Employee Ownership Trusts: A Silver Bullet or a Shot in the Foot?

What is an Employee Ownership Trust [EOT]?

EOTs are often pitched by “specialists” as a low transaction risk, low cost, tax-free, silver bullet divestment route for any business owner. However, such proponents do not always point out the residual risks to owners, tax inefficiencies for employees and the relative merits of other transaction routes such as trade sales or management buyouts (MBOs).

Establishing an EOT involves the sale of at least 51% of the shares in a business at market value to a trust which holds the shares for the benefit of all employees. Consideration payable to the owners is in the form of excess cash and deferred consideration.

An owner selling shares to an EOT pays no CGT or Income Tax at all, either on the cash or the deferred consideration.

In practice, EOTs suit some business models and contexts much better than others.  They come with a raft of structural and constitutional complexities to consider and address, both in their immediate impact and in orchestrating any form of future refinancing or sale.

As EOTs were designed to be “forever” deals, launching into such a restrictive, long-term structure without a thorough evaluation of the alternatives and then careful planning, communication and implementation, risks business owners shooting themselves in the foot.

Benefits of EOTs

The main benefit is that owners pay no tax and see their legacy live on through an independent UK business. They can also choose to keep a minority interest, with the prospect of eventually sharing in the upside if the business’s value increases over time.

Employees can receive meaningful tax-free bonuses and, when all the deferred consideration is paid off, are effectively beneficial owners of the business through the trust.

Therefore, selling to an EOT can also help facilitate management succession and boost employee engagement, morale, retention and productivity.

Challenges and Risks

So, what’s the catch?

EOTs are long-term, change-of-control structures. This is due to deferred consideration being paid over an extended period out of future post tax profits, and HMRC’s new rule (from the last Budget) that a business cannot be sold within four years, up from two, without the tax benefits unravelling.

Former owners cannot control either the company or the trust boards. EOTs, therefore, suit stable, cash-generative businesses with flat hierarchies, emerging leaders, low staff churn, and high employee engagement to ensure understanding of the trust and how value is created. This might include consultancies, veterinary practices, recruitment firms and architects.

Importantly, EOT structures are also highly tax inefficient for employees on any eventual sale of the business. The trust must first pay tax on the held-over capital gains from the original sale and then, on the distributions to employees. There are NICs and Income Tax to pay at employees’ marginal rates.

These factors make EOTs less well-suited to businesses with a large, nomadic workforces, since they will be less motivated by some distant benefit that they cannot compute and might not be there to collect.  They are also unlikely to be the best option for those with a pyramid people structure with a senior leadership team at the top, who will be better incentivised by the more concentrated ownership and greater tax efficiency that comes with an MBO.

In the next article, Roger examines alternatives to an EOT and structural considerations in getting an EOT right, a must-read for any business owner exploring their options.