Employee Ownership Trusts

If you are a business owner considering selling your business, one of the most important decisions you’ll face is choosing the right exit strategy. While traditional options like selling to a competitor or private equity firm are common, an increasingly popular alternative is selling to an Employee Ownership Trust (EOT). This option not only offers attractive tax benefits but also provides a way to reward your employees and ensure the long-term success and legacy of your business.

In this comprehensive guide, we'll explore everything you need to know about Employee Ownership Trusts, from how they work and how they’re taxed to the pros and cons of this approach. By the end, you should have a clearer understanding of whether an EOT is the right choice for your business.

What is an Employee Ownership Trust?

An Employee Ownership Trust (EOT) is a type of trust set up to hold a controlling stake in a company on behalf of its employees. This model was introduced by the UK government in 2014 to promote employee ownership and offer an alternative to traditional business sales. The primary purpose of an EOT is to ensure that the employees collectively own and benefit from the company’s success, while the business owner can exit the business, often in a tax-efficient manner.

How Does an Employee Ownership Trust Work?

In an EOT structure, the trust acquires a controlling interest (typically more than 50%) in the company from the existing shareholders. The trust then holds these shares on behalf of the employees, who become beneficiaries of the trust. This means that, while the employees do not directly own the shares, they benefit from the profits and growth of the company.

Here’s a simplified overview of how an EOT transaction typically works:

1. Valuation of the Company: The company is independently valued to determine the price at which the shares will be sold to the trust.
2. Establishment of the Trust: A legal entity, the Employee Ownership Trust, is set up specifically to acquire and hold the company shares on behalf of the employees.
3. Funding the Purchase: The trust purchases the shares from the existing owners. This can be funded through the company’s profits, external financing, or deferred payments from future profits.
4. Employee Benefits: Once the trust owns the company, employees benefit through profit-sharing arrangements, bonuses, or other financial incentives tied to the company’s performance.

How is an Employee Ownership Trust Funded?

One of the critical aspects of setting up an EOT is determining how the trust will fund the purchase of shares. The funding mechanisms can vary, but they generally include:

1. Company Profits: The most common method is using the company’s retained earnings or future profits to finance the purchase. The company can make contributions to the trust over time, which are then used to pay the selling shareholders.
2. External Financing: In some cases, the trust may secure a loan from a bank or other financial institutions to fund the purchase. The loan is then repaid from the company’s future profits.
3. Deferred Payments: The selling shareholders may agree to receive payment over a period of years, allowing the trust to pay them from future profits. This is often used in conjunction with other funding methods.

How is an Employee Ownership Trust Taxed?

The UK government offers significant tax incentives to encourage the use of EOTs, making them an attractive option for both business owners and employees. Key tax benefits include:

1. Capital Gains Tax Exemption: When a business owner sells a controlling interest in their company to an EOT, the sale is exempt from Capital Gains Tax (CGT). This can result in substantial tax savings compared to selling the business through other means.
2. Income Tax-Free Bonuses: Once the EOT is in place, the company can pay annual bonuses to employees that are exempt from Income Tax, up to a maximum of £3,600 per employee per year.
3. Corporation Tax Deductions: Contributions made by the company to the EOT are generally deductible for Corporation Tax purposes, which can reduce the company’s tax liability.

How to Set Up an Employee Ownership Trust

Setting up an EOT involves several legal and financial steps, which typically require the guidance of professional advisors. Here’s a general outline of the process:

1. Engage Professional Advisors: It’s essential to work with experienced legal, tax, and financial advisors who understand the complexities of setting up an EOT.
2. Valuation of the Business: Obtain an independent valuation of your business to determine the fair market value of the shares that will be sold to the EOT.
3. Drafting the Trust Deed: A trust deed is drafted to establish the EOT. This document outlines the trust’s purpose, governance structure, and how the trust will operate on behalf of the employees.
4. Financing the Transaction: Determine the most appropriate funding mechanism for the share purchase, whether through company profits, external financing, or deferred payments.
5. Share Sale and Transfer: The shares are sold to the EOT, and the trust takes ownership on behalf of the employees.
6. Ongoing Management: Once established, the EOT needs to be managed according to the trust deed, ensuring it operates in the best interests of the employees.

Pros and Cons of Employee Ownership Trusts

As with any business exit strategy, there are advantages and disadvantages to using an EOT:

Pros:

• Tax Efficiency: The significant CGT exemption makes EOTs highly tax-efficient for selling shareholders.
• Employee Engagement: Employees often feel more invested in the success of the company, leading to higher motivation and productivity.
• Legacy Preservation: Selling to an EOT can help preserve the company’s culture and values, as the business remains in the hands of those who helped build it.
• Stability: An EOT can provide stability to the business by reducing the risk of disruption from an external sale.

Cons:

• Complexity and Cost: Setting up and managing an EOT involves significant legal, financial, and administrative costs.
• Profit Dependency: The success of an EOT largely depends on the company’s continued profitability, as future profits are often used to fund the purchase of shares.
• Control and Decision-Making: Selling a controlling interest to an EOT means relinquishing some control over the business’s future direction.

Employee Ownership Trust Problems

While EOTs offer many benefits, they are not without challenges. Some potential problems include:

1. Financing Challenges: Securing sufficient funds to purchase the shares can be difficult, especially if the company’s profits are volatile or insufficient.
2. Management Complexity: Managing an EOT requires careful planning and ongoing governance to ensure it operates in the best interests of the employees.
3. Employee Expectations: Transitioning to employee ownership can raise expectations among employees, who may expect higher salaries or bonuses, which the company might not always be able to meet.

FAQ Section

What is an Employee Ownership Trust?

An Employee Ownership Trust (EOT) is a trust set up to hold a controlling stake in a company on behalf of its employees. The trust allows employees to benefit from the company’s success while ensuring the business remains stable and preserves its legacy.

How Does an Employee Ownership Trust Work?

An EOT works by purchasing a controlling interest in a company from the existing shareholders. The trust then holds these shares on behalf of the employees, who benefit from the company’s profits and growth.

How is an Employee Ownership Trust Taxed?

EOTs offer significant tax benefits, including a Capital Gains Tax exemption for the selling shareholders and Income Tax-free bonuses for employees, up to £3,600 per year.

How is an Employee Ownership Trust Funded?

An EOT can be funded through company profits, external financing, or deferred payments. The chosen method depends on the company’s financial situation and the agreement with the selling shareholders.

How to Set Up an Employee Ownership Trust?

Setting up an EOT involves engaging professional advisors, obtaining a business valuation, drafting a trust deed, securing financing, and selling the shares to the trust. The process can be complex and requires careful planning.

Are Members of Employee Ownership Trusts Still Employees?

Yes, employees remain employees of the company even after the EOT is established. However, they become beneficiaries of the trust and may receive profit-sharing benefits or bonuses tied to the company’s success.

What Are the Pros and Cons of an Employee Ownership Trust?

The pros of an EOT include tax efficiency, increased employee engagement, legacy preservation, and business stability. However, the cons include complexity and cost, dependency on future profits, and potential challenges in managing employee expectations.

Conclusion

Employee Ownership Trusts offer a unique and compelling exit strategy for business owners looking to sell their companies. By transitioning ownership to employees, you can ensure the long-term success and stability of your business while benefiting from attractive tax incentives. However, the process is not without its challenges, and it’s crucial to carefully weigh the pros and cons before deciding if an EOT is the right fit for your business.

If you’re considering selling your business and think an EOT might be the right option, consult with experienced advisors who can guide you through the process and help you achieve your goals.