Employee ownership trusts
A large proportion of business owners never manage to successfully sell their business or have a suitable successor leaving them to simply shut shop. In the last few years, particularly with sluggish M&A activity as well as depressed valuations and market confidence, more owners are using alternative mechanisms to extract themselves whilst keeping the business alive. One mechanism gaining increasing popularity involves the owners selling their business to their employees via an Employee Ownership Trust scheme.
What is an Employee Ownership Trust?
An Employee Ownership Trust is a tax incentive scheme (EOT) that allows the control of the business to transfer to the employees;
Legislation was introduced in 2014 as part of a wider change to the Finance Act to incentivise more employee ownership and encourage business owners to sell to employee owned vehicles.
How does it work?
The process takes between 3 months to 12 months to put into place with about 1 month taken to get clearances from the HMRC to proceed with the transaction and the remaining time for agreeing the terms and setting up the framework up with the employees;
Individual employees do not directly own shares, rather the employees, as a body. The ultimate beneficiary of any bonus granted or gain on exit is for the employees at time of that event (not necessarily today’s employees).
What are the main benefits?
Perfect for owners considering a planned exit rather than immediate or where a sale to an external buyer does not seem as viable;
The vendor does not pay any capital gains tax on sale if control passes to the Employee Ownership Trust which is a huge benefit particularly with the declining relief available via Entrepreneurs Relief;
Employees, as a group, are now business owners and can grant themselves tax free bonuses of up to £3.6k per annum.
What conditions need to be satisfied?
1. Controlling interest: 51% of the share capital of the business must be owned by the trust. The trust must control income, capital and voting. Careful consideration must be taken to ensure any share options issued post sale do not dilute the EOT below 51%.
2. Employee benefit: All employees, excluding those who already holds 5%+ of the share capital at the time of trust is set up, must benefit from the scheme.
3. Employee equality: The Employee Ownership Trust deed must state that any benefits from the trust must be for all eligible employees on same terms, albeit benefits such as remuneration, length of service or hours worked can be used to distinguish between employees.
4. Trading company: The company must be a trading company or the holding company of a trading group i.e. carrying on a trade, not a property or investment company.
5. Limited participation: continuing shareholders who are directors or employees (or a connected person) must not exceed 40% of the total number of employees of the company/group. This shows there has been significant change in ownership.
Who can be a beneficiary?
All employees are beneficiaries of the trust, but there are some additional conditions that need to be met as follows:
Employees must satisfy a company’s minimum continuous employment which can be a little as 12 months;
Relatives or dependents of a deceased employee can become beneficiaries;
Non-executive directors and freelance company secretaries can become a beneficiary but not contractors or agency staff as they are not on the payroll;
Eligible employees for the preceding two years continue to be a beneficiary in the event of a company ceasing to trade or the trust no longer holding shares in the company; and
Any individual (or its connected persons) with rights to acquire or hold 5% or more of the company share capital cannot be a beneficiary. These are considered excluded participators.
Other applications
Partnerships
Businesses held by partnerships could also benefit from this scheme by first incorporating the partnership and, providing the relevant conditions are satisfied, the shareholders (former partners) can then sell a controlling interest to the Employee Ownership Trust.
New businesses
Using an Employee Ownership Trust to set up a new business can be done by issuing 51% + of the new shares to the trust rather than directly to individuals.
Management Buy-Out (MBO)
An incumbent management team could conceivably acquire up to 49% of the business in one stage or multiple stages with 51% of the share capital held by employees via an Employee Ownership Trust.
The incumbent management would likely be trustees and beneficiaries of the Employee Ownership Trust (so long as each individual shares do not exceed 5%) helping the vendors pass control. This could be less disruptive than a normal sales process and ownership is likely to be transferred to management in a gradual way. Vendors will need to be careful to structure consideration paid to them as deferred consideration so as not be classed as ongoing employee remuneration.
The employees are also likely to support the MBO in a positive manner given their participation in the ongoing life of the business.
Remember, whilst the incumbent management team will see a capital return at exit, only employees who are there at the point of exit will see a capital value given to them which, in theory, should encourage longer service and loyalty to the business.
A business will normally require tax clearances from the HMRC for both structuring as an MBO and an Employee Ownership Trust.
Valuation
A key requirement of an Employee Ownership Trust is that the valuation can be defended to the HMRC by an independent specialist that the trustees can rely upon. If the HMRC determine the consideration to be above the market value, the excess will be subject to income tax, so extra care is needed.
The vendor should be willing to accept a lower valuation as the net proceeds may still be the same or higher due to the Employee Ownership Trust tax advantage.
Consideration payments to the vendor
Most typically, Employee Ownership Trusts will normally include a cash upfront payment, a vendor loan with commercial interest terms applied and sometimes a bank loan to partly fund the contribution payments required.
Employee Ownership Trusts do not typically attract significant external financing to fund the acquisition, therefore the consideration payments are largely funded out of the profits in the business over a period of time ranging from three to ten years. In comparison, a trade sale would typically see consideration payments made over one to two years.
Employee Ownership Trust transactions can include more complex payment terms such as consideration linked to an ‘earn out’ or conditional payments, but the Employee Ownership Trust trustees need to act in the best interest of the trust and the benefit of the employees, not for their own personal gain.
Quick final tips
Selling price
Don’t inflate the valuation – this could backfire with HMRC applying income tax on the excess value. However, tax clearances tend to mainly focus on ensuring the sale is a bona fide Employee Ownership Trust with control actually moving from the owner to the trust. Consider including an anti-embarrassment clause to cover a scenario where the business profits improve post transaction so the vendor does not lose out on this improved outlook.
Trustees
Choose your trustees wisely, they will have a lot of power. Whilst the former owners cannot be the sole trustees, it is important the directors are held to account. Inserting a corporate trustee may offer some protection.
Tax rules
Don’t fall foul of the Employee Ownership Trust rules, as you can still get disqualified in the tax year following the tax year when the Employee Ownership Trust was put in place. Getting disqualified can be a very costly event! Be careful with what is defined deferred consideration versus employment income as HMRC are ever watchful of ‘disguised’ payments.
In conclusion
Employee Ownership Trusts do not offer vendors a quick ‘get out’ strategy and so require a level of pragmatism and patience. However, the potentially significant tax benefits and a more orderly phased exit with employees and management bought into the process could outweigh a sale to an external, unknown entity. For more a more information on what is appropriate to your needs before taking any action, get in touch with us.
This article represents a summary of Accelve's assessment of the applicable rules and should not be considered to be tax advice. Independent tax advise should be sought before any such scheme is entered into. All rules and figures referenced within were reasonably believed to be correct at the time of writing, however these are subject to governmental changes. Article Dated: October 2020