Understanding Employee Ownership Trusts: A Path to Sustainable Business Success

Employee Ownership Trusts (EOTs) have been in existence for many years and have gained significant traction as an innovative business model that empowers employees, fosters a collaborative working environment, and ensures business continuity.

Introduced through the Finance Act 2014, EOTs offer a framework where employees collectively own a significant portion, or the entirety, of the business they work for. The tax reliefs delivered encourage more employee-owned businesses, which due to its inclusive nature, helps foster a culture of shared responsibility, enhanced motivation, and long-term sustainability.

This article explores the popular nature of EOTs, the associated tax benefits, some of the key conditions, and offers insight into funding acquisition, with supporting examples.

Why utilise EOTs?

EOTs represent a transformative approach to business ownership in the UK, offering a pathway to sustainable growth, enhanced employee engagement, and significant tax benefits. Unlike traditional employee share ownership plans, EOTs involve the trust holding shares on behalf of the employees, rather than the employees holding individual shares. This collective ownership model ensures stability and a unified direction for the company’s growth.

By aligning the interests of employees and the company, EOTs can create a more motivated workforce and a resilient business structure. As more companies explore this model, EOTs are likely to play an increasingly prominent role in the UK’s corporate landscape, fostering a more inclusive and collaborative business environment.

Let’s explore some of the key tax advantages

• The most valuable tax relief is the exemption from capital gains tax (“CGT”) on the gain arising to the vendor on the sale of a controlling interest in a trading company (“Company”) to an EOT, where all employees are equal beneficiaries. The tax-free sale is only available in the tax year the controlling interest is sold.
• No CGT is payable on sale of the company to an EOT (this is even more advantageous than Entrepreneurs Relief). However, the transaction is only free of tax at the point where the EOT takes control of the company.
• Employees of a company owned by an EOT are entitled to bonuses of up to £3,600 each per annum tax free. These bonuses will still attract NICs.
• They can solve succession issues and provide long term stability as ownership is unlikely to ever change following the sale.

The conditions

We’ve outlined 4 conditions that must be met in the tax year in which the controlling interest is sold to the EOT and the tax year after, otherwise the CGT exemption is clawed back.

• The trading company requirement – the company must carry on a trade whose activities do not include non-trading activities to a ‘substantial extent.’ That is normally interpreted as being less than 20% of turnover and capital employed that relates to non-trading activities.
• All-employee benefit requirement – the EOT must benefit all employees equally but exclude past and present shareholders and their relatives if their interest is more than 5%. It is not possible for the EOT to pay out dividends to employees; instead bonuses may be paid which are subject to PAYE and NICs, although up to £3,600 is exempt from income tax per employee per annum.

It is possible to vary distributions from the EOT to employees based on their salary, length of service or hours worked, but it cannot be engineered in a way that some employees receive a distribution and others do not.

• The controlling interest requirement – the EOT must, in the tax year in which it acquires shares and the remainder of that tax year, hold more than 50% of the ordinary share capital, voting rights and entitlement to income and capital distributions of the company.
• Limited participation requirement – this condition is met if in the 12 months before and at all times after the controlling interest is sold to the EOT the participator fraction is no more than 40%. The participator fraction is broadly the number of shareholders (and loan creditors) who are also employees or directors (including their relatives if they are employees or directors) divided by the total number of employees of the company and its 75% subsidiaries.

Funding of the EOT acquisition explained

In most cases an EOT acquisition is funded by the company making an initial cash contribution to the EOT, with the remaining consideration funded by way of contributions paid to the EOT over time out of future company profits.

The level of the initial contribution is dependent on the company’s cash reserves available at the time of sale and the transaction can therefore be relatively flexible in terms of how it is structured.

Here’s an example calculation:

The following calculation assumes that 51% of the company is sold to an EOT on the first tranche and is therefore tax free. The second tranche is subject to the normal capital gains tax rules and assumes the £1 million limit for business asset disposal relief (“BADR”) is available for 2 remaining shareholders.

If 100% of the company were to be sold to an EOT in one sale, the full £5m sale proceeds would be free of tax.

However, if 100% of the company were to be sold without use of an EOT, a capital gains liability of circa £800k would arise and this equates to an effective tax rate of circa 16%.

Explore the benefits of Employee Ownership Trusts with Verallo

At Verallo, we specialise in helping businesses transition to Employee Ownership Trusts, ensuring a smooth and rewarding process for owners and employees alike.

Whether you’re looking to secure your company’s future, enhance employee engagement, or take advantage of significant tax benefits, our expert team is here to guide you every step of the way.

Get in touch by calling 0203 912 9933 or emailing info@verallo.com.