Long Term Incentive plans, Employee Ownership Trusts and employee Benefit Trusts

Usually, companies implement an LTIP, Long Term Incentive Plan, for senior executives whose planned awards fall outside of the permitted maximum of an HMRC approved share plan.

Employee Share Ownership  Trusts are being increasingly used by the owners of a business to create a sale which is 100% free of capital gains tax and approved by HMRC. Employee Benefit Trusts can be created also where there is commonly  a crossover with Long Term Incentive Plans.

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.

LTIP – How to achieve the best plan

The basic idea behind a LTIP is that participants receive share options or shares if they satisfy certain performance criteria over time. Sometimes, the LTIP participants have to invest a proportion of salary or cash bonus towards the acquisition of shares.

With LTIP’s an Employee Benefit Trust is normally set up and the directors select the participants, performance criteria, required share retention period and terms. Tax planning is usually part of the design of the plan and we are highly experienced at this.

Performance criteria under an LTIP

The pay out from the LTIP depends on performance targets linked to the company’s growth metrics.  Increasingly performance targets include soft or behavioural components to promote the culture of the company.

LTIP malus clauses

Financial misconduct is often discovered after the fact. Those involved might have left with their pockets full or they may expect an LTIP pay out after the end of the retention period.

  • The employer company can recover the award under an LTIP if permitted by the LTIP rules, under:
  • Claw back provisions – the participant will have to repay if the performance of the business is not as good as initially reported;
  • Malus provision – the LTIP award can be adjusted downwards to reflect a change in circumstances.

LTIP tax

  • Taxation of LTIPs depends on the nature of the award. LTIPs can be taxed as:
  • A bonus paid in shares and taxed as income from employment;
  • A share option – depending on whether the option is approved (CSOP), or unapproved, capital treatment may be available.

LTIP: holding shares in an Employee Benefit Trust

Most companies which operate LTIPs hold LTIP shares via an Employee Benefit Trust (EBT). An EBT provides an internal market for shares which makes the LTIP very attractive for employees.

What is an Employee Ownership Trust?

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 for 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.

Key points to note with Employee Ownership Trusts

  • 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.

Tax Reliefs with Employee Ownership Trusts

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’.

All employees

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.

Catherine Gannon

A highly experienced and practical lawyer with an additional qualification as a Chartered tax advisor, Catherine is also a regular writer and speaker for a variety of commercial organisations.

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