Employee Ownership Trusts

Employee Ownership Trust (“EOT”) structures remain a popular option for business owners looking to exit their business. There are clear tax benefits for selling shareholders and the opportunity for employees to obtain tax-free cash flow on an annual basis.

However, it is easy to get blinded by the upfront tax benefits and lose sight of some of the challenges associated with both a sale to an EOT and also if and when the EOT plans to sell its shares in the future.

Employee Ownership Trusts – The Basics

An EOT is a trust for the benefit of all the employees of a company or group. If the owner(s) of a business sell a majority stake (more than 50%) in their business to an EOT, any gain they make on the sale should be tax free. Many conditions must be met before tax free sales can be carried out, but if appropriate advice is taken, clear tax benefits can be obtained. It is also possible to pay employees tax-free bonuses of up to £3,600 per year when they own an EOT.

This all sounds very appealing, but if tax benefits are the only or main reason you are considering an EOT structure, it may be wise to consider the points below before embarking on the process. Generally, EOTs are a great solution for those who are entering the process for the right reasons – but for those who see it as a way to make money tax-free, it can cause significant difficulties in the future.

To lose control!

The first point may seem obvious but it is often overlooked. The shareholder(s) must sell a majority stake to the Employee Ownership Trust – so they are no longer able to control the destiny of the company. The seller(s) can of course stay with the business and become trustees of the trust, but best practice for trustees is that there should be at least one independent trustee and possibly an employed trustee as well. There is a strong feeling that this requirement could become law at some point.

So, although the previous owners continue to run the business on a day-to-day basis, the long-term future of the business is in the hands of the directors, whose responsibility it is to protect the interests of the employees. Business owners can and do find this transition difficult to make.

Jam tomorrow…

In the majority of cases, the purchase by the Employee Ownership Trust will be funded by a combination of cash from the business from day one and deferred payments funded by future profits. This often means that a significant portion of shareholders’ cash flow depends on the company’s future performance. Does this mean you will have to stay involved until you receive your money? What happens if business performance deteriorates? Could deferred consideration cripple the company’s cash flow? How long are you willing to leave your money on the table? The longer payments are spread out over a longer period of time, the greater the risk of something going wrong.

One would think that the deferred payments could be funded by the proceeds of the sale by the trust at some point in the future – although this could well be a possibility given the amount of tax the EOT will have to pay on upon a subsequent sale (see below), how confident will you be that you have sufficient cash remaining to repay the outstanding amounts? And will the directors consider that a future sale would be in the best interests of employees?

The lesson here is that when considering the sale value to the employee share trust and the level of deferred payments, ensure that a balance is struck between all competing factors: the affordability of payments, the length of the recovery period, how long you will need to stay to look after your interests and other factors as well.

Death and taxes

In a typical business sale situation, the sellers of a trading company will convert a very Inheritance Tax (“IHT”) friendly asset (shares in a trading company) into a very unIHT friendly asset: cash. In the absence of further planning, the entire amount of this money would be exposed to IHT in the event of the unfortunate death of the owner. However, in general, if the deal has been negotiated well, the landlord will have received a significant majority of this money up front, so at least the money is there to pay IHT.

However, in the case of an employee share trust, a large part of the proceeds may be deferred amounts. If the worst happens, these monies will be considered an asset of the deceased’s estate (a debt) and subject to IHT on the entire amount owed – although some of the money should not be received for many years. years. The law does not provide for IHT to be deferred to match the receipts of the deferred consideration, so this can mean a real cash flow hit for beneficiaries… There are ways to manage the risk, but it is much better to think about it before the sale than after.

Second outing

In the hope that the second exit does not fall under the previous prong, many business owners will retain an ownership interest in the company they are selling in anticipation of a second sale in the future. The first thing to note here is that the tax-free sale to the Employee Share Fund is a one-time wonder: any sale in a subsequent tax year will be fully subject to capital gains tax in the normal way. Second, of course, they no longer have control of their own destiny – it will be in the hands of the administrators!

Common misconception

A common misconception is that the tax-free sale of shares to the EOT is some sort of exemption – nothing could be further from the truth. Certainly, provided the business owner is attentive to the conditions, once a certain period has passed, he is in the clear. However, the same cannot be said for the Employee Ownership Trust.

Where the tax free sale takes place, for CGT purposes the EOT assumes the tax cost basis of the original owner’s shares. So if the owner has simply subscribed for £100 worth of share capital, this is treated as the cost of the shares to the EOT, regardless of the actual price paid at the time the EOT acquires the shares.

In practice, this may mean that the EOT will actually pay CGT (at 20%) on the entire proceeds of any sale. As above, this can leave a very large hole in the cash received to pay employee benefits or to pay the balance of any deferred consideration.

If there is money left to pay to employees, the hard blows come one after the other. The employee is taxed on the distribution of profits as if it were remuneration from their employment – ​​at rates of up to 47%, including NIC. In addition, the employer will have to pay the NIC at 13.8% on the amounts distributed.

What does that mean?

All this means that the net amount received by employees can only represent a relatively small proportion of the gross proceeds from the sale. This is a point that directors will need to consider when determining whether a sale is the right option for the benefit of employees.

In summary…

None of the above is intended to dissuade anyone from exploring an EOT as an option for their business. For the right companies and when done for the right reasons, EOT can be extremely effective in driving employee engagement and, with it, profitability and growth. However, for those who undertake an EOT without taking advice and understanding the full implications, the structure of the EOT can be the source of considerable difficulty (and cost)! It is essential that the decision to move forward is as informed as possible so that all of these potential issues can be considered and managed before they arise.

Next steps

At ETC Tax we have implemented a number of EOT transactions by working with business owners to ensure they get the results they are looking for and giving them honest and impartial advice as to whether a EOT suits them. For more information on EOT and other forms of corporate exit, contact us.