Succession is one of the most important considerations for any family business. In many cases, this is about which family member will continue to run the family business and how to hand-over from one generation to another in a way which ensures the continued success of the business and the family.
There are though other options, which might be looked at out of necessity, if succession is difficult for any reason, or if there is a better strategic approach for the family business. One of these strategic options is selling a stake in the family business to an Employee Ownership Trust (EOT), which gives a number of very advantageous tax benefits.
An EOT is a special form of employee benefit trust which buys a controlling interest in a company and holds this interest on behalf of and for the benefit of the employees of the relevant company.
EOTs were first introduced by the Finance Act 2014 (the Act) which grants several tax incentives to EOTs to encourage company owners to adopt an employee-ownership model. The most significant tax incentive is that Capital Gains Tax (CGT) will not arise on the sale of a majority stake (ie more than 50 per cent) in a business to a qualifying EOT, although the EOT will have to pay stamp duty on the consideration for the shares in the usual way. In addition there is relief from inheritance tax on certain transfers into and from EOTs.
Additionally, bonuses paid to employees of companies controlled (ie more than 50 per cent) by an EOT benefit from income tax free bonuses of up to £3,600 per employee per year, although bonuses will still be subject to national insurance contributions.
Other than the attractive tax advantages of selling to an EOT, there are various other benefits of adopting an employee-ownership model. Studies indicate that a workforce with a vested interest in the company are more productive, less likely to move elsewhere and are more innovative.
EOTs can also provide a succession solution where there are doubts over who will take over a business when an owner retires or dies. Whilst not therefore the classic solution to succession for family businesses, EOTs represent a way for a family business to continue in a slightly different way, with the option of the family retaining an interest in, and material involvement with, the business but engaging a wider group of employees in the ownership and running of the company.
The mechanics of a sale to an EOT are fairly straightforward. An EOT will be established with existing shareholders often becoming trustees. EOT trustees are also often corporates. Commonly, the shareholders and the trustees will jointly engage a share valuation expert to value the company and use this valuation to inform the purchase price. The shareholders then sell their shares to the EOT with consideration for the shares largely taking one of three forms:
- Shares are sold at market value or another commercial sum but with a significant amount left outstanding as deferred consideration. The outstanding amount becomes a debt owed by the trustees to the relevant shareholders and the debt is then repaid in stages using the trading profits of the company (this is the most common method).
- Shares are sold at market value or another commercial sum and paid for in full by the EOT taking on third party debt.
- Shares are sold at nominal value (where the shareholders wish to make an altruistic gift of the shares).
CGT liability on such a sale will not arise if the following four key conditions are met:
- The company whose shares are transferred into the EOT must be a trading company or where there is a group, the principal company of a trading group.
- The EOT must meet the “all employee benefit requirement”, which broadly means that the assets of the EOT must be for the benefit of all eligible employees. Although the assets of the EOT must generally be applied for the benefit of all eligible employees on the same terms, trustees may allocate benefits of differing amounts by reference to factors such as salary, length of service or hours worked.
- The EOT must not hold an interest of more than 5 per cent in the relevant company (before the transfer to it) and must hold a controlling interest (ie more than 50 per cent) in the company at the end of the tax year in which the transfer to it takes place.
- The continuing shareholders who are directors or employees (and any persons connected with such directors or employees) must not exceed 40 per cent of the total number of employees of the company or group.
A few words of warning
The rules governing EOTs are complex and shareholders considering selling their interest to an EOT should be aware of several potential pitfalls.
Disposals must take place in the same tax year
Where there is more than one shareholder, CGT will not arise if all disposals by the various shareholders take place in the same tax year and the EOT acquires a controlling interest during that tax year. CGT will arise in the case of multiple disposals by multiple shareholders over successive years.
Sale by the EOT
If shareholders sell their shares to an EOT and the EOT then sells these shares before the end of the same tax year, the sale to the EOT will come back into charge and the original shareholders will have to pay CGT on their gain.
Consideration paid by the EOT to the selling shareholder is generally left outstanding and the repayment is deferred over several years. If the company fails to make profits, the company may be unable to make payments to the EOT, which would restrict the payment of the deferred consideration, or extend the period over which it is received.
Annual tax-free bonuses
A breach of the complicated rules governing the annual income tax free employee bonus can lead to disproportionately high tax charges.
EOTs will not be suitable for many family businesses. However, in certain circumstances, especially where there is no natural family successor, they may be an attractive option to be considered carefully.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, February 2021