Employee Ownership Trust (EOTs): What Happens Next?

 

Introduction to Employee Ownership Trusts (EOTs), what happens next…

Employee Ownership Trusts (EOTs) are increasing in popularity, and it’s not hard to see why: the founders sell (with no tax to pay), the employees inherit an indirect stake in the business, and everyone celebrates with cake!

 

But what happens next?

As employee ownership is still a relatively new concept, having only been widely talked about since 2014 it’s fair to say that this is still relatively unexplored territory.

Indeed, whilst sales to EOTs continue to gain publicity, with The Entertainer becoming one of the most recent well-known names to announce it is moving to employee ownership, there appear to be few, if any, well-publicised examples of EOT-owned businesses being sold.

Whilst it is, of course, possible for the EOT to sell the shares it owns in a trading company, in practice, it’s likely to be rare given the commercial complexity and the need to consider employee interests.

However, businesses will evolve, markets will shift, and shareholders’ (including EOTs needs will change. So, how could it work?

That would largely depend on the original situation on sale to the EOT and whether it was:

• A complete sale of 100% of the shares to an EOT
• A partial sale (anything between 51% and 100%) where the selling shareholder retain an interest in the company; and
• More complex hybrids, such as an EOT combined with a share option scheme

 

Each brings its own commercial and tax considerations, and we have explored these below.

1 When All Shares Are Sold to the EOT

Where 100% of the shares are transferred, the trustees hold them on trust for the employees. At that point, the company is “locked into” the employee ownership model.

• Resale: A later trade sale isn’t impossible, but it must be justified as being in the employees’ best interests. Independent trustees, in particular, may be reluctant to sell unless the rationale is compelling.
• Other challenges: second-tier management may feel disincentivised as high earners are unlikely to be excited by tax-free bonuses of £3,600 per annum and we have seen examples of these individuals deciding to leave once EOT sales complete, realising that there is no longer much in it for them. The concern there is that once the original shareholders have left the business day-to-day, the only way to truly incentivise future generations of managers and leaders is with large salaries.

Tax considerations

The initial sale will qualify for a capital gains tax (CGT) exemption if all statutory conditions are met. However, if the company is later sold to a third party, that transaction is treated as a disposal by the trust itself. The EOT is subject to CGT (albeit with possible exemptions if it still qualifies as an employee benefit trust). Care is also needed with distributions, as payments to employees will fall within income tax rules and the after-tax proceeds would then be subject to income tax and national insurance when distributed to the employees.

 

2 When a Majority Interest Only Is Sold

EOT legislation requires that the trust owns a controlling interest (more than 50%). But that still allows founders or investors to retain a minority stake.

• Resale: In this case, the trustees and the continuing shareholders sit side by side so all would have to agree to sell.
• Other challenges: problems night arise if the founder later wants to sell their minority holding. The trustees may be unwilling or unable to buy, and third-party buyers may not want a minority stake. Additionally, minority stakes are typically worth less per share than majority holdings, so exit expectations need to be managed.

This hybrid approach can work where the founder wants to stay engaged and share in future growth, but it complicates the long-term succession picture.

Tax considerations

The founder’s initial sale of a majority interest can qualify for the CGT exemption, provided the trust meets the statutory ownership and employee benefit requirements. If the founder later disposes of their retained minority stake, this will be taxed under normal CGT rules, with no special relief as there is only one “bite at the cherry”. In addition, there is a risk that if the founder’s continuing role or benefits are too generous, HMRC could argue that the EOT does not meet the “all-employee benefit” condition, jeopardising the CGT relief on the original transaction so care needs to be taken.

 

3 EOTs Combined with EMI Options

Some businesses adopt a hybrid model such as ownership through the EOT, alongside Enterprise Management Incentive (EMI) options for key (second-tier) management. This can work well as it rewards all employees equally while still giving senior staff an extra incentive.

• Resale: on a second exit, option holders expect to realise value. But if the trustees are reluctant to sell, there is a potential conflict between management’s desire to crystallise their options and the trust’s duty to employees.
• Other challenges: EMI options can be very tax-efficient, but care is needed to ensure compliance with the “equality requirement” for the EOT. The EMI scheme cannot undermine the principle of broadly equal treatment. Additionally, aligning the voices of trustees, option holders, and ordinary employees can be tricky.

This structure offers flexibility but requires careful drafting of trust deeds, option terms, and shareholder agreements to avoid future stalemate.

Tax considerations

An EMI scheme is very tax efficient because qualifying option gains can benefit from Business Asset Disposal Relief (BADR) even if the option holder holds less than 5% of the ordinary share capital and voting rights shares. However, as outlined above combining an EMI with an EOT requires careful planning to ensure the trust’s “broadly equal” benefit test is not undermined by the EMI favouring only senior staff. On a second exit, EMI option holders may trigger CGT at exercise/sale, while the EOT itself may face CGT on any share disposal. In addition, corporation tax deductions may be available for option gains, but the interaction with EOT rules must be managed to avoid double-counting or disallowance.

 

Conclusion

The first sale to an EOT may not be the end of the story. Once the cake is eaten, the business continues to evolve. Owners, trustees, and employees should recognise that.

In summary:

• 100% EOTs bring stability but limit flexibility for future sales, with the trust itself bearing tax on a later disposal.
• Majority EOTs with retained minority shareholders create scope for continued involvement, but the minority stake will not enjoy special tax relief and can create tension.
• EOTs with EMI overlays provide a nuanced blend of broad participation and management incentive, but raise complex interactions at the second exit around CGT, income tax, and corporation tax.

EOTs are powerful vehicles if done right, but they require careful planning.

Businesses whose main drivers are tax relief or short-term exit may find themselves better served by alternatives such as trade sales or MBOs. Don’t let the tax tail wag the dog!

If you have any queries about this article or employee ownership, please get in touch.