Employee Ownership Trust (“EOT”) structures continue to be a popular option for business owners looking to exit their business. There are clear tax benefits to be had to the selling shareholders and the opportunity for employees to get some tax-free cash on an annual basis.
However, it is easy to be blinded by the up front tax benefits and lose sight of some of the challenges associated both with a sale to an EOT and also if and when the EOT looks to sell its shares in the future.
An EOT is a trust for the benefit of all of the employees of a company or group. If the owner(s) of a business sell a controlling (more than 50%) interest in their company to an EOT then any gain they realise on the sale should be tax free. There are lots of conditions to be met before the tax free sale is achieved but if proper advice is taken then there are clear tax benefits to be achieved. There is also the opportunity to pay employees tax free bonuses of up to £3,600 per year when under the ownership of an EOT.
This all sounds very attractive, but if the tax benefits are the sole or main reason you are thinking of an EOT structure then it may be wise to consider the points below before launching into the process. As a general rule EOTs are a great solution for those who enter into the process for the right reasons – but for those who see it as a way to realise some tax-free cash it can lead to significant difficulties in the future.
The first point may seem an obvious one but it often overlooked. The shareholder(s) have to sell a controlling interest to the Employee Ownership Trust – so they no longer are able to control the destiny of the company. The seller(s) can of course remain in the business and they may become trustees of the trust but best practice for trustees is that there should be at least one independent trustee and potentially an employee trustee as well. There is a strong sense this requirement may become law at some point.
So while the former owners may continue to run the business day to day the long term future of the business is in the hands of the trustees, whose responsibility is to protect the interests of the employees. Business owners can and do find this a challenging transition to make.
In the majority of cases the purchase by the Employee Ownership Trust will be funded by a combination of cash from the company on day one and deferred payments to be funded out of future profits. This often means a significant chunk of the shareholders’ cash is dependent on the future performance of the business. Does that mean you will need to stay involved until you have received your cash? What happens if business performance takes a turn for the worse? Could the deferred consideration hamstring the cashflow of the business? How long are you prepared to leave your cash on the table? The longer the payments are spread over, the greater the risk of something going pear shaped.
There may be a thought that the deferred payments can be funded out of the sales proceeds of a sale by the trust at some point in the future – while this may well be a possibility then given the amount of tax the EOT will need to pay on a later sale (see below) how confident will you be that the is enough cash left to repay the outstanding amounts? And will the trustees consider a future sale to be in the best interests of the employees?
The lesson here is , when looking at the sale value to the Employee Ownership Trust and the level of deferred payments, make sure a balance is struck between all of the competing factors – affordability of the payments, length of the payback period, how long you will need to stay to look after your interests and other factors as well.
In a typical business sale situation, the sellers of a trading company will be converting a very inheritance tax (“IHT”) friendly asset (shares in a trading company) into a very IHT-unfriendly asset – cash. Absent other planning the full amount of that cash would be exposed to IHT in the event of the owner’s unfortunate demise. Generally though, if the deal has been well negotiated, the owner will have received a significant majority of that cash up front so at least the money is there to pay the IHT.
Looking at an Employee Ownership Trust situation however, a large proportion of the proceeds may be made up of deferred amounts. In the event the worst happens then those amounts will be considered to be an asset of the estate of the deceased (a debt) and subject to IHT on the full amount owed – even if some of the cash is not due to be received for many years. The law does not make provision for the IHT to be deferred to match the receipts of the deferred consideration, so this can mean a real cashflow hit to beneficiaries… There are ways to manage the risk but these are far better thought of before the sale than after.
In the hope that the second exit does not fall within the previous section, many business owners will retain a stake in the company they are selling in anticipation of a second sale in the future. The first thing to note here is that the tax free sale to the Employee Ownership Trust is a one-hit wonder – any sales in a later tax year will be fully subject to capital gains tax in the normal way. Secondly of course they no longer have control of their own destiny – that will be in the hands of the trustees!
A common misconception is that the tax free sale of the shares to the EOT is some sort of exemption – nothing could be further from the truth. Certainly provided the business owner is careful about the conditions then once a certain period has passed they are in the clear. However the same cannot be said for the Employee Ownership Trust.
When the tax free sale takes place then for CGT purposes the EOT assumes that tax cost base of the shares from the original owner. So if the owner simply subscribed for £100 in share capital then that is treated as the cost of the shares to the EOT, irrespective of the actual price paid at the time the EOT acquires the shares.
In practice what this can mean is that the EOT will effectively pay CGT (at 20%) on the full proceeds it receives from any sale. As above this can leave a very large hole in the cash received to pay out benefits to employees or to pay the balance of any deferred consideration.
If there is cash left to pay out to employees then the hits keep on coming. The employee is taxed on the distribution of the proceeds as if it were remuneration from their employment – at rates of up to 47% including NIC. In addition the employer will have to pay NIC at 13.8% on the amounts distributed.
All of this means that the net received by employees can be only a relatively small proportion of the gross proceeds from the sale. This is something the trustees will have to weigh up when considering whether a sale is the right option for the benefit of the employees.
None of the above is intended to put anyone off exploring an EOT as an option for their business. For the right businesses and when done for the right reasons the EOT can be hugely successful in driving employee engagement and with it profitability and growth. However, for those who enter into an EOT without taking proper advice and understand all of the implications then the EOT structure can be the source of considerable pain (and cost!). It is critical the decision to proceed is as well informed as it can be so all of these potential issues can be priced in and managed before they arise.
At ETC Tax we have implemented a number of EOT transactions working with business owners to ensure they achieve the outcomes they are looking for and giving honest impartial advice as to whether an EOT is right for them. For more information on EOTs and other forms of business exits contact us.
