Understanding Employee Ownership Trusts

Introduction to Employee Ownership Trusts

Employee Ownership Trusts have grown in popularity over the past few years with an attention grabbing headline of ‘NO CGT IF YOU SELL YOUR COMPANY TO AN EOT’.

In this article, we’ll do a little digging into Employee Ownership Trusts to see if the attention grabbing headlines are a bit too good to be true.

What is an Employee Ownership Trusts?

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

This structure is designed specifically for trading companies as non-trading entities (such as investment companies) do not qualify.

Key Features of an Employee Ownership Trusts

To qualify as an EOT, the trust must own more than 50% of the company’s shares and voting rights. This creates a separation of ownership and management, where the trustees are the legal owners of the company and act in the best interests of the employees.

Meanwhile, the existing management team can continue to run the day-to-day operations.

The Impact of Employee Ownership Trusts: Stats…

As mentioned earlier in this article, employee ownership through EOTs is fast gaining popularity. As of October 31, 2023, there were over 1,650 employee-owned businesses in the UK, with approximately 330 new businesses adopting this model in the previous 12 months. The benefits appear to be clear with:

• 57% of these businesses reported increased profits.
• 83% saw a rise in employee engagement.
• 73% noted improved job satisfaction.

What are the Advantages?

From the stats above, EOTs offer several compelling benefits:

• Enhanced Productivity: Employees tend to be more engaged and motivated when they have an interest in the businesses success. This drives productivity.
• Legacy Protection: The business owners can protect their legacy while facilitating a leadership succession over time.
• Financial Benefits for Owners and Employees: Owners can access the value they’ve created, and employees can receive annual tax-free bonuses of up to £3,600. Additionally, the sale of shares to an EOT can be tax-free if done within the same tax year, offering significant capital gains tax relief.

What are the potential drawbacks?

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

• Limited Participation: The sellers of the business generally can’t be beneficiaries of the trust, meaning they must relinquish control.
• Mental Adjustment: For original owners, losing control of the company can be a significant psychological hurdle.
• Valuation Risks: If HMRC suspects the company’s valuation is overstated, it may classify excess value as employment income, triggering tax liabilities under disguised remuneration rules.
• Restrictions on Tax-Free Payments: Bonuses can only vary based on specific criteria like remuneration, length of service, or hours worked. Failing to comply with these rules could jeopardise the EOTs status.

Are there many risks?

The risks associated with EOTs can be pretty severe:

• Tax Benefits Withdrawal: If the Employee Ownership Trusts loses control of the company or the company ceases trading, the associated tax benefits can also be withdrawn.

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

• High Tax Rates on Sales: If the Employee Ownership Trusts sells the company, it assumes the seller’s base cost, meaning it pays tax on the held over gain. Any distributions to employees are taxed as employment income, which can be costly (particularly for higher earners).
• Considerations for Sellers: Sellers must consider the impact on any shares they retain and the potential Inheritance Tax (IHT) implications, particularly if deferred consideration is involved. Fixed term insurance might be necessary to cover IHT exposure.

Ok, I’m still interested…….what are the practical considerations for setting up an Employee Ownership Trusts?

Setting up an Employee Ownership Trust requires diligent planning:

• Trustee Identity and Location: There are ongoing consultations about requiring a UK residency for the trust and the inclusion of at least one independent trustee.
• Funding Considerations: Contributions to the Employee Ownership Trusts to fund share purchases may be treated as dividends for tax purposes, so it’s crucial to seek advice.
• Dividend Payments: Receiving dividends can be tax-inefficient for the trust, and deferred consideration periods pose risks for sellers.

Summary

Employee Ownership Trusts can offer significant benefits for businesses and employees, but they come with complex requirements and potential risks.

If implemented for the right reasons, an Employee Ownership Trusts can drive productivity, protect a business owner’s legacy, and provide financial rewards for employees. However, tax incentives should not be the sole motivation for establishing an EOT. Given the numerous qualifying criteria and the serious consequences of disqualification, it’s essential to seek specialist tax and legal advice before proceeding.

The team at ETC Tax have a wealth of experience in dealing with employee ownership trusts. If you are a trading company and want more information about Employee Ownership Trusts please get in touch.