Most start-ups are tight on cash, it’s normal. But that doesn’t mean a new business cannot attract high calibre employees and collaborators. The potential to realise a significant lump sum can persuade people to come on board and encourage them to stay. All you need is an incentive plan. But which one?
The entrepreneur faces a myriad of questions when confronting this choice. Is it better to award shares, share options, or cash? If employees are to become shareholders, should they enjoy the same share rights as founder members? When is the best time to put an incentive plan in place? What approvals does the company need?
A useful first step is to consider some key issues:
Control - Some companies prefer not to give employees shares at the outset, or at all, because they wish to avoid the need to accommodate the interests of minority shareholders. There is also the added complication of retrieving shares from employees who leave.
Decide if you are prepared to have minority shareholders and whether a departing employee should relinquish their shares.
Reward - Share options can provide employees with a more effective incentive than awarding shares upfront because they can be designed to be exercisable only once the company achieves set targets, or when the company is sold or listed.
Review your business plan. Is the intention to pass ownership to the next generation or to work towards an ‘exit’?
Tax - Certain incentive plans that benefit from tax approved status are tax efficient. If the required conditions are met, these ‘schemes’ are likely to be best.
Check whether the size of your company and the nature of its trade will qualify the company for a tax advantaged scheme.
Timing - The longer a business is established, the more likely it is that the shares have more than just ‘hope value’. Affordable shares will be an attractive incentive to participants.
Consider whether the incentive plan can be implemented now, or whether it would be wise to wait until the management team is more established?
The range of incentive plans is broad. Below, we outline the more popular plans available to small and medium sized, unlisted companies and discuss the tax treatment of each.
Tax advantaged share option schemes
The basic tax advantage of these schemes is that when the shares under option increase in value, the gain is taxed at the more attractive capital gains tax rates, rather than being subject to the higher income tax rates. Further, the tax charge is only triggered when the shares are sold or gifted.
Enterprise Management Incentive options
Enterprise Management Incentive (EMI) options allow an employee, including a director, to buy shares in the company at the market value of the shares at the time the options are granted. The expectation is that by the time the options are exercised, the shares have risen in value, and the employee will receive the shares at a discount.
A company can grant EMI options of up to a maximum share value of £250,000 per employee, and up to £3m in total. These schemes are subject to HMRC approval and specific registrations, notifications and annual returns must be made.
Which companies can grant EMI options and to whom?
A company is qualified to grant EMI options if it:
- is not a subsidiary of another company
- is based in the UK
- has gross assets of no more than £30m
- has fewer than 250 employees, and
- is engaged in a ‘qualifying trade’.
Non-qualifying trades include investing in land, shares or financial instruments, financial services, leasing assets, receiving licence or royalty fees, legal/accountancy services, property development, farming or forestry.
- The company will have discretion to decide which employees should have options, however the chosen employees must work full time for the company. A full-time worker is someone who works for the company at least 25 hours per week or for at least 75% of their paid working time. Employees may not hold more than 30% of the company’s shares.
- The shares under option must be part of the ordinary share capital of the qualifying company, fully paid up and not redeemable, however they can be a separate class of shares, with or without voting rights. EMI options can be made subject to conditions for vesting (eg performance metrics of the company), but the options must be capable of being exercised within 10 years.
Tax treatment of EMI options
- There is no income tax liability on the grant of an EMI option.
- Provided the exercise price is at least the market value of the shares at the date of grant, there will also be no income tax charge at the time the EMI option is exercised, and the shares are acquired. In most cases the market value will be discounted to reflect the minority shareholding that the options relate to. Usually the share value is agreed with HM Revenue and Customs before the options are granted so as to provide certainty.
- When the shares are eventually sold by the employee they will be liable to capital gains tax on any gain realised over the market value at grant. If the disposal qualifies for Entrepreneurs’ Relief the tax rate will be 10%. The date of the option grant will need to pre-date the sale of the shares by a minimum of two years. Each taxpayer has a lifetime limit of £10m which can be taxed at the Entrepreneurs’ Relief rate.
- In most cases there will be no national insurance contributions (NICs) to pay if no income tax is due, but there will be NICs if income tax is payable and the shares are ‘readily convertible assets’ (which broadly means that a market for the shares already exists). The employer and the employee may agree for the employer NICs liability to be borne by the employee who may get tax relief for doing so.
- The EMI option holder’s employer can claim tax relief equal to the gain the employee makes when the options are exercised.
Unapproved share options
For companies which are not eligible for a tax advantaged scheme, share options are still a cost-efficient and flexible incentive to offer staff. These options are referred to as ‘unapproved options’ and they can also be awarded to both employees and non-employees eg consultants.
Tax treatment of unapproved options granted to employees
- There is no income tax liability on the grant of an unapproved option to an employee.
- On exercise of an unapproved option the employee must pay income tax on the market value of the shares less the exercise price paid. If the shares are readily convertible assets (see above), this income tax will be collected under Pay As you Earn (PAYE) and NICs will also be due.
- The amount on which tax is paid is added to the employee's acquisition cost of the shares for capital gains tax purposes, when the shares are sold. Entrepreneurs’ Relief may be available (see above) if the conditions are met.
Tax treatment of unapproved share options granted to consultants
- A consultant can receive options in return for consultancy services provided to the company.
- The tax effect of granting share options on this basis is generally understood to be that an income tax charge arises on the value of the option at grant based on the market value of the shares at that time.
- There is no income tax charge on exercise and any growth in value thereafter should be chargeable to capital gains tax. Entrepreneurs’ Relief would not normally be available.
Nil paid shares
Where an immediate share award is desired, but the intended recipient does not have sufficient funds to pay full value for their shares, the company can defer payment and issue the shares as ‘nil paid.’ The amount owing on the shares will be a debt which must eventually be settled by the recipient. The recipient will bear the risk that the share value may fall below the price they are obliged to pay.
Tax treatment of nil paid shares
- At the time of issue there would be no income tax or national insurance contributions provided the shares are purchased for market value.
- A sale of the shares will be subject to capital gains tax on any increase in value. Provided the conditions are met, including the minimum two-year holding period and depending on the share rights afforded to the nil paid shares, Entrepreneurs’ Relief may be available.
- If the unpaid amount is not subject to interest a shareholder who is an employee may be liable to an annual tax charge based on the outstanding amount.
Growth shares are designed to reward participants for the growth in value of the company above a ‘threshold’ or ‘hurdle’ which is specified on issue. Only once the hurdle is met, do the shares have value. Growth shares are popular with companies which do not meet the conditions for tax-advantage share schemes or who wish to offer incentives to non-employees such as consultants and non-executive directors.
Tax treatment of growth shares
- Growth shares should not trigger an income tax charge on issue if the value of the shares at issue is robustly established and paid up (or agreed to be paid up).
- The increase in value of a growth share would be subject to capital gains tax on disposal of the shares. Entrepreneurs’ Relief may be available provided the conditions are met and the growth shares have sufficient value to entitle the holder to 5% of the proceeds on sale.
Growth shares should be introduced with caution if the company has existing shareholders who acquired their shares under the Enterprise Incentive Scheme (EIS). There are circumstances when an issue of such shares can cancel the tax breaks afforded to the EIS shareholders.
A phantom share option plan is a cash bonus plan under which the amount of the bonus is determined by reference to the increase in value of the shares subject to the option. No shares are actually issued or transferred to the option-holder on the exercise of the phantom share option.
Tax treatment of phantom equity
- No income tax is payable on the grant of a phantom share option. When the bonus is paid it will be subject to income tax and national insurance contributions in the same way as salary payments.
Deferred share bonus plan
Under a deferred share bonus plan all or part of the employee's bonus is delivered in shares. Receipt is usually deferred and made contingent on the recipient remaining in employment until the end of the deferral period.
Tax treatment of a deferred share bonus
- The share award will be subject to income tax at the time the shares are issued. National Insurance Contributions will be due if the shares are ‘readily convertible assets’ (i.e. marketable) at that time.
- A subsequent disposal of the shares will be subject to capital gains tax. Entrepreneurs’ Relief may be available provided the conditions are met.
The incentives lawyers at Farrer & Co can help you to choose an incentive plan and tailor it to your business. We can implement the plan, register it with HM Revenue and Customs (as required) and explain to all the participants how it works.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, September 2019