A combination of Covid-19, lower company valuations and a rise in Capital Gains Tax (CGT) all mean that the EOT route is, in some cases, beneficial for those selling their companies and employees taking on the new ownership. Furthermore, with MBO’s becoming more difficult to finance and structure, EOTs offer a viable alternative.
In this article we discuss how EOTs work, who they can benefit and the situations where they could be worth considering.
What are EOTs?
EOTs are employee-owned companies that have indirect employee share ownership through a trust. There are other types such as employee benefit trusts (EBTs) but the EOT is slightly different in that it allows the owner/shareholders to receive the proceeds from selling the business completely tax free.
John Lewis is a good example of a UK business with this type of indirect employee ownership model. However, this is by no means the only example and there are many other companies of all sizes, with similar ownership structures.
When the shares are sold to the EOT, the business will usually take on a debt for the remaining value of the shares that it still owes to the exiting owners. These can be paid out of the future profits of the business.
Key benefits
for the ‘selling’ owner/shareholders
- Owners/shareholders can receive the payment for their shares from the EOT completely free of any tax.
- Owners of businesses may feel that this is a more adequate way of disposing of the business and rewarding employees who have given long service to the business, whilst ensuring business continuality for clients and customers.
- The EOT can pay the owners/shareholders for their shares in the operating company over a period of years out of the dividends (gifts) it receives. This means that they can receive regular income rather than single lump sum payments.
- Disposing of a business via this route realises the value (and cash) in the balance sheet. It is a tax efficient way to access this value, so it may particularly appeal to companies sitting on good reserves, assets value or cash positions.
- Owners/shareholders who wish to continue with some involvement in the business can do so.
- In sales situations where there is just one potential buyer, an EOT may provide a viable alternative – which at the very least could be used as a negotiation tool.
Key benefits
for the ‘acquiring’ employees
- Employees do not have to contribute any money to ‘own’ shares in the business. This may appeal to the owner/shareholders as they are not burdening their employees with having to personally borrow or raise the finance needed to purchase their shares in the company.
- Employees can receive the first £3,600 of profit share completely free of any income tax when paid to them out of an EOT (however National Insurance Contributions still apply).
- Over the longer-term employees can benefit from dividends based on company performance and capital growth of their shareholding.
Key benefits
for the business
- Employees tend to be more motivated under an EOT as they share in the profits of the business therefore the business is more successful in the long term.
- If 100% of shares are transferred to an EOT it effectively removes the ownership and valuations as an issue for the life of the business.
Is an EOT right for my business?
EOTs are clearly a tax efficient way of disposing of a business, but they can also be viewed as a positive solution for rewarding a loyal workforce, rather than the change or redundancy risk associated with a usual company sale.
However, the tax considerations should only be only one factor of the decision to become an employee-owned company. Once set up it is not easy to reverse an EOT structure, therefore professional advice should always be sought before and during setting up an EOT.
It is important to consider how the business will function after the company has become owned by the EOT, and there are many non-tax issues that must be addressed, such as who will the trustees be, how will they be appointed and how will they influence commercial decisions.
Finally, if you do embark on an EOT is important to communicate and engage with your employees as early as possible. Poor communication, leading to rumours and hearsay is often involved where employees do not positively take to an EOT.
Main drawbacks to EOTs
Before taking a decision on setting up an EOT it is also important to consider any drawbacks, some of which are noted below:
- The owners/shareholders are taking a risk, as the profits in the business may not be enough to pay off all of the sale price in a reasonable timeframe.
- There can be a difficulty in agreeing the value of the business and subsequently the funds the owners/shareholders receive from the EOT.
- The value received may be less than if the business was sold on the open market, though this may be negated through the associated tax efficiencies.
- Employees have an indirect ownership of the company, i.e. they do not actually become shareholders themselves. Therefore, the next generation do not control the company in the same way as the previous shareholders and cannot receive dividends.
In summary
EOTs are not right for everyone, but in certain situations, as we have shown here, they can be very useful.
There is much to consider so it is important to appoint an experienced team of advisors to assist you at every stage.
Our team have significant experience across various employee ownership schemes and we can assist, from determining if an EOT is right for you, to planning and setting up your EOT. Furthermore, we have good relationships with lawyers also experienced in this field who can work with us to provide you with a full advisory service.
Please contact us if you would like to discuss how we can assist you.
Oscar heads our tax department and provides advice on tax structuring, planning and compliance services to entrepreneurs and their businesses.