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Stephen Hill Partnership Blog

Employee Ownership Trusts

Employee Ownership Trusts

An owner of a trading company can now sell some, or all of their shares to an employee ownership trust (“EOT”) provided that certain conditions are met. The shares can be sold for full market value without incurring any Capital Gains Tax (“CGT”) liability. This structure also benefits the employees of the company.

 

  1. What is an EOT?

An EOT is a special form of employee benefit trust established to hold shares on behalf of employees in a company. It is a structure that was created by the Government in September 2014 to encourage company owners to sell a controlling stake of the company to its employees.

An EOT possesses the following characteristics:

  • It must have a controlling interest in the company i.e. it must be greater than 50%;
  • It must be established for the benefit of all employees in the company – this excludes, broadly, any individuals who hold or have previously held 5% of the shares;
  • It must treat all employees on an equitable basis.

 

  1. How do EOTs work?

The shareholders of a business will sell shares representing at least a majority stake (51%) to a newly formed trust – the EOT – which will then hold the shares for the long term benefit of the employees as a whole.

Example

Current Structure

As an example, assume that the company below is your average owner managed business, owned in its entirety by a single director shareholder who takes a small salary from the company each year and tops this up with significant levels of dividends.

Employee Ownership

The below diagram shows the general structure after the implementation of the EOT. The shares will now be held by the new trust for the benefit of the employees.

 

The EOT trustee might be a subsidiary of the company with a mixture of independent and internally-appointed trustee directors, or an independent professional trustee.

 

  1. How does a sale to an EOT work?

There are three key steps:

  1. A qualifying EOT will be established with a corporate as the trustee of the EOR (the Trustee Company).
  2. The shareholders sell their shares to the Trustee Company under a share purchase agreement. The shareholders and the Trustee Company will jointly engage a share valuation expert to value the company: the Trustee Company will use this value as the basic for determining the purchase price. On the sale of the shares, the purchase price will create a debt owed by the Trustee Company to the shareholders which will be left outstanding (see diagram).
  3. The company will continue to generate trading profits each year and it will use these profits to make contributions to the EOR. The EOT will use these contributions to repay the outstanding purchase price that it owes to the shareholders.

 

  1. How will the sale be funded?

 

The EOT may be able to draw on external bank funding for the sale.

However, the usual structure is as follows:

  1. The company contributes cash to the EOT which the EOT pays upfront to the existing shareholders as part consideration for the shares.
  2. The EOT also issues a form of loan note to the existing shareholders representing deferred income which can be drawn down on over a given future period.
  3. Each year, the company will continue to make payments out of profits to the EOT.
  4. The EOT will then use this cash to redeem part of the loan notes from the existing shareholders.

 

  1. What are the advantages of selling to an EOT?

Some of the main advantages are:

  1. It allows employees to indirectly buy the company from its shareholders without them having to use their own funds. This thereby creates an immediate purchaser and addresses any succession issues.
  2. Shareholders can sell their shares for full market value.
  3. No capital gains, income or inheritance tax liabilities should arise on the disposal of a controlling interest in a company to an EOT (or on the subsequent receipt of the purchase price by the former shareholders)
  4. Not all shareholders are required to sell their shares to the EOT
  5. The directors can remain in situ post-disposal and can continue to receive market-competitive remuneration packages
  6. The EOT is generally seen as a “friendlier purchaser” which means the sale process may be quicker, with potentially lower fees.

 

  1. When is this structure likely to be used?

The structure will generally be used as a way to facilitate the exit of controlling shareholders who do not want to sell to a third party buyer, and would like to reward the existing employees by allowing them to indirectly own the business that they have helped to build.

This would be a solution for:

  • Family-owned companies where the next generation are not in a position to take over running the business.
  • Entrepreneurs who want to retire and realise value, but who want the business they have built up to continue on and don’t want to end up working for a new buyer at the end of their career.
  • Any business where the continued commitment and motivation of all employees is key. This structure can be a way of engaging your employees and ensuring their commitment.

It will not however be available to non-trading investment companies or service companies.

 

 

  1. What are the generous tax reliefs?

The following tax reliefs are potentially available if certain conditions are met:

  1. The sale of the shares will be free of any Capital Gains Tax. This means that the consideration received by the exiting shareholder(s) will be available to them in full.
  2. Any payments from the company to the trust to fund the sale can be made on a tax free basis.
  3. Employees of the company can receive annual bonuses of up to £3,600 per employee per tax year, free of Income Tax. However the Company will have to ensure that National Insurance is paid.
  4. EOT companies may also qualify to operate tax-advantaged EMI and SIP schemes.

 

  1. Key qualifying conditions

There are five key conditions that need to be met in order to carry out a qualifying sale.

  1. The company must be a trading company or the principle company of a trading group.
  2. The trustees of the EOT must restrict the application of any settled property (the shares) for the benefit of all eligible employees on the “same terms”.
  3. The trustees must retain on an ongoing basis, at least a 51% controlling interest in the company.
  4. The number of continuing shareholders (and any other 5% participators) must not exceed 40% of the total number of employees of the company or group.
  5. Trust property must generally be applied for the benefit of all eligible employees on the same terms but the trustees may distinguish between employees on the basis of remuneration, length of service and hours worked.

 

  1. What restrictions are there?

The EOT itself can only act to benefit all employees on equal terms. However, the company will be able to continue to make decisions on pay for its directors and employees in the normal way – the EOT will act as a shareholder, not as a substitute for the company board.

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