Employee ownership trusts

Employee ownership trusts are quickly becoming a popular exit solution for entrepreneurs who want to keep the business they created independent by allowing employees to buyout a controlling share. In the hands of the employees the company can benefit from increased engagement and commitment to the business. This guide provides an introduction to employee ownership trusts however the rules are complex and you should consult a corporate solicitor for more specific advice.

What is an employee ownership trust and how does it work?

An employee ownership trust (EOT) is a method of share ownership whereby employees hold a controlling stake in the company for whom they work, via a trust. An employee ownership trust is similar to an employee benefit trust (a trust set up to provide benefits to employees in the form of shares or share options), with additional tax advantages.

An EOT can hold anything from 51% to 100% of the company’s shares, and the trust must benefit all the employees on an equal basis. 

The tax benefits of an EOT are:

• Where a company’s shareholders sell a controlling interest to an EOT, any gains they make will be exempt from capital gains tax
• Employees are entitled to receive an annual bonus of up to £3,600 free of income tax, provided that all employees are entitled to receive bonuses on the same terms

Examples of employee ownership trusts

In UK, the John Lewis Partnership, Mott McDonald and the West Highland Free Press are all Employee Ownership Trusts.

Pros and cons of employee ownership trusts

Here are the principal benefits of an EOT:

• Tax efficient for the selling shareholders and the employees in terms of CGT, inheritance and income tax reliefs
• Not all shareholders need to sell to the EOT
• The company will be in the hands of the employees who will be highly motivated to see it succeed
• Sickness and absenteeism tend to be less in EOT-owned companies
• Business performance and productivity improves when companies become EOT-owed
• Many of the benefits of an EOT relate to the impact on a business of being owned by its employees
• The existing management team of the company can remain in place after a sale to an EOT
• Sales of shares to an EOT tends to be a quicker than sale to an unrelated third-party purchaser

The disadvantages of an EOT are:

• When selling shares to an EOT, it’s necessary to obtain a market valuation of the company so the sale price can be agreed. It’s important not to overvalue the company, as the purchase price will need to be paid by the company itself, potentially being a drag on profits in the future
• Selling shareholders will be paid over time as opposed to the cash they would receive in a market sale
• If the company’s performance declines after sale to an EOT, then repaying the funding used to buy the shares can be problematic. Alternatively, the selling shareholders can miss out on an increase in the value of their shares if performance improves after sale to an EOT
• The trust is controlled by trustees, and it’s important to choose these individuals carefully as they will be significant figures in the business
• If any ‘disqualifying events’ occur in the second tax year of operation of an EOT (the company ceasing trading, the EOT failing to meet the qualifying rules for example), then the selling shareholders will be liable to CGT

Funding an employee ownership trust

EOTs can be set up using bank loans to purchase the underlying company’s shares, but the more common arrangement is for the purchase to be paid in instalments from future profits of the company. The company will make gifts of profits to the EOT to fund these instalments.

Setting up an employee ownership trust

Prior to setting up an EOT, you should ask for clearance from HMRC for the scheme to make sure that it qualifies. There are five conditions to be met:

• The company must be a trading company
• The EOT’s trustees must make sure that the shares are held by employees on the same terms
• The trustees must maintain a controlling interest at all times
• The number of remaining shareholders after the sale to an EOT who are also directors or employees mustn’t exceed 40% of the total number of company employees
• Trust property must be held on an equal basis for all company employees, also some preferential treatment is allowed if it relates to length of service for example

When you set up an EOT, you need to think carefully about the following matters:

• Who will be the trustees? These individuals have a great deal of decision-making power as the trust holds a controlling interest. The potential for a conflict of interest could arise if an employee or company director is also appointed as a trustee
• How will the company operate in practice, and what protections need to be built into the constitutional documents to ensure good corporate governance and avoid potential conflicts of interest
• What is the market valuation of the company, and who will perform the valuation?
• How will the EOT pay for the shares, including any interest on any debt raised

Are members still employees?

After a sale to an EOT, the status of employees remains unchanged – they will still be employees.

Is there a difference between a stock ownership trust and a share ownership trust?

No – a stock ownership trust is the US term for a share ownership trust.