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Employee Ownership Trusts – an alternative means of succession planning

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10th November 2020 5 min read
An Employee Ownership Trust (EOT) is an indirect form of employee ownership first introduced in the 2014 Finance Act, in order to offer a tax incentive for companies wishing to adopt a model similar to that made famous by the retail giant John Lewis, under which a company is owned by its employees.

An effective means of succession planning, with distinct tax advantages, an EOT may also be an option for owners looking for an alternative way to pass on their companies, or substantially decrease their involvement in the business.

Here we explain how an EOT is established and set out the relevant qualifying conditions, alongside the tax benefits and commercial considerations associated with an EOT, to enable you to decide whether this might be a suitable option for your business.

When an Employee Ownership Trust is likely to be used

An EOT is a popular exit route for private companies and has become a viable alternative to a management buyout (MBO). In our experience it is an ideal option for shareholders who find themselves in situations where there is no viable buyer for a business. This could be due to little or no interest in the market, or there being no viable succession plan for the current management team to take the business forward.

An EOT may also be a solution for owner managers who are keen to protect their employees from the upheavals that often come with changes of ownership, whilst rewarding them for their loyalty by allowing them to indirectly own the business they have helped to build.

Establishing an Employee Ownership Trust

Broadly speaking, an EOT is an extension of the Employee Benefit Trust (EBT) concept, albeit with full statutory approval from HMRC, and with distinctive features and tax advantages. The steps involved in establishing an EOT are as follows:

  • A new trust is created for the benefit of the company’s employees as a whole. The trustee of the EOT will be a new corporate trustee company.
  • A company valuation will need to be prepared and agreed between the trustees and the selling shareholders.
  • The corporate trustee company will then acquire between 51% and 100% of the company’s shares, with a view to holding them for the long-term benefit of the employees. Consideration payable to the selling shareholders would typically comprise a cash payment on completion and an amount of deferred consideration.
  • As future profits are generated in the company, these can be paid to the EOT to make the deferred consideration payments to the selling shareholders.

Qualifying conditions

To achieve a qualifying sale to an EOT, there are a number of conditions that will need to be met:

  • The company whose shares are transferred must be a trading company, or the principal company of a trading group.
  • The EOT must meet the ‘all-employee benefit requirement’ which means that trust property must be applied for the benefit of all employees on the same terms. Whilst the trust cannot prioritise benefits to the advantage of particular employees, bonus levels can be calculated according to factors such as length of service and hours worked under this legislation.
  • Trustees must, on an on-going basis, retain at least a 51% controlling interest in the company.
  • The number of continuing shareholders who are also directors or employees of the company must not exceed 40% of the total number of employees of the company.

Tax benefits of an Employee Ownership Trust

  • The sale of the shares to the EOT is exempt from Capital Gains Tax (CGT) in the hands of the selling shareholders.
  • The cash payments, which must be structured as capital contributions, from the company to the EOT are also exempt from tax in the hands of the trustees.

Employees of the EOT can receive an annual bonus of up to £3,600 income tax free, subject to the ‘all-employee benefit requirement’.

Benefits for shareholders

  • The board of the company can still be structured as required (subject to the agreement of the trustees).
  • Selling internally removes the need for third-party investors, meaning shareholders can potentially save on time and fees, and maintain market confidentiality.
  • Directors who have sold their shareholding can remain in post after disposal, continuing to receive a salary for their director’s duties.
  • Not all shareholders are required to sell their shares to the EOT, as long as at least 51% of the shares are transferred, the remaining shareholders can remain in situ.

Funding considerations

Consideration will need to be given to how the trustees fund the share purchase.

In a typical MBO, the ability of the purchasers to raise the necessary funds needed to acquire the shares from the selling shareholders can often be an issue. It is therefore often favourable for the consideration due to the selling shares to be paid on a deferred basis, whereby future profits generated in the company are used to make these payments. Similarly, where an EOT has been established, the profits can be contributed to the trust to facilitate the payment of any deferred consideration.

However, this may not be suitable in every scenario and alternative funding sources may be considered, these include:

  • Loan funding
  • The company can borrow money and lend it to the trustees to make the deferred consideration payments
  • The trustees can facilitate borrowings on behalf of the EOT
  • The company can borrow and use the funds to make further capital contributions to the EOT
  • Voluntary contributions – the company makes a voluntary contribution to the EOT which then uses those funds to acquire the shares from the selling shareholders

Careful thought will need to be given to how the consideration is structured. If the EOT takes on borrowing in order to pay part of the consideration, this may help to mitigate some of the downside risk for the sellers. However, in certain circumstances, lenders may seek a debt to equity conversion  in the event of any default on the loan repayments, this could dilute the EOT’s holding to less than 51%, which would ultimately result in a loss of all tax benefits associated with an EOT .

How we can help

Whilst the EOT is still a relatively new concept in tax terms, the fact remains that it is has become a viable exit route for a variety of business owners. If you are looking to invest in your employees for the long term, or are considering your succession planning options, but do not have a viable management team to take the business forward, an EOT could be a suitable option for your business.

Working closely alongside you to thoroughly understand your objectives, our specialist tax and corporate finance teams would work hand in hand to advise you on the suitability of the EOT and/or any other succession and exit planning strategies, ensuring all advice is tailored to your specific circumstances. Our expert corporate finance team is also well positioned to provide advice on sourcing the necessary finance and funding options.          

If you are considering succession planning options, please get in touch with a member of our tax or corporate finance teams, who will be able to provide you with further advice.