Employee ownership trusts: Tax-free succession explained

Introduced in an effort to promote employee ownership of businesses, Employee Ownership Trusts (EOTs) allow business owners to sell their shares to an employee-owned trust free from CGT and grant tax relief on bonuses of up to £3,600. 

Indeed, even before the increases to CGT in the Autumn 2024 Budget, EOTs had become an ever more popular option for business owners looking to part with the ownership of their companies. EOTs are suitable for various companies and have been adopted by major retailers such as John Lewis and numerous small and medium-sized enterprises. 

What are EOTs?

An EOT is a collective vehicle that purchases a controlling interest in a company and holds it on behalf of the employees. It is a type of employee benefit trust that attracts generous tax reliefs. It was introduced 10 years ago by the Finance Act 2014.

They are different from an employee share scheme, which is an arrangement whereby a small percentage of a company’s shares are reserved for its employees, who will, either immediately or at some time in the future, hold shares alongside other shareholders (usually the founder and/or outside investors) who together own most of the company.

What do EOTs involve?

• The creation of a trust for the benefit of employees
• which purchases shares in a trading company… 
• so that it holds a controlling interest in the trading company (at least greater than 50% of the ordinary shares and voting rights).
• This enables a Capital Gains Tax (CGT) free disposal for selling shareholders where the shares are sold in the same tax year in which the EOT obtains control, and then
• enables payment of up to £3,600 income tax free annual bonuses for qualifying employees of the trading company, which can now exclude directors.

EOTs operate:

• through a corporate trustee, which holds the shares in accordance with a detailed trust deed on behalf of the employees of the trading company;
• by receiving funds from the company, as and when they are available, to fund the purchase of the shares. Some consideration is usually paid on completion of the sale and the remainder deferred and paid over time, anything up to 10 years;
• with a mix of executive directors of the trading company, employee representatives,Sellers and an independent professional trustee; and
• on a business-as-usual basis for the trading company, but with the benefit of greater employee engagement.

EOT tax reliefs

One of the attractions of an EOT is the tax reliefs. In particular:

• An individual who disposes of shares to an EOT may be eligible for relief from CGT, making any gain exempt from CGT. This also benefits minority shareholders who might not have the benefit of Business Asset Disposal Relief (formerly Entrepreneurs’ Relief); and
• a company that is owned by an EOT can pay up to £3,600 each year in tax-free bonuses to its employees (this does not prevent higher bonuses being paid, just the additional party will be subject to income tax in the normal way.

There are reliefs from inheritance tax so that certain dispositions made to an EOT are not chargeable transfers of value, although selling shareholders should note that where the purchase price is to be paid in instalments and an individual who has sold their shares dies before having been paid in full, the value of any unpaid instalments will be treated as part of their estate for inheritance tax purposes. Shareholders with critical illness or older in years should discuss these implications with their tax adviser.

The EOT CGT relief is more generous than the CGT reliefs that are available for disposals to standard Employee Benefit Trusts but are also more restrictive, making it important to take advice to avoid some of the pitfalls that can wipe away these benefits.

Conditions for achieving tax reliefs

Certain conditions must be met to secure the CGT relief for the sellers and exemption from income tax on bonus payments made by the trading company to its employees.

Conditions common to these reliefs are:

• The all-employee benefit requirement (although directors can now be excluded from the annual bonus).
• The equality requirement (which requires that distributions must be for the benefit of all employees of a company on the same terms).
• The controlling interest requirement (holding more than 50% of the ordinary share capital, voting rights and entitled to more than 50% of the profits and assets on a winding up).
• The trading requirement; and
• the participation requirement – the ratio between excluded participators (people who are both 5%+ shareholders and directors/company secretary or employees, including for this purpose any employees who are their relatives) and employees must not be more than 2/5 (i.e. 40%) (this is to prevent the relief being claimed in companies where there are only a few non-shareholder employees).

In addition, for CGT relief to be available, the participator or any person connected with them must not have claimed the same CGT relief in any earlier year in relation to the disposal of shares in the same company or any member of the same group. 

A properly established EOT will ensure these conditions are met and, so far as possible, include controls to prevent a disqualifying event. 

Disqualifying events

If any of the conditions are breached during the first four tax years after the end of the tax year in which the sale takes place (increased from the first tax year by the Autumn Budget 2024), the CGT relief can be clawed back from the Sellers resulting in CGT becoming due on the gain that occurred at the time of the disposal. Other disqualifying events will also be introduced by the Finance Bill 2024-25, taking effect from the 30 October 2024 as follows:

• Trustee independence requirement: which prevents sellers or persons connected with them from retaining control of the trading company, following the sale to the EOT, via the trust arrangements.
• Residence requirement: the EOT trustee must be resident in the UK (i.e. offshore trustees are no longer permitted).
• Market value: the trustee(s) must take all reasonable steps to ensure that the consideration paid for the shares purchased by the EOT does not exceed market value and the interest rate on deferred consideration does not exceed commercial rates.

A disqualifying event has consequences for the Seller and/or the EOT, depending on when it occurs. If an event occurs in or before the fourth tax year following the disposal of the shares to the EOT, the Seller will be liable for CGT on the gain in the value of the shares from the Seller’s base cost at the time of disposal to the EOT. If the disqualifying event occurs after the fourth anniversary, there is a deemed disposal and immediate re-acquisition at market value by the EOT of all the shares it originally purchased, resulting in a CGT charge to the EOT. The employees will, therefore, need to factor in the tax charge as part of the costs of a future sale of the trading company owned by the EOT. If the sale occurs before the Seller has been paid in full, then that part of the proceeds will be due to the Seller, as a sale of the trading company will entitle the Seller to demand the balance of deferred consideration. 

Major decisions to be made by the EOT will be within the control of the EOT trustees, usually on a unanimous basis, so there will be checks and balances before any decision that could lead to a disqualifying event.

The risks and rewards

An EOT offers several advantages, in addition to the tax benefits available to the Seller and the EOT, including:

• Simpler process – as compared to a sale to a third party, where the Seller will need to provide warranties and negotiate documentation for the sale with the Buyer and have ongoing liability for a period post sale.
• Flexibility – so long as the EOT has a majority interest, a Seller can choose to retain shares in the target company (noting they will not attract CGT relief when sold in the future).
• Higher return – the sale proceeds are tax-free, giving the Seller greater flexibility as to the price to be paid by the EOT for the shares.
• No third party is required – provided the Seller has a team that can continue the business, then it avoids the need to find a Buyer.
• Preservation of identity – as ownership of the company will not be transferred to an external third party, the values and identity of the company are likely to remain the same.
• Engaged employees – employees are given the opportunity to share ownership of the company, which should lead to greater engagement, innovation, and profitability, provided the terms of the sale to the EOT are reasonable.
• Reduced corporation tax – where profits are being distributed using the tax free (but not NIC free) bonus, then the profits subject to corporation tax will be reduced; and
• EMI schemes – it is still possible to incentivise key employees alongside the implementation of the EOT through share incentive schemes.

There are risks mostly stemming from disqualifying events that can trigger the loss of the CGT relief by the Seller or result in a deemed sale and immediate reacquisition of the sale shares, giving rise to a CGT charge, depending on when the event occurs. These risks are managed by ensuring you take advice at all appropriate times and seek assistance from professionals with expertise in EOTs.

For information, please read our article on the effect of the Autumn Budget 2024 on EOTs

How can we help?

If you are considering your options for succession planning, Tees Law has a large team that can advise you on all aspects of business succession planning, including EOTs and other employee benefit trusts. We are always happy to liaise with your tax advisers to ensure that any succession plans will work in the way that they are intended to. 

Please get in touch with Tracey Dickens or Lucy Folley, who will be pleased to assist you.

Join our upcoming webinar

Tees are hosting a webinar on Wednesday 29 January from 2 pm – 3pm. Come along and hear from our experts who will help you have a better understanding of EOTs and why they might be right for you.

Click here to Register