Considering the future of your business? An Employee Ownership Trust (EOT) is emerging as a powerful and increasingly popular succession strategy, offering compelling benefits for business owners and their employees. With 1,756 UK companies now under employee ownership via EOTs as of July 2024, and forming 6% of UK business transfers this year, this model is rapidly gaining traction, driven by its simplicity and attractive tax advantages.
This article delves into the specifics of EOTs, providing you with a comprehensive understanding of how they work, the significant tax benefits for sellers and employees (including Capital Gains Tax exemption for sellers and up to £3,600 tax-free annual bonuses for employees), and the process of setting one up. We'll also explore the pros and cons to help you determine if an EOT is the right path for your business.
If you're contemplating an EOT for your business and want to explore its suitability, our specialist EOT solicitors are here to provide tailored advice.
Jump to:
- What is an employee ownership trust and how does it work?
- What are the advantages of an employee ownership trust?
- What are the pitfalls of an employee ownership trust?
- Who owns the shares in an EOT?
- Who makes the decisions in an EOT?
- If I sell my business to an Employee Ownership Trust, am I passing control of my business to the employees?
- If I choose to sell to an EOT, will I not receive a valuation as favourable as I would when selling to a third party?
- If I sell to an EOT, will I be able to raise equity finance post-transaction to grow my business?
- What are the tax implications of an employee ownership trust?
- Who are excluded participators in an EOT?
- What is the controlling interest requirement for an EOT?
- How do you finance an employee ownership trust?
- Can an EOT grant security?
- How do you set up an employee ownership trust?
- How do I maintain an employee ownership trust?
- Are members of an employee ownership trust still employees?
- Are employee ownership trusts synonymous with aggressive tax planning?
- What’s the difference between a stock ownership trust and a share ownership trust?
- What happens when an employee leaves a company owned by an EOT?
What is an employee ownership trust and how does it work?
An employee ownership trust or EOT is a legally binding arrangement whereby individuals known as ‘trustees’ manage shares of a company on behalf of employees, known as ‘beneficiaries’ of the trust. An EOT is similar to an employee benefit trust that provides benefits to employees in the form of shares or share options.
An EOT can hold anything from 51% to 100% of a company’s shares, and the trust must benefit all employees on an equal basis.
The idea behind an EOT is that an entrepreneur wishing to sell their business without putting it on the open market can instead sell to its employees. Sometimes, the seller will remain involved in the business post-sale. The reasons for pursuing an EOT are several; most significantly, there are tax advantages for both the seller and the employees. High-profile EOTs include Riverford Organics, Richer Sounds and Go Ape.
What are the advantages of an employee ownership trust?
The principal financial advantage of an EOT from the standpoint of employees is that they may benefit from receiving a share of the company’s profits, rather than just a salary. Also, since they are de facto owners of the company, benefits tend to be more generous than non-EOT companies, and there’s an annual £3,600 exemption from income tax on any profit share they receive each year.
EOTs tend to be more successful than ‘normal’ companies since employees feel more invested in the business and are likely to be more productive as a result. Management remains in place, and sickness/absenteeism reduces.
Research shows EOTs create more motivated and happier employees. Employees also report greater job satisfaction.
Employee-owned businesses are more financially resilient than non-employee-owned businesses. Recent research has shown that employee-owned businesses were less likely to see their profits decline over the last 5 years including through the pandemic and supply chain crises.
In addition, the sales process is less stressful than an open market sale to a third party.
For the seller, the sales process tends to be simpler, there are tax benefits such as the CGT exemption, and sellers who are emotionally invested in their business can see it go to a ‘friendly’ buyer. Sellers don’t have to market the business to potential sellers or go through a costly due diligence process with associated fees There is less disruption to business as usual or risk that the sale will fall over.
What are the pitfalls of an employee ownership trust?
An EOT isn’t for everyone.
One disadvantage is that it can be more difficult to find a bank to finance the purchase price and often sellers will not wish to burden the business with significant third-party debt. As a result sellers get paid out over time from the business profits. One consequence of this is that profits are lower, so employees may not immediately see financial benefits from the transaction.
EOTs may be less suitable for companies with fluctuating cash flow, as any loans need to be paid back from profits and repayments can be a drag on profitability. In addition, the sale will be at market value – a disadvantage for sellers who may achieve a premium on the open market.
Despite the CGT exemption, if the company fails to meet the HMRC conditions for an EOT following the sale, this exemption can be lost, and the tax clawed back from the selling shareholders.
Finally, as the trust will be run by trustees, sellers need to pick these individuals carefully as they’ll be significant figures in the business.
Who owns the shares in an EOT?
The shares in an EOT are legally owned by the trustee, as majority shareholder of the employee-owned company. The shares are not legally owned by the employees.
Who makes the decisions in an EOT?
The day-to-day decisions relating to the commercial operation of the employee-owned company continue to be the responsibility of the Board. The trustee of the EOT as majority shareholder will have voting control in relation to shareholder matters and will make decisions in relation to making payments from the EOT. It may consult with any employee representative body on matters relating to the employees, as indirect owners of the company.
If I sell my business to an Employee Ownership Trust, am I passing control of my business to the employees?
You won’t pass control over. Upon a controlling share sale to an Employee Ownership Trust (EOT), the EOT trustees become majority shareholders, with standard board control powers and the usual suite of powers and responsibilities of a majority shareholder.
Their primary duty is to manage the trust property (the EOT company's shares) in the best interests of employees, the beneficiaries.
The Board retains responsibility for the company's management and day to day operations, and there's no mandate to change the Board composition, though this can be an opportunity for new appointments.
In summary, while EOT sales align member and employee interests, employees have an indirect interest as EOT beneficiaries.
If I choose to sell to an EOT, will I not receive a valuation as favourable as I would when selling to a third party?
A sale to an EOT is considered a transaction at market value, and it's crucial to have an independent valuation to support the transaction. This is significant for both the trustee and the company, as it demonstrates that the agreed sale value aligns with a fair, arms-length negotiated transaction value.
From the seller's perspective, this valuation is also vital for tax purposes, ensuring that the company is not overvalued and that the seller can fully benefit from capital gains tax relief for EOT sales. If less than 100% of the equity is sold to the EOT, it's essential to evaluate whether any minority discounts to the valuation are appropriate.
If I sell to an EOT, will I be able to raise equity finance post-transaction to grow my business?
Following the sale to an EOT, the EOT trustee must hold at least 50.1% of the ordinary share capital and be entitled to 50.1% of voting rights and income and capital rights conferred by the company's share capital. In addition, there must be no provision in any agreement whereby these conditions would cease to be met without trustee consent.
This means that an employee-owned company can divest of a minority interest to an investor without breaching the control requirement.
It will be important to consider the company's future finance raising requirements and the timing of a sale to an EOT in the company's life cycle.
What are the tax implications of an employee ownership trust?
The biggest benefit of an EOT is the CGT exemption for the selling shareholder. As an example, if a shareholder sells their company and makes a £1,000,000 gain, they could save up to £200,000 in tax at current (2023) CGT rates.
In addition, each employee can receive up to £3,600 each year free of income tax, although they’d still need to pay national insurance.
There are numerous conditions for EOT tax relief:
- Your company must be a trading company – that means it’s a commercial company selling goods or services for a profit – investment companies don’t qualify
- You need to have a commercial reason for the sale
- You need to sell at least 50.1% of the shares, i.e. a controlling interest
- The shares need to be ordinary shares
- The trustees must maintain a controlling interest
- For a specified period prior to the sale and after the sale, the sellers who are directors and shareholders can’t comprise more than 40% of the total number of company employees
- A shareholder who holds 5% or the right to acquire 5% or more of the shares or has done during the 10 years prior to the transaction cannot be a beneficiary of the EOT
Before you set up an EOT, you’ll need to get clearance from HMRC. This typically takes around a month to six weeks. Before you go for clearance, you’ll need to get the company valued, decide on the trustee, arrange funding and determine the percentage of shares to be sold.
We’d advise you to get an independent valuation and make sure your financial projections post-sale leave plenty of room for loan repayments.
Who are excluded participators in an EOT?
Excluded participators is a tax term which is relevant to the availability of EOT tax relief on a sale of shares to an EOT. It refers to shareholders who hold or have held or optionhholders who hold or have held options over at least 5% of any class of shares in the company in the 10 years prior to the EOT transaction , together with their close relatives. Excluded participators cannot receive benefits from the EOT.
What is the controlling interest requirement for an EOT?
This is a requirement of EOT tax relief that at least 50.1% of the shares are sold to the EOT trustee.
How do you finance an employee ownership trust?
Cash on the balance sheet may be used to fund the transaction. You can also get a bank loan to buy the company shares, or the payment can be made in instalments from the company profits.
If you borrow to fund an EOT sale, there will be interest to pay on the loans, so you’ll need to make sure there will be sufficient profits to fund repayments of capital plus interest. The repayment schedule is likely to be five to ten years, and the EOT will pay profits into the trust to make the loan repayments.
Can an EOT grant security?
Security can be granted by the EOT trustee over its shares in the employee-owned company to a third-party lender into the EOT without prejudicing the requirements of the EOT tax relief.
How do you set up an employee ownership trust?
An EOT normally takes around three to six months to set up. Unlike with a sale to a third party who’s new to the business, this time will be spent organising a valuation and dealing with HMRC rather than due diligence and preparing documents. This is because the seller and the employees are already familiar with the business and the documents will be shorter and less complex.
You may decide to combine your EOT with an incentive scheme for employees, and this can provide additional tax and other benefits for directors and staff. It’s important to consider the timing of implementation of other incentive schemes as well as how these schemes will operate alongside your EOT to ensure the overall effectiveness of the arrangements.
You’ll need to think carefully about who the trustees will be. Appointing independent trustees avoids the potential for a conflict of interest.
How do I maintain an employee ownership trust?
After the sale, the business will carry on much as before, except that the majority shareholder will be the trustee rather than the selling shareholder. This is why you need to pick your trustees carefully so that they consider the needs of employees and have experience of acting as a majority shareholder.
There are no legislative requirements as to who may be appointed as a trustee. Their main role is to make sure the deferred consideration is paid to the sellers, the profit-sharing policy works and surplus cash held by the company is distributed appropriately. They’ll also require information on the performance of the company and want to ensure the company is meeting its financial covenants like any key investor.. They’ll also oversee the role of directors.
Are members of an employee ownership trust still employees?
After a sale to an EOT, the status of employees remains unchanged – they will still be employees.
Are employee ownership trusts synonymous with aggressive tax planning?
An EOT benefits from specific reliefs laid down in tax legislation. This structure should not be confused with some of the more aggressive tax planning arrangements which have been marketed in the past using employee benefit trusts.
What’s the difference between a stock ownership trust and a share ownership trust?
None – a stock ownership trust is the US term for a share ownership trust.
What happens when an employee leaves a company owned by an EOT?
After an employee leaves, they will generally cease to be entitled to receive any benefits from the EOT. However, there are narrow circumstances in which former employees will again become eligible to receive benefits even though they are no longer employees and it will be important to understand and manage these implications.
Where staff numbers are small, it will also be important to ensure that employee exits do not jeopardise the limited participation requirement for tax purposes. Broadly, this is the requirement which compares the number of management/employee shareholders with total workforce numbers to ensure the EOT transition is to a broad base of employees, who are neither current owners nor related to current owners.
For more answers to commonly asked questions and advice on employee ownership trusts, consult our specialist EOT solicitors. Get in touch on 0808 164 8989, email us at enquiries@harperjames.co.uk, or fill out the short form below with your enquiry.
