Employee ownership trust (EOT) enable business owners to transfer a controlling interest in their business into employee ownership without paying capital gains tax (CGT).
What is an Employee Ownership Trust?
An Employee Ownership Trust is a specific type of Employee Benefit Trust (EBT) introduced by the government in 2014 to reward employees and encourage employee engagement. An EOT provides an indirect form of employee ownership whereby the trust holds a controlling stake in a company on behalf of all the company’s employees.
Where a shareholder sells a controlling stake in their business to an EOT and qualifying conditions are met there can be significant tax advantages. This makes EOTs useful in succession planning as an alternative to an external sale, a private equity backed buy-out or a management buy-out (MBO).
How does an employee ownership trust work?
Put simply:
- A qualifying EOT is set up.
- The business owners sell more than 50% of the current share capital to the EOT for market value (using an independent valuation). The purchase price is left outstanding as a debt owed by the EOT to the selling shareholders (or the EOT can make an initial payment to the shareholders using third party debt finance, leaving only part of the sale price outstanding).
- The company uses future profits to make contributions to the EOT and the EOT uses these payments to repay the outstanding purchase price owed to the selling shareholders.
Qualifying conditions
Determining the price which the EOT must pay for the shares is of critical importance – setting this too high risks the trustees being found to be in breach of their duty of care towards the employees as beneficiaries of the trust.
These are the key conditions which must be met for the selling shareholders to benefit from the CGT exemption:
- The company must be a trading company or the principal company of a trading group.
- All employees must be entitled to be beneficiaries of the EOT, subject to a qualifying period of up to one year and any benefit to employees must be on the same terms for all eligible employees. So the trust cannot prioritise benefits to the advantage of particular employees, but it can allocate benefits of differing amounts according to factors such as salary and length of service.
- The EOT must not hold a controlling interest in the company (ie more than 50% of ordinary share capital and voting rights, profits available for distribution and 50% of the assets on winding up) before the tax year of the transfer and must hold a controlling interest at the end of the tax year in which the transfer takes place.
- The number of continuing shareholders (and any other 5% participators) who are directors, employees or persons connected with them must not exceed 40% of the total number of employees of the company or group.
What are the advantages of selling to an Employee Ownership Trust?
Shares can be sold to the EOT at their full market value without having to pay any CGT either at the time of the sale or potentially also when deferred consideration is paid. This compares to paying CGT at 10% on the first £1 million of lifetime capital gains that qualify Business Asset Disposal Relief (BADR) or 20% on gains that do not qualify for BADR.
The sale should also be free of income tax and inheritance tax, albeit we would recommend seeking HMRC clearance on this.
The EOT only needs to buy a controlling interest, so not all shareholders have to sell their shares to the EOT. While shareholders could, in theory, only dispose of only enough of their shareholding for the EOT to obtain control, this is unlikely to occur in practice as the CGT exemption will not apply to any later disposal.
The directors who have sold their shareholding can stay in post after the sale and can continue to receive a salary for their director’s duties.
By selling internally, the shareholders don’t need to find an external investor and time and fees can often be saved on the transaction.
What are the advantages of an EOT for employees?
Employees can get an interest in the company without having to use their own funds.
The employees will feel more engaged as they have a stake in the business they’re working for.
Employees can be paid tax-free bonuses of up to £3,600 a year so long as these are paid to all qualifying employees on the same terms. This bonus is still subject to NIC though. This is a cash bonus, not a dividend, and so it can be paid without the company having to make a profit or have distributable reserves.
The only factors which may be used to determine the award are:
- The employee’s remuneration
- The employee’s length of service
- Hours worked by the employee
So allowing full-time employees to receive more than part-time employees, for example, without losing the tax-free nature of the payment.
Consultation
In summer 2023, HMRC held a consultation to review the tax treatment of EOTs (and EBTs) to ensure they remain focused on their policy objective of rewarding employees and encouraging employee engagement. The government is currently analysing the feedback and is due to publish a summary of responses later in 2024. Possible changes include:
- Preventing former owners and those connected to them from retaining control of an EOT-owned company by appointing themselves in control of the EOT trustee board,
- Requiring the EOT trustees to be UK resident,
- Legislating that contributions made by the company to the EOT trustees in order to repay the former owners for the acquisition cost of the company shares, will not be treated as distributions and therefore potentially liable to income tax in the hands of the shareholders,
- Allowing directors to be excluded from Employee Ownership Trust bonus payments.
How we can help
Using an Employee Ownership Trust is one of several ways a business owner can exit their business. This route is becoming more popular, not least because of the tax advantages available given the reduction in the lifetime allowance for business asset disposal relief. Whether it’s the right option for you will depend on several factors, including whether your business is suited to employee ownership. For more on the options available to you for existing your business, see Succession planning: how can I pass on my business?
We can help you decide whether using an Employee Ownership Trust is the right option for you and can advise all aspects of implementing such a sale.
This factsheet is based on law and HMRC practice at 21 May 2024.
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