Employee Ownership Trusts (“EOTs”) were launched in 2014 as a tax-efficient way of transferring ownership of a company. The EOTs were designed to encourage a more collegiate ownership of companies similar in style to the John Lewis Partnership model. The impact of COVID-19 on businesses may encourage owners of SME’s to re-evaluate their position. Rather than continue working and building up a successful business to pre-COVID levels, do they want to consider an exit in the short to medium term? A sale to an EOT may be an attractive alternative to a normal “trade sale” to a competitor or a management buyout.
Who has used EOTs
Businesses considering EOTs have to be businesses established as a company (rather than as a partnership) and in a majority of cases we have seen such companies being controlled by one person (or a couple) who is looking to retire or substantially decrease their involvement in the business. The common theme with the businesses is that they are reliant on their human capital in that their staff are the business. Although the name on the door may initially attract the clients, it is the individuals who build and maintain the client relationships.
The owner generally wants to protect their business “legacy” rather than selling to another company which could move the business to another part of the country and leave the employees high and dry. The tax advantages of a sale to an EOT are a bonus but not the main driver behind the sale to an EOT. However, with the reduction in the value of Entrepreneurs’ Relief (to be called Business Asset Disposal Relief), the tax savings from a sale to an EOT may become more important.
EOT owned businesses include a wide range of business sectors. However, in a large majority of cases, all are heavily dependent on their people with very little in terms of fixed assets and goodwill.
What happens with an EOT?
An EOT is a trust which has to own a controlling interest in the company in order to achieve the tax benefits for the selling shareholder and the staff. If the relevant conditions are satisfied:
- The seller will pay no capital gains tax (“CGT”) when they sell their shares with no upper limit on the value. Business Asset Disposal Relief with CGT at 10% on the first £1m of lifetime gains is not even relevant.
- Employees can be paid a tax-free bonus of up to £3,600 per year.
As with all tax approved arrangements, the devil is certainly in the detail and there are a number of conditions to be satisfied for a period of up to two years following a sale to the EOT. A breach of the conditions can result in the original sale becoming liable for CGT and is really bad news for the seller.
The EOT will own the shares in the company for the benefit of the employees. The employees can be given the power to vote on key decisions affecting the company, such as a sale to a third party, either directly or through the appointment of an employee council. Smaller scale businesses may appoint an employee to act as a trustee of the EOT (or more usually as a director of the trustee company). However, the day to day running of the business will remain with the directors.
What are the benefits of an EOT?
There are a number of benefits of an EOT:
- The future of the business (or the founder’s business legacy) can be secured for the employees rather than being at the mercy of a third-party buyer
- The ability for the current owners to sell without paying any tax on the sale of the shares
- The EOT can buy the company when there is no realistic prospect of a sale to a third party
- The management team do not have to take on personal debt to fund a management buyout or to buy the shares personally
- The ability to pay an annual tax-free bonus to employees
- Allow the employees to influence the performance and direction of the business
The Employee Ownership Association, a membership organisation which champions and promotes employee ownership, has funded independent research that supports the claim that employee owned businesses have been more resilient and achieved increased growth compared to non-employee owned businesses.
Why doesn’t everyone use an EOT?
An EOT is not a panacea for all companies and there are a number of practical difficulties to overcome:
- Funding – the EOT has to be funded by someone to buy the shares. The company can make a contribution to the EOT. Banks may be reluctant to lend to an EOT trustee so funding usually has to be directed via the company which may not have the ability to service additional borrowing. In many cases, the selling shareholders will fund the sale by deferring the payment of the consideration over a substantial period of time (over 10 years in some cases).
- Management of the business. The business still requires a capable management team to take the company forward. Management by committee vary rarely works. A founder will probably wish to stay on in some capacity, particularly if there is a large amount of deferred consideration payable.
- An EOT does not lend itself to a traditional management buy-out scenario with management taking a shareholding in the business with a view to selling in three to five years’ time. The EOT trustee may not wish to sell its majority shareholding and in addition may not be able to buy the shares from the new management.
- The company may not obtain a corporation tax deduction for the contribution to the EOT.
- Future contributions to an EOT could be treated as a distribution or a dividend paid to the EOT by HMRC (although obtaining tax clearance at the outset regarding the funding of deferred consideration can mitigate this risk).
An EOT can be a neat solution to a company owner looking to retire and sell up when there is no obvious third-party buyer provided the company has the ability to fund an EOT either directly by a lump sum or deferred consideration or via a third-party loan. In some cases, the exiting owner has to compromise on what he or she thinks the business is worth or take a larger proportion of the consideration on deferred terms. However, an EOT has proved to be an attractive solution for the selling shareholder and the management and employees in a “people critical” business.
For more information on EOTs and how they may assist your company please contact Andrew Evans on 029 2039 1761 or by email on Andrew.firstname.lastname@example.org