EOTs have some great tax perks.
You’ve likely heard the headline, “no CGT”, and “tax free staff bonuses”.
But are these true?
What are the criteria?
Any downsides of EOTs?
Overview of EOT tax benefits
Headline number 1:
“Zero capital gains tax for the founder”
Headline number 2:
“Tax free profit share payments for staff”
These are both often true, but they oversimplify. Below we go into more detail about:
- impacts of EOTs, tax by tax
- key criteria to qualify
- pitfalls to avoid
Taxes
Capital Gains Tax and EOTs
Is it true? Do founders really suffer no capital gains tax when selling to an EOT?
Yes, subject to criteria detailed further down, which need to be met for at least 12 months prior to EOT sale, and afterwards too.
Technical CGT point – “nil gain nil loss” transfer
The sale from founder to EOT isn’t “exempt” from capital gains tax. Nor is it tax free/does it get a 0% tax rate.
It’s deemed a nil gain nil loss transfer. Same as spouses transferring assets between them.
Whilst the EOT continues to meet the criteria, from a practical perspective the sale is tax free.
But if/when the criteria are breached, capital gains tax can arise. The original base cost for the founder becomes relevant.
Who this impacts depends on when any breach occurs.
Timeline for a criteria breach, and who suffers
If they’re breached before sale, then in practice you’d be able to delay/reconsider your options.
If they’re breached after sale, but before the end of the tax year following sale, the founder will become liable to CGT. I.E. if they sold on 30 June 2024, any breach prior to 5 April 2026 could impact the founder’s tax treatment.
If they’re breached after that, the trust will become liable to CGT. It will be deemed to have sold then immediately reacquired the shares, triggering the tax lawfully avoided at point of sale to the EOT.
There is a get out if rules were breached for less than 6 months, and for reasons outside your control.
So for example if a couple of employees quit unexpectedly, leaving you short of the participator rule, but you employed replacements swiftly, you would be ok.
Examples showing when this becomes an issue
You set up the company with 100 x £1 shares, so base cost to you is £100. You sell to an EOT for £500,000, paid over 5 years.
Example future situation 1
Within a year of sale, the business is struggling, and a few employees are made redundant. The business now falls short of the participator rule. As it was done deliberately (making them redundant) rather than outside their control (employees unexpectedly quitting), even if they replaced the staff within 6 months it’d still be a breach.
The founder’s initial sale to the EOT is now taxable (normal CGT rules apply), as the criteria were breached before the end of the tax year following sale.
Example future situation 2
10 years after sale, the founder’s fully paid off, and a healthy war chest is built up. The company uses that to buy an investment property to rent out. They also decided to wind down the trade of the company, as the future wasn’t looking good. The company is therefore no longer a trading company, now being an investment one, but otherwise continues to operate.
The founder’s initial sale is safe, as the breach was long after the EOT acquired the shares. So the EOT is deemed to have sold and immediately reacquired the company shares. This triggers the EOT to effectively have to pay the CGT that the founder legally avoided on the initial sale.
Example future situation 3
2 years after sale (and 2/5ths of the £500k paid to the founder), the business has continued broadly the same. The future doesn’t look too rosey. But the trustees get an offer of £500k for the business (same as the purchase price). Given projections, this seems a good offer. It’s put to the staff, and they agree.
Whilst unlikely in the real world, for numerical ease, we’ll assume due diligence doesn’t pose any issues, and the full £500k is paid as cash upon completion.
CGT is triggered on the sale. As it’s after the end of the tax year following the founder’s sale, their initial sale is not impacted.
Whilst the EOT bought for £500k, it inherited the founder’s low base cost of £100. So if it sells for £500k, then the gain subject to capital gains tax is £499,900 (not £nil as the trustees might wrongly expect).
For ease we’ll consider this gain £500k for the remaining calculations. It suffers 20% capital gains tax, so £100k. This leaves £400k left.
But remember the founder had only been paid £200k of the £500k they sold to the EOT for. So the founder gets a further £300k of these sale proceeds to clear that debt. Hence there’s £100k left.
This £100k can be distributed among the staff like a profit share payment. So it goes via payroll, suffering employment taxes/NICs etc.
Still a very nice receipt, no doubt about that. But it may not be as lucrative for the staff as they’d initially hoped from a £500k sale! Understanding this may reduce the appeal for staff to collectively lobby the EOT to sell.
Income Tax and EOTs
If there’s a second tax related headline for EOTs, it’s the £3,600 tax free profit share to employees each year.
Again, true. Again, rules to be careful of.
The participator ratio rule still applies. Bear this in mind this when considering senior employees being given share options/buying shares.
Also consider it if business isn’t going so well and you’re “downsizing”. If multiple junior/mid-level staff leave and are not replaced, you could be in trouble.
Corporation tax and EOTs
The trading company
Being controlled by an Employee Ownership Trust has no direct impact on a trading company’s corporation tax status, or liability.
Indirectly EOTs tend to reduce corporation tax liabilities of the trading company significantly!
Why? Profits are paid out to staff via payroll. Those profit share payments are a valid business expense for corporation tax.
Hence company profits after profit share payments tend to be modest.
Do remember that whilst the founder is being paid off, those contributions (unlike profit share bonuses to staff) are made from post corporation tax profits.
The trustee company
Most commonly this entity will never make a profit, so never suffer any corporation tax.
It will waive dividends, instead asking the trading company to process profit share payments to employees via payroll.
EOT transfer costs
Worth mentioning that the costs of transferring ownership can be paid by the trading company but should be disallowed for corporation tax (as not “wholly and exclusively for the benefit of the trade”).
Our understanding is you can legitimately reclaim VAT on these fees (subject to normal rules).
Inheritance tax and EOTs
This is a risk of EOTs that founders should be aware of. Especially older founders or those with a terminal illness.
Significant shareholdings in a company often qualify for Business Property Relief (BPR) should you pass away. This means they pass to beneficiaries with no IHT suffered.
By selling your shares to an EOT, you’re converting an asset that qualifies for BPR (the shares) to one that doesn’t (cash/deferred consideration). You’re adding a high value asset to your estate for IHT purposes. Potentially causing a big increase in IHT liability payable following your passing.
If this is a concern, discuss with your tax adviser/financial adviser.
The Government are being lobbied about this, as it is putting some older business owners off EOTs. Watch this space!
Blog post re succession planning
Key criteria
Participator Rule and EOTs
This is a significant and potentially complicated part of qualifying for most of the tax benefits of EOTs.
Ratio of participators to staff must not exceed 2/5 (i.e. 40%)
Why have this rule?
To get the perks, EOTs should involve a significant change in who owns/controls the company. There should be a decent number of employees gaining some power/right to income.
The participator rule attempts to prevent companies with multiple shareholders and minimal employees from benefitting from the tax perks (eg see “company B” example further down).
What is a participator?
For EOT purposes, it’s anyone who owns 5+% of any class of the company’s share capital.
Plus for this purpose also include any employees who are their relatives:
- Spouses/Civil Partners
- Siblings
- Children/Nieces/Nephews
- Parents/Aunts/Uncles
Examples
Company A is owned 100% by its sole director, Gemma. She is on the payroll alongside 10 other employees. None of the staff are related to Gemma.
The ratio is 1:11 = 9%, way below 40%, it’s fine.
Company B is owned 25% each by 4 siblings. They have two other employees who assist, one of whom is the spouse of a shareholder.
The ratio is 5:6 = 83%, well above 40%, not even close to qualifying.
Company C is owned 50% each by a husband/wife couple. The company employs 6 other staff plus them, and 1 of the 6 is their daughter. So 8 people on the payroll in total, but 3 participators (including the daughter).
The ratio is 3:8 = 37.5%, they’re just ok. However if one of the unrelated employees left, or was promoted to director, or they employed another family member, they’d breach the threshold.
The other critical thing is…
Controlling stake obtained by the EOT
The capital gains tax relief only applies when you sell a controlling stake. I.E. >50%.
Again a key mantra of EOTs is that the employees have real power.
If the EOT held 49%, founder retained 51%, the founder’s decision would be final.
Hardly sounds like power to the employees!
FAQs
Q “I like the idea of dabbling my toe, selling a small % whilst I retain control. Can I benefit?”
A “You can sell a minority shareholding to an EOT, but you’ll suffer capital gains tax.”
Q “I like the idea of selling my shares gradually, in instalments over multiple years. The EOT will gain control at some point. Can I benefit?”
A “Only in the tax year where the EOT acquires a controlling stake. For the other tax years, you would pay CGT.”
EG if you owned 100%, and sold 33.3% each year over 3 tax years to an EOT:
– year 1 – EOT buys 33.3%, it owns 33.3%, it doesn’t control the company, you pay CGT
– year 2 – EOT buys 33.3%, it owns 66.7% so does control the company, this sale is tax free
– year 3 – EOT buys 33.3%, it owns 100%, but it controlled the company last year, you pay CGT.
The above does encourage founders liking the idea of EOTs to go all in.
Blog post re example finances for EOT sale
Must be a trading company
The company the EOT is buying shares in must either be a trading company, or the holding company of a trading group. I.E. it can’t be an investment company.
To be honest this one will rarely be an issue, but it’s one of the criteria so needs mentioning.
Profit share bonuses paid out to employees of companies controlled by an Employee Ownership Trust must be paid out equitably…what does this mean?
You can’t single out any individuals, or groups of employees. Either positively or negatively.
Profit share bonuses must be made to all employees, on a set basis, to qualify for the tax exemption.
Split profit share:
- Equal for all
- Proportional to salary
- Proportional to hours worked
- Proportional to length of service
There’s varying logic on what’s “fair”. Should:
– all get the same, we’re all human, all equal?
– high paid staff get more, as they likely had a bigger role in generating profits?
– long standing employees get more than recent recruits?
– full time staff get more than part time staff?
All can be argued as fair/best. There’s no right/wrong answer.
You can also split it into pots, apportioning each in line with the above. Examples could include:
– up to £3,600 per employee split equally, anything above that in line with salary
(maximise tax free benefit for all, but if firm does particularly well, senior staff reap most reward)
– 50% based on length of service, 50% based on hours worked
(long-term full-time staff get the max, whilst more recent recruits and part timers get less)
It’s a myth that everyone must earn the same in employee owned companies.
Top performers can be paid higher salaries. Profit shares can be aligned with salaries too.
£3,600 isn’t a limit
It’s worth stressing profit share payments can be above £3,600 per employee per tax year.
Only the first £3,600 will be tax free. The rest will be taxable like normal salary.
Don’t think profit shares must be below £3,600.
“Normal” bonuses
Does your business have a few employees who have gone above and beyond?
You can reward them individually with bonuses. The company being EOT controlled doesn’t prevent this.
It just can’t be a “profit share bonus”, hence won’t benefit from the £3,600 tax free.
Hence you’d need to distinguish between what we might call “normal bonuses” and “EOT profit share bonuses”.
Take care to avoid these EOT pitfalls
EOTs can be great from a tax perspective, but be careful the below don’t trip you up.
Max valuation, no sweeteners for staff
The more you sell your business for, the better for you, right?
To a point, yes. But be too greedy and it can backfire. Remember you’re paid out of future profits. For those profits to arise, you need employees to continue running the business successfully.
If staff are:
– busting a gut
– on low salaries
– creating big profits
– which all go to you
their enthusiasm may dry up!
You need your key staff on board. They need to be able to see some benefit from their efforts.
A huge valuation, that can only be paid by eating up 90+% of profits for a decade, isn’t going to incentivise staff!
A reasonable valuation, and/or other sweeteners to the deal, can help make it more attractive to employees. In turn this makes it more likely you’ll be paid off in full.
Trying to sneakily retain control
We’ve heard it all:
“Can I sell 51% to the EOT, but the 49% I retain hold extra voting weight?”
“What if I put clauses in the trust deed which say the founder trustee’s say outweighs others?”
“My spouse is on the payroll, I’ll make them the employee trustee?”
“Can the independent trustee be my brother?”
“Can I retain 1 share which has special rights enabling me to veto any decisions?”
Any of these causes significant risk of HMRC disputing you having actually transferred control.
You run the risk of the sale proceeds suffering capital gains tax, and staff profit share bonuses not gaining the £3,600 tax free element.
In short, only do an EOT sale if you’re mentally at peace with no longer controlling the company. You can still work there, but it won’t be “your” company anymore.
Perhaps pre transfer:
– you were the sole director and shareholder.
– the company is small, just 5 staff plus you.
Great, you meet the 40% ratio (indeed just 16.7%).
You then transition to an EOT, selling 80% of your shares to the EOT, retaining 20%. You’re taking a step back, but won’t be stepping down fully just yet.
Of the 5 employees, you decide 2 of them warrant being offered EMI share options. Whilst these will be for 4% each of the overall share capital, the company now has different share classes. So the options are >5% of their own share class. Even though at the moment these are just share options for the individuals, rather than actual shares owned, it still makes them count as participators.
So whilst the company still has 6 employees total, 3 of them are now participators.
Oops, that’s 50%, above the 40% limit. Until it’s rectified, the company cannot benefit from the £3,600/employee tax free bonuses.
Also if it was before the end of the tax year following transfer, you may have to pay capital gains tax on the EOT sales proceeds too. Disaster!
Share options can be a great way to incentivis key staff to really focus on the company’s success. But care needs to be taken.
Employing family members
It can be tempting. Who can you trust more than your family?
This may apply to new directors too. Perhaps they’re keen to employ:
– a sibling, as a potential future co-leader
– a spouse to assist part time with admin around childcare
– a young adult child for a bit of paid work experience
They may want to recruit these people with the best of intentions. The individuals may be brilliant, and could be great additions to the firm.
However, it’s that pesky 40% rule you need to be careful of. Breach this and the staff can no longer get tax free bonuses. Plus if soon after transfer, risk to tax-free status of the sale too!
Remember to add close family members of participators to the participator tally.
Summary
Employee Ownership Trusts DO have some great tax perks, but take care.
- Ensure you meet the participator ratio…
- …not just on transfer, afterwards too!
- Ensure EOT gets a controlling stake
- Then zero Capital Gains Tax for founder
- £3,600/year income tax free (but not NIC free) profit share per employee
- Corporation Tax often reduced too
- Be aware of Inheritance Tax risk