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Business Services  •  Business Tax

Could an employee ownership trust be your exit strategy?

By RJP LLP on 26 April 2023

Selling shares in a company to a third party as an exit strategy has become slightly more challenging in recent years, firstly due to Brexit, then Covid, and now the uncertain economic climate. Valuations have tended to be on the slightly lower side which acts as a disincentive to exit for some shareholders keen to secure a higher price. Who can blame them?

However, exiting their company remains a very important goal for many owner managed companies, and one option that has become increasingly popular in recent years is the employee ownership trust (EOT). This is a special trust established for the benefit of all the company’s employees and to which the current shareholders sell over 50% of their shareholding. The trustees tend to be representatives of the employees and shareholders and those trustees effectively become the primary shareholders by virtue of the trust’s shareholding.

In overview, the current shareholders sell more than 50% of their shares to the EOT at an agreed open market value and the capital gains arising on the sale are held over. When the shares are eventually sold on the open market, the EOT will pay capital gains tax on both the gain it makes  at that time and the held over gain.

Eligibility criteria for an employee ownership trust

If you are interested in considering an employee ownership trust as an option for a company exit, here are the main qualifying criteria:

  • The company in which the shares are being sold must be a trading company or the holding company of a trading group – this means non trading companies e.g. property investment companies, are not eligible;
  • There must be a minimum proportion of employees in the company who are not the owners of connected persons (such as spouses) of the shareholder – this means an EOT is generally not available to small, family run companies;
  • The EOT must at all times hold a controlling interest in the company - this means the shareholders must sell more than 50% of the company’s ordinary share capital to the EOT and the percentage shareholding of the EOT must at no stage fall below this minimum level;
  • The EOT must be for the benefit of all employees on the same terms, although the amounts paid out to employees do not have to be equal. These can be set according to position in company and salary level, length of service or hours worked;
  • Only UK taxpayers (individuals not corporates) can sell shares tax-free to an EOT.

Provided that all the qualifying criteria are met, it can be relatively straightforward for a shareholder to exit their company through an employee ownership trust; a sale can be faster to complete than a sale to a third party and paperwork can be less complex, with no need to conduct the same level of due diligence. There is also less chance of the sale falling through. The company still needs to be valued, with the valuation being realistic and fair for the type of business. HMRC advance clearance is also needed.

Benefits of an employee ownership trust

An employee ownership trust offers generous tax incentives for both the original shareholder; it provides a way to exit and secure some consideration without pursuing an external third party sale. The transaction still requires an independent valuation and the shares must be offered to the EOT for a ‘fair price’ but the transaction is treated as a no gain/no loss exchange and is capital gains tax free at that time.

Tax advantages of an employee ownership trust

There are generous tax benefits for sellers using an employee ownership trust:

Capital gains tax relief - the proceeds will attract capital gains tax relief on the entire gain arising from the sale; the transaction is treated as a no gain/no loss transaction and the trust technically acquires the shares at the seller’s tax base cost.

Contrast this with the typical rate of capital gains tax charged at 20% on share sales, or at best, 10% if the seller is eligible for business asset disposal relief. This relief is only available on £1 million of lifetime gains and for a serial entrepreneur who may have already used their £1 million allowance, an EOT will provide a more tax efficient exit.

EMI – an EOT can be run alongside an EMI (enterprise management incentive) scheme, whereby once the trust is created, management can be further incentivised with tax efficient share options for the future.

Tax free income - annual bonus payments can be paid to employees by the EOT and up to £3,600 per person is tax free.

 

Disadvantages of an EOT

A share purchase by an EOT is generally funded out of future company profits, therefore a sale to an EOT is generally only attractive to shareholders wishing to wind down their involvement in the company and take profits arising in the next few years as tax-free capital rather than as income subject to income tax.

When an EOT eventually sells the shares the trustees must first fund from the sale proceeds any outstanding amounts due to the original shareholders. They will then pay capital gains tax on the gain the EOT has made from the shares and also on the gains held over by the original shareholders.

Following these payments, any amounts  remaining in the EOT are payable to current and past (in the last two years) employees of the company as income, subject to income tax.

In summary therefore, whilst the tax advantages on the sale of shares to an EOT can be attractive in the right circumstances, the tax liabilities on the exit of shares from an EOT are onerous.

To discuss this further and find out more, email partners@rjp.co.uk.

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