What is an Employee Ownership Trust (EOT)?

An EOT is a trust that enables a company to become owned by its employees and can be set up by a company’s existing owners, perhaps as part of their exit or succession planning strategy, or by founders starting a new business which they wish to be employee-owned. It was created by the Finance Act 2014, to encourage more companies to become employee owned.

Download our essential quick guide to the EOT (Employee Ownership Trust)

Importantly for many business owners, an EOT creates two tax breaks:

  • Those selling their shares may do so free of capital gains tax
  • Once a company is owned by an EOT, it can pay annual bonuses to its employees free of income tax

There are two main conditions to enable the tax breaks:

  • The trust must hold more than 50% of the shares in the company
  • If employees receive any benefit from the trust, they must all be included and on the same terms

How is an employee ownership trust funded?

Normally, an EOT will acquire a controlling interest in a company from its current shareholders.

Commonly, a 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, the EOT being funded by the company from its future profits.  Occasionally, a company owner will give their shares to the EOT but in most cases they will wish to be paid.  Sometimes it is possible to arrange an external loan which will enable the purchase price (or a larger part of it) to be paid in one go.

How does an EOT work?

An EOT will be run by its trustees.   Their role will not be to manage the company (this will continue to be the role of the management team) but to ensure that the company is being well led and in a way which maximises employee engagement and commitment. This is sometimes facilitated by the creation of an employees’ council.

Watch the video below to get a good understanding of how an it works in practice.

Employee ownership trust tax reliefs

  1. FULL RELIEF AGAINST CAPITAL GAINS TAX

The sale of a controlling interest in a business to an employee ownership trust (EOT) will be entirely free from capital gains tax (CGT).

What is an employee ownership trust?

An EOT must meet the following requirements:

  • The company whose shares are transferred must be a trading company or, where there is a group, the principal company of a trading group.  A company which has significant cash, land or other investments may not be a trading company.
  • The EOT must meet the “all-employee benefit requirement” – see below.
  • The EOT must not hold a controlling interest of more than 50% in the company before the transfer to it. However, the EOT must hold a controlling interest in the company at the end of the tax year in which the transfer to it takes place.
  • Where the transferor has an interest of 5% or more in the company in the 12 months before he transfers his shares to the EOT there is an additional requirement. The requirement is that the number of employees who hold 5% or more of the company must not exceed two fifths (2/5) of the workforce generally. (please see the worked example below.)

Example of the 2/5 ratio in operation : CGT relief

A company has 3 people who each hold more than 5% of the Company’s shares and are employees or directors (Shareholder Employees). and a total of 9 people who are employees.  On the face of it, the ratio will be 3/9 which would satisfy this ratio requirement. If, however, one of the 9 is, for example, the son of one of the Shareholder Employees, he will be counted in with the Shareholder Employees as a relative. The ratio will become 4/9 which will not satisfy the requirement and it will not be possible for any selling shareholder to claim the CGT exemption.

This is a complicated aspect and specific advice may be required in individual circumstances.

What is the “all-employee benefit requirement”?

Broadly, if the EOT provides benefits (such as cash or shares) to individual employees, it must generally do so in favour of all eligible employees, and must do so on the same terms (separately called the “equality requirement”).

The EOT cannot, therefore, skew benefits to the advantage of particular employees, although it can allocate benefits of differing amounts by reference to factors such as salary, length of service or hours worked. “Employees” can also include certain dependants of deceased employees. Anyone personally holding 5% or more of the company’s shares (or who has done) may not be a beneficiary of the EOT.

 

  1. INCOME TAX FREE BONUSES

Bonuses paid to employees of companies controlled by an EOT benefit from an income tax (but not national insurance) exemption.

What are the conditions for the income tax relief?

The key requirements for income tax relief are:

  1. The employer company must be a trading company or a member of a trading group.
  2. A controlling interest in the company or, in a group of companies, the principal company in the group, must be held by an EOT, for at least twelve months.
  3. Provisions very similar to the equality requirement for the CGT exemption also apply to the income tax exemption.
  4. The company should not have more than a ratio of 2/5 for directors (plus any employees related to them) to employees and directors in total. (Please see the worked example below.)
  5. There is a maximum limit of £3,600 income tax free bonus per employee per tax year
  6. The payment must not consist of normal salary, must not be made by a service company and must be made under an arrangement under which:
  7. all employees of the company, or, where there is a group, any group company must be eligible to participate in any award (although employees with continuous service of less than 12 months can be excluded); and
  8. all employees participating in the arrangement must do so on equal terms (although awards can be determined by reference to pay, length of service or hours worked).

Example of the 2/5 ratio in operation: income tax free bonuses

A company has 3 people who are directors and 9 people who are either employees or directors.  On the face of it, the ratio will be 3/9 which would satisfy this ratio requirement. If, however, one of the 9 is, for example, the son of one of the directors, he will be counted in with the directors as a relative. The ratio will become 4/9 which will not satisfy the requirement and it will not be possible to pay income tax free bonuses.

This is a complicated aspect and specific advice may be required in individual circumstances.

Watch this Employee Ownership Trust video

What are the benefits of an Employee Ownership Trust?

For a private company owner wishing to retire but looking for an alternative to a trade sale, an EOT is certainly worth considering.  It places the business in the hands of people who understand what makes it tick, have a strong personal commitment to its long term success and are highly motivated by their ownership to make it thrive.

Possible benefits for your company include:

  • Ownership succession which preserves your business and its culture
  • A stronger performing business
  • A commitment to the longer term
  • A more resilient and adaptable business

Possible benefits for your employees include:

  • Builds a clear shared purpose and collaborative way of working
  • Employees who are owners are more engaged and committed
  • Income tax free annual bonuses

Possible benefits to you as a business owner include:

  • Leadership succession can be implemented over time
  • As a retiring owner, you can be paid market value for your shares
  • No capital gains tax
  • Employee ownership can be implemented at a pace that suits you

Why we chose an EOT

We realised the only way to ensure our values-led culture and to ensure the legacy of what we had built up was actually through an Employee Ownership Trust

Val King, The Rooflight Company

Watch three of our clients talk about how they created an EOT in their company

  • Michelle Leggatt, Mindworks Marketing

  • Val King, The Rooflight Company

  • Oliver Richards - Director, Orms Architects

Might an EOT be right for your company?

Employee ownership has the potential, by sharing the rewards of your company’s success with its employees, to  create a powerful incentive to engage in the business and work together to improve its performance for everyone’s benefit.  You can find more evidence on our Employee Ownership page.

You should consider an EOT if:

  • You are looking how to retire from the ownership of your company in a way which creates a strong platform for future success in the interests of you, your business and its people, or
  • You don’t feel a trade sale or management buyout is feasible or the best solution, or
  • You want to start a new business with maximally committed and engaged people and a strong shared purpose, or
  • You work in a business which needs to find a succession solution but has not been able to do so.

In the present difficult economic climate are you asking, “What can we do to maximise our chances of survival and bouncing back?”

We suggest that you read our short guide, in which we look at the role employee ownership can play: Employee Ownership and Business Recovery

Robert Postlethwaite of Postlethwaite Employee Ownership & Share Schemes Solicitors

Talk to us: to explore how an Employee Ownership Trust could work for your company, please call us on 020 3818 9420.

We are an employee-owned law firm specialising in employee ownership. and are considered as leaders in our field, working with businesses of many sizes across many sectors.  Our practical approach, know how, ability to demystify and profound technical knowledge all enable us to help you create an employee ownership structure that is right for your business, its people and current owners.

 

Robert Postlethwaite Managing Director