Understanding Employee Share Trusts

Introduction to employee share trusts

Employee share trusts have grown in popularity in recent years with a catchy title: “NO CGT IF YOU SELL YOUR BUSINESS TO AN EOT”.

In this article, we’ll dig a little deeper into employee share trusts to see if the attention-grabbing headlines are a little too good to be true.

What is an employee share trust?

An EOT is a type of trust that holds shares in a company on behalf of its employees. Unlike direct employee shareholding, where employees are shareholders, EOT allows employees to benefit from the success of the company without owning shares themselves.

This structure is designed specifically for commercial companies, as non-commercial entities (such as investment companies) are not eligible.

Main features of an employee share trust

To be considered EOT, the trust must hold more than 50% of the shares and voting rights of the company. This creates a separation between ownership and management, where directors are the legal owners of the company and act in the best interests of the employees.

During this time, the existing management team can continue to manage daily operations.

The impact of employee share trusts: statistics…

As mentioned earlier in this article, employee ownership through EOTs is rapidly growing in popularity. As of October 31, 2023, there were more than 1,650 employee-owned businesses in the UK, with around 330 new businesses adopting this model in the previous 12 months. The advantages seem obvious with:

• 57% of these companies reported an increase in profits.
• 83% saw an increase in employee engagement.
• 73% noted an improvement in job satisfaction.

What are the advantages?

Based on the statistics above, EOTs offer several interesting benefits:

• Improved productivity: Employees tend to be more engaged and motivated when they care about the success of the company. This boosts productivity.
• Legacy Protection: Business owners can protect their legacy while facilitating a succession of leadership over time.
• Financial benefits for owners and employees: Owners can access the value they have created and employees can receive excluding tax bonuses of up to £3,600. Additionally, the sale of shares to an EOT can be tax-free if made in the same tax year, providing significant capital gains tax relief.

What are the potential downsides?

Despite the apparent benefits, there are some challenges to consider:

• Limited participation: The sellers of the business generally cannot be beneficiaries of the trust, which means they must relinquish control.
• Mental adaptation: For the original owners, losing control of the business can be a significant psychological hurdle.
• Valuation risks: If HMRC suspects that the valuation of the business is overstated, it may classify the excess value as employment income, thereby triggering tax liabilities under disguised remuneration rules.
• Restrictions on tax-free payments: Bonuses can only vary according to specific criteria such as remuneration, seniority or hours worked. Failure to comply with these rules could jeopardize EOT status.

Are there many risks?

The risks associated with EOT can be quite serious:

• Withdrawal of tax benefits: If employee share trusts lose control of the company or the company ceases trading, the associated tax benefits may also be removed.

In such cases, the EOT may be deemed to sell its shares at market value, which could result in capital gains tax without having the cash to cover it.

• High sales tax rates: If employee ownership trusts sell the business, they assume the seller’s cost basis, meaning they pay taxes on the gains held. Any distributions to employees are taxed as employment income, which can be costly (especially for high earners).
• Considerations for sellers: Sellers should consider the impact on the shares they retain and the potential inheritance tax (IHT) implications, particularly if it is deferred consideration. Term insurance may be required to cover IHT exposure.

Ok, I’m still interested…….what are the practical considerations for setting up an employee share trust?

Creating an employee shareholding trust requires careful planning:

• Identity and location of the trustee: Consultations are ongoing on the requirement of UK residency for the trust and the inclusion of at least one independent trustee.
• Financing Considerations: Contributions to employee share trusts to fund share purchases may be treated as dividends for tax purposes, so it is crucial to seek advice.
• Dividend payments: Receiving dividends can be tax inefficient for the trust, and deferred consideration periods present risks for sellers.

Summary

Employee ownership trusts can offer significant benefits to businesses and employees, but they come with complex requirements and potential risks.

If implemented for the right reasons, employee ownership trusts can boost productivity, protect a business owner’s legacy, and provide financial rewards to employees. However, tax incentives should not be the only motivation for creating an EOT. Given the numerous eligibility criteria and the serious consequences of disqualification, it is essential to seek specialist tax and legal advice before proceeding.

The ETC Tax team has a wealth of experience in the area of ​​employee share trusts. If you are a trading company and would like more information about employee share trusts, please contact us.