Posted by James Pearson on 20 Jul 2020
The Employee Ownership Trust (EOT) was introduced by the Coalition Government in 2014 with the aim of promoting employee ownership in the UK, similar to the John Lewis model. The 2014 rules provide an incentive for owners to sell a controlling stake in their business.
What is an EOT
An EOT is a special form of employee benefit trust which holds a controlling stake in a trading company on behalf of all its employees. EOT’s are sometimes seen as a way of extracting profits tax-free, but while that may be possible, care should be taken as there are pitfalls and significant conditions must be met.
What are the tax advantages?
- When a controlling interest in a company (or parent company of a trading group) is sold to an EOT, the seller has no capital gains tax (CGT) on the disposal, as it is deemed to be made at no gain / no loss. This is better than the minimum 10% rate of CGT available for a sale on the open market.
- Certain bonuses of up to £3,600 each per tax year, which are paid to all employees, are exempt from income tax (but are not exempt from National Insurance Contributions). As this is not a dividend it can be paid when there are no profits/distributable reserves in the company.
- There are no inheritance tax charges on the transfers into or out of the trust, and the trust assets should be outside the scope of the relevant property regime.
How does an EOT Disposal Work?
An EOT is established and enters into an agreement to purchase the company shares at market value. The consideration is usually left as a debt (deferred consideration), which is paid off over several years using the ongoing profits of the business. The selling owner will normally continue to work for the business, being paid a salary for his time and effort.
What are the Main Qualifying Conditions?
- The company whose shares are transferred must be a trading company/principal company of a trading group.
- The EOT must meet the ‘all-employee benefit requirement’/‘equality requirement’ – any benefit to employees must be on the same terms for all eligible employees (participators are not 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 (i.e. more than 50% of ordinary share capital) at the start of the tax year of the transfer but must hold a controlling interest at the end of the tax year in which the transfer takes place. This effectively limits the relief to a single tax year and means most disposals will be for the full ownership of the company, not just a controlling interest.
- The proportion of employees who are participators (or connected to participators) must not exceed 40% in the 12 months following the disposal. This appears to be intended to prevent owner-managed businesses with few/no employees from using an EOT to extract tax-free profit, to prevent the type of abuse that blighted previous employee benefit trusts.
It is important to note that the relief may be clawed back if the qualifying criteria are subsequently broken.
Why use an EOT?
Aside from the tax benefits shown above, there are other perceived benefits:
- Employees indirectly own the company, increasing engagement and commitment, plus it allows employees to indirectly buy the company without having to use their own funds.
- This also creates an immediate purchaser for the company, allowing shareholders to sell their shares for full market value and addressing succession issues. The sale normally fixes the price at the date of sale agreement, meaning the vendor does not benefit from any growth during the payment period.
- Not all shareholders are required to sell their shares to the EOT (although in practice it is unlikely that shareholders would want to miss out on the CGT-exempt disposal opportunity).
- The vendors can remain as employees after the disposal, receiving remuneration for their work.
- As the sale to the EOT does not involve outside parties, the sale process may be quicker and cheaper than a third party sale, where numerous warranties and indemnities may be required.
With the Government known to be looking at the low rates of CGT available in the UK, having already reduced the lifetime limit for Entrepreneur’s Relief, disposals to Employee Ownership Trusts have never looked better. Tax Innovations can help to guide you past the potential pitfalls of selling your business to an EOT.
If you would like any advice regarding Employee Ownership Trusts or would simply like to discuss other ways in which we could help you or your business, please contact us on 01962 856 990 or firstname.lastname@example.org
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