Employee Ownership Trusts (EOTs) can be extremely useful for any business owner who is considering their exit strategy. In this article we have explored what an EOT is as well as the pros and cons for the owners, the business and the employees.
What is an EOT?
An EOT allows a company to be owned by its employees. The existing business owners set up a trust for the benefit of all the employees, and the trust becomes the majority owner of the business. An EOT is generally utilised as part of an exit or succession planning strategy and a well-known business example is John Lewis.
EOT’s were first introduced by the Government in the Finance Act 2014, with the intention that they would enhance employee engagement, which would lead to improved productivity and increased job creation and retention. This model of ‘shared capitalism’ is encouraged by the Government through the offer of annual tax incentives for employees as well as significant tax savings for business owners upon selling.
What are the key benefits of an EOT for a Business?
The benefits of an EOT for the business include increased resilience, better profitability, and a more sustainable business. Employees are more motivated by the added incentives which in turn increases their motivation and performance. The mindset of employees is also likely to become more entrepreneurial, with better commitment to long term business goals.
By utilising the EOT model, the business is also able to retain the existing culture and legacy, while implementing a gradual change in leadership and retaining shareholders expertise.
How do employees benefit from EOTs?
From an employee perspective, the benefits of an EOT include
- Direct reward for their contribution to the development of the business
- Satisfaction from being part of an employee-owned business
- Income tax free annual bonuses up to £3,600 per year
- Opportunity to engage in business improvement and development
- Easier route to ownership (versus direct share ownership)
Benefits to selling business owners
Finally, the key benefits for retiring or selling owners are that they will receive full market value for their shares and zero Capital Gains Tax on the business sale.
They are not susceptible to the circumstances or indecision of trader buyers which means that they have better control of the timing of their exit and the succession process can take place over a defined period, allowing good business continuity.
The process of setting up an Employee Ownership Trust
Firstly, a market value price is agreed (based on an independent assessment) and the EOT acquires a controlling stake in the trading business from the current shareholders. The funding for the purchase usually derives from surplus cash on the trading company’s balance sheet, but funders may also be approached for loan funds. These loans will be based on the assets and cashflows of the trading business.
The remaining business value is repaid to the previous shareholders out of future profits generated by the company. In practise, the trading company makes a contribution to the EOT, and the EOT makes payment to the previous shareholders.
How does an EOT affect Employees?
Employee Owned Trusts must benefit all employees, and as part of this, they can receive tax free annual bonuses (within specific criteria) up to £3,600 pa.
Following successful repayment of the previous shareholders, employees receive the full benefits that would normally be received by the shareholders in a private company via membership of the EOT. Any new employees automatically join the EOT, and those leaving the company cease to be members.
In certain cases, senior management might receive additional benefits beyond those received as a standard EOT member, and this is generally put in place to ensure they are fairly rewarded for their contribution. This incentivisation could for example be, direct minority equity stakes or share options.
Tax benefits of selling to an EOT?
As a way of encouraging employee ownership, several tax benefits are offered by the government, and assuming that all qualifying conditions are met, the EOT sale should be tax free for the retiring owner. The tax incentives for a business sale to an EOT include:
- Capital Gains Tax (CGT) exemption – total exemption from CGT when a shareholder sells their shares in a trading company to an EOT, which results in the EOT having a controlling interest in the company (more than 50%)
- Income Tax relief – tax-free annual bonuses of up to £3,600 for qualifying employees
- Inheritance Tax (IHT) relief – transfer of shares to the EOT by the vendor are an exempt transfer for IHT (provided the relevant requirements are met) It is also possible for the EOT to benefit from relief from IHT principal charges and exit charges
Qualifying conditions for sale to an EOT
As mentioned, there are various qualifying conditions that must be met in order for tax benefits to apply and these include the following:
- The company must be either a trading company or the holding company of a trading group
- The EOT must benefit of all employees (providing they are not, and have not been within 10 years before the sale, 5% participators in the company)
- The EOT must control the company following the acquisition (i.e. hold more than 50% of the share capital)
- Shareholders with more than a 5% personal interest in the company, who are also employees/directors, must not make up more than 40% of the total employees of the company
- The EOT must benefit the employees on principally equal terms (relative remuneration, hours worked, or years’ service can be used to differentiate between employees)
Further Guidance on Employee Ownership Trusts
If you are considering the shift to an Employee Ownership Trust for your business, you can access further information from the Employee Ownership Association, alternatively we can also direct you to trusted specialists who can support with the transition.