may impact the company’s future ability to borrow for expansion or other business purposes.

How can we help?

We work with a number of lenders who are familiar with lending to EOTs and are happy to make appropriate introductions.

Following the transfer of shares into the EOT, all key decisions which would usually made at shareholder level (including the appointment of the board of the company) will be made by the trustees of the EOT. It is therefore very important to appoint suitable and experienced trustees.

Using a corporate trustee

Trustees may be individuals, but typically a corporate trustee (a company set up to fulfil the role of trustee) will be used so as to limit the liability of individual trustees (a key concern for people taking on the role of trustee). If using a corporate trustee, it is the identity of its directors which will be key.

Ensuring independence and real control

There are two key considerations when determining who the trustee(s) (or its directors) will be:

Control must pass – if the former owners are the only or make up the majority of the trustees, then it may be tricky to show that they are no longer in control of the business and therefore the criteria for tax relief may not be met.

• The trust must be able to act independently – the trustees must be able to hold the directors of the company to account and to meet the duty of the trustees to act for the benefit of all eligible employees on the same terms – the trustees and the board of the company should not consist of exactly the same group of people, as there is an increased chance of conflicts of interest arising.

Potential solutions:

• engage professional trustees (but note the additional expense and administration); or
• appoint independent directors to the board of the corporate trustee if using.

There is a lot of flexibility in how the business can be managed going forwards. The day-to-day management of the business will generally continue to be carried out by the board of the company, but with certain important matters reserved to the trustees.

The former owners can continue to be involved in the management of the business, as executive or non-executive directors, but some changes may be necessary to the board to ensure control has passed from the former owners and ensure that the trust is able to act independently of them (see above).

Whilst the company is now operated for the benefit of the employees, it does not mean it has to be managed by the employees. However, in order to make a success of the new structure, it will be important to engage with the employees and allow their voice to be heard.

Ways of doing this include:

• appointing an employee representative to the board of trustees; and/or
• setting up an employee council to be consulted by the company’s board, the board of trustees or the employee representative before certain decisions are made.

The main consideration here will normally be how many employees the company has and what is appropriate/effective from a logistical point of view.

How can we help?

Setting up the trust, advising on ways to show the separation of power between the board of the company and the trust as well as on an appropriate management structure.

Yes! It is possible for an EOT to offer share incentives, although the trustees would have to be mindful of their obligation to benefit all qualifying employees. Alternatively, it is possible for management share schemes to be run through a separate employee benefit trust or run directly by the company provided that the EOT retains control of the company.

We recommend that the commercial advantages of incentivising key managers are considered at the planning stages of a sale to an EOT, when they can best be taken into account.

How can we help?

We can discuss with you how best to incentivise managers and set up appropriate share incentive schemes for you.