How does an employee ownership share trust work?

How does an employee ownership share trust work

Employee ownership share trusts can be a great way for a business owner to plan their exit and can be a simpler and more tax efficient alternative to selling a business via a trade sale and can help to protect business continuity.

An Employee Ownership Trust (EOT) is a tax incentivised scheme that transfers control of a business for the benefit of employees. An EOT acquires a controlling interest in a company from current shareholders. Employees don't directly own the shares, but the shares held by the trust are used to the benefit of employees.

In this blog, we will cover all the key aspects of an employee ownership trust, including its uses, how to set up an EOT and the benefits that employee ownership trusts can bring both to shareholders and employees.

What is an Employee Ownership Trust (EOT)?

Employee ownership is the model in which the share capital of a business is partly or entirely owned by its workforce. An employee ownership trust owns a controlling stake in a company on behalf of all its employees. An EOT does not mean employees directly own the shares; it means that the shares the trust holds will be used to the benefit of the employees.

Types of employee ownership

Employee ownership can work for private companies of all sizes and in a wide variety of industry sectors.

Indirect employee ownership

The indirect ownership EOT model means the employees do not own shares in the company directly, instead they are beneficiaries of the trust which owns the controlling shareholding. This type of ownership is best suited to businesses with higher staff turnover and those with larger employee numbers.

Direct employee ownership

This model allows direct ownership of shares by employees. Employees might purchase shares or be gifted shares under a Share Incentive Plan (SIP), potentially tax-free. This type of scheme can improve employee retention and performance of employees if tied to metrics such as business growth targets.

Hybrid model

This method is a combination of trust ownership and employee direct share ownership. This can be a good model for succession and exit planning. The business owner sells their shares to the EOT when it is first established and then over time some of this interest is transferred to employees. Again, this model can benefit exit planning strategy, retain key employees and can be tied to financial performance metrics.

Why would a business offer EOTs?

There can be many reasons for business owners to consider an employee ownership structure. For many owners it is a way to exit their business. Implemented correctly, employee ownership can be a highly effective exit route for sellers; in terms of the return to the shareholders, creating a more sustainable and strategically advanced business and retaining highly motivated, rewarded and engaged employees.

Tax relief and savings available to both the shareholders and employees can also be a driving force in offering employee ownership trusts.

Other reasons to consider an employee ownership trust are:

• To improve employee engagement and retention.

• To improve productivity and innovation.

• When an owner wants to partially exit their business but to retain some control or stake in the business (up to 49%).

• To extract value from the business tax efficiently.

What are the benefits of EOTs?

Employee ownership can be highly beneficial for both selling shareholders and the employees themselves.

Business exit and the availability of tax reliefs (see below) can be the main benefits behind the increasing use of EOTs, but there are many other benefits of using an employee ownership trust including:

• Encouraging employee engagement.

• Helping to align the goals of stakeholders and employees.

• Improved business performance as employees are more engaged.

• Reduction in staff turnover.

• Quick to arrange and complete an EOT than undertaking a trade sale.

• Protecting the legacy of your business.

• Allowing a tax-free disposal by UK individual shareholders.

• Allowing an exit where there is no obvious third party purchaser.

• Enabling the business owner to retain up to 49% of the shares and some involvement in the business.

• Availability of share capital to incentivise management and key employees.

• A way of extracting future value and profits in a tax efficient manner.

• Avoiding a take-over.

Tax incentives for setting up an employee ownership trust

There are a number of corporate tax and personal tax advantages of EOTs for both the shareholder and the employees. These generous tax breaks are as follows:

Fully exempt from Capital Gains Tax (CGT)

When you sell your controlling interest to an EOT, you are completely exempt from Capital Gains Tax.

Tax-free bonuses up to £3,600

All qualifying employees can enjoy tax-free annual bonuses of up to £3,600.

Inheritance tax exemption

Under the correct conditions, shares transferred to an EOT will be an exempt transfer from inheritance tax.

The restrictions on Business Asset Disposal Relief and the likely increase in tax rates mean that the tax cost of exiting for business owners will be higher in future. As a result, employee ownership trusts are becoming more popular as an exit strategy for many business owners.

What are the drawbacks of EOTs?

Whilst there are many benefits of an EOT, there are some important areas that should also be considered before you set up an EOT:

• Price is certain with an EOT, but could be lower than that offered by a strategic trade buyer (but this will depend on the market, your business and sector and if you can find a high value strategic buyer for your business).

• If you are using it to exit your business and realise value then it's worth considering that Day 1 cash will be restricted by cash and reserves on the balance sheet, and funds that can be raised from funders by the EOT. Deferred consideration generally makes up the remainder of the consideration and is paid over several years.

• Ensure the team are skilled enough to run the business over the longer term and when the owner fully exits. Without a capable management team to take over the business, the business may not succeed longer term.

Qualifying conditions for an employee ownership trust

To set up an employee ownership trust the following conditions must be met:

1. The group or company must be trading.

2. Trustees must hold more than 50% of the company (or holding company of a group). The trustees must be entitled to more than 50% of ordinary share capital and voting rights, profits for distribution and assets on a winding up.

3. The trust assets must be available for the benefit of all eligible employees on the same terms. Those employees with less than 12 months service can be excluded.

4. The assets of the trust can be applied based on remuneration, length of service and hours worked, with each of those factors to be applied separately. The assets of the trust cannot be applied such that only some employee's benefit.

    

Setting up an EOT

An EOT sale does not mean that the business has to become wholly run by the employees. The former shareholders can remain involved at management level, although they concede board control of the business to a trust but they can take a position as a trustee after the sale.

Typically the process for setting up an EOT is as follows:

• A purchase price will be agreed (based on an independent assessment) which must not be more than market value and payment will then be made in instalments.

• A new company is created which will act as the employee share ownership trust and the shareholders sell their trading business shares to this EOT company.

• A sale and purchase agreement is executed and after the sale, the company trades as a wholly-owned subsidiary of the EOT company.

• A trust document sets out the obligations of the Trust to the employees.

On setting up an EOT, funding will be required in order to allow the EOT to purchase shares from the existing owners. The nature and structure of this funding should be carefully considered. The owners/shareholders are often paid for their shares out of future income generated by the company, rather than the trustees being funded by third party lenders.

Who can be a trustee of an EOT?

Once an EOT is set up, most of the responsibilities of ensuring the success of the Trust fall to the Trustees. The Board of Trustees is typically made up of an Employee Trustee, a Professional/ Corporate Trustee, and often one of the sellers will take a Trustee position too. The Board is not restricted to one Trustee per representative group.  

How do EOTs work for your employees?

There is no legal obligation to involve employees in the sale of the company to an EOT, but it is important to involve them in some way and communicate the basis of the EOT and the benefits to them as employees. They will need to understand the following:

• Within an EOT, individual employees are not issued separate share certificates with their name on. The EOT is owned by the body of employees.

• Employees will need to understand that they do not personally own a percentage of the business and that they are working for each other’s benefit whilst they are in the business, and not just for their personal benefit.

Another tax incentive for employees is that companies that are controlled by EOTs can pay annual bonuses tax free of up to £3,600 per year to each employee (although this is still subject to national insurance).

Profit distribution

With an EOT, the trust owns the shares. This means that the profit goes to the EOT, which then distributes the profit to the employees. In many cases, this future profit is then used to pay the owner for the shares as deferred consideration.

Conclusion

An increasing number of owners are now assessing the benefits of selling their businesses to their employees via trusts versus a trade sale. This process can be owner led, does not require the employees to drive it and valuations are a commercial discussion with no requirement for the involvement of a 3rd party and an EOT can be simpler and easier to complete than a trade sale.

Generally, trust ownership will be simpler both to set up and run. But this does not make it an automatic best choice for all companies, some of which may feel that individual ownership is better suited to their future company.

However, a disposal of shares to an EOT provides both an extremely tax-efficient exit solution for shareholders and a way to encourage and motivate the workforce going forward. However, the rules can be complex with various qualifying conditions so it is important that professional advice is sought.

For more help and advice on EOTs or any other tax planning or business exit support, contact our accountants in Chester, Wirral, or Liverpool.