A sale to an employee benefit trust provides many of the benefits a seller could receive through a third party sale but there a incremental benefits, less disruption and confidentiality. The tax break for the sellers are substantial – the shares can be sold at full market value without the sellers incurring any liability for Capital Gains Tax (“CGT). It is possible to seek advance clearance from HMRC as to the tax position on sale of the business for certainty.
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What benefits can an EOT bring to shareholders in a private company?
An EOT is an employee benefit trust set up as a vehicle for the owners of a trading company to pass ownership to a trust which pays them consideration and then owns the business for the benefit of the employees. The shares in the trading company being transferred can be sold to the EOT at market value. The proceeds paid to the sellers of the shares in the trading company are received free of any Capital Gains Tax (CGT) liability.
The EOT does have duties which would prevent it from agreeing to pay more than the commercial market value. The usual way to fix market value is to consider EBITDA. The employee benefit trust it can pay less than market value if the sellers agree to this. Businesses can be gifted to EOTs for no consideration if that is intended. More details on selling to an EOT are set out here.
An EOT possesses the following characteristics:
- the EOT must operate for the benefit of ‘all employees’ ‘on the same terms’ – this does not mean that some employees can be more senior and paid more than others. What it does mean is that they are all beneficiaries under the trust.
- The company must be a trading company or part of a trading group – HMRC has definitions of what trading means. The intention is to rule out investment companies.
- The EOT must acquire a controlling interest in the trading company (more than 50%).
- The number continuing shareholders who are directors/employees must not exceed 40% of the total number of employees in the company – this means very small companies may not qualify.
How the benefits are delivered to shareholders
In the right circumstances EOTs have attractions.
- Selling to an EOT allows employees to indirectly buy the company from its shareholders without them having to use their own funds.
- Choosing to sell to an EOT creates an immediate purchaser and is generally seen as a friendlier purchaser. This means the sale will often be quicker and have lower professional fees.
- Shareholders can sell their shares for full market value without being worried about Capital Gains Tax.
- Not all shareholders would be required to sell their shares. As long as a controlling interest is sold, other shareholders can keep their shares.
- An EOT can be used to create greater employee engagement and commitment. The potential benefits for employees may lead to a more committed workforce.
- Selling to an EOT may be an attractive option for entrepreneurs wanting to retire but wishing for the company they built to continue.
This structure would typically be used when an exiting shareholder does not want to sell to a third party and instead would like to reward the existing employees by enabling them to indirectly own the business that they have helped to build.
Drawback to EOTs
In practice the biggest draw back will be finding a management team that are capable of running the business once the owners have sold out to the EOT. However, there is a bridge as the directors will still run the company, the EOT acts only as a shareholder, and therefore does not control the day to day running of the company. This means the board are still able to make decisions.
This point is important if the sale to the EOT is intended to be on a commercial valuation which releases funds via loans to the sellers. A weak management team may not be able to generate the funds to repay any loans made by the business to the sellers.
Imagine you think your business is worth say £10 million but the company only has spare cash of say £6 million. Ignoring working capital considerations for the purposes of an easy illustration, the sellers could borrow £4 million from the bank to pay themselves £10 million on sale out of which £6 million is paid on completion and £4 million is left outstanding to be repaid to the sellers out of future trading profits. There is a risk to the sellers of default which the banks would have the sellers underwrite.
If all the requirements for an EOT are met, there can be significant tax benefits.
Shareholders disposing of the controlling interest will do so exempt from Capital Gains Tax. Therefore, the selling shareholders can enjoy the consideration paid to them in full. Payments made from the company to the trust can also be made tax free.
Each year, employees can receive annual bonuses of up to £3,600 each. These bonuses must be paid to ‘all employees’ from the EOT. This must be done ‘on the same terms’.
Tax free bonuses of upto£3,600 can be paid to ‘all employees’ from the EOT. The reason this must be to all employees is that the trust can only act to benefit all employees on equal terms.
There are however measures that can be introduced to determine who receives a bonus payment. A qualifying period may be used for new employees. This period can be for a maximum of 12 months, during which the new employee will not experience the benefits of the EOT. After the qualifying period has ended the employee will experience equal benefits to all other employees.
On the same terms
- Hours worked
- Length of service
The trustee of the Company’s employee trust wishes to make a payment to employees based on an individuals hours worked and their length of service in the previous year. It does so by allocating ‘qualifying points’ to each eligible employee. Each employee receives 10 qualifying point for each year of service and two qualifying points for every £1,000 of gross salary. Each qualifying point is equal to £100 of bonus payment.
An employee who has 10 years’ complete service and an annual gross salary of £50,000 would receive a bonus of:
Service: 10 years x 10 points = 100 points
Salary 50 (i.e. £50,000/£1,000) x 2 = 100 points
Total qualifying points = 200 points.
The total bonus amount is £20,000 (being 200 qualifying points x £100). The trustee of the EOT uses the assets of the trust to pay £16,400 of the bonus (which is subject to the deduction of income tax and NICs) and the Company pays the balance of £3,600 tax free, but subject to NICs.