Employee Ownership Trusts and the Entrepreneur

Tax exemption and employee participation

Which entrepreneur wouldn’t want to sell his or her company at full value, tax free? And even better, without having to find the buyer and negotiate a deal? That is the tantalising prospect if you consider selling your company to an employee-ownership trust (EOT). I recently completed Excello Law’s latest such deal for CDY Ceiling and Partitions Ltd, based in Hull.

The special tax rules were introduced in 2014 to encourage employee ownership, on the John Lewis model. Previous tax reliefs helped business owners to give their company to employees, but there were not many owners willing and able to be so generous. Now the rules allow a sale to an EOT at a full price, funded from the assets and future cashflow of the company. The seller pays no capital gains tax at all on the sale.

What’s not to like? Some of the advantages of selling to an EOT are:

• The CGT exemption.
• The ability to set the price, so long as it is not more than market value, based on valuation.
• No hard-nosed negotiation with a trade buyer or institutional investor over price or warranties and indemnities, saving time and professional costs.
• Deferred payment to match the company’s free cashflow.
• The sellers can stay as directors and keep management control while they are paid out.
• The sellers can retain shares, so long as the EOT has control.
• Employees do not own shares directly and do not have to be paid out if they leave. They do not have to be given a voice in management.
• Improved engagement and incentives for the workforce.
• Income tax free bonuses can be paid to employees of EOT-owned companies of up to £3,600 per person per tax year.
• An EOT can suit even small companies with modest workforces.

There are some possible downsides, depending on circumstances:

• The need to find trustees for the EOT. If professional trustees are used, they will need to be paid and can be costly. Trustees have heavy legal responsibilities and should usually have liability insurance.
• Trustees have to act in the interests of the employees. They may want to negotiate the terms of the sale, even if it is funded entirely by the company. Trustees should have separate legal advice. There may be tensions between the sellers, the trustees, the management and the workforce. There can be conflicts of interests and each group needs to understand its legal responsibilities.
• If the trust is UK resident, the trustees will pay capital gains tax on any future sale of the company, calculated on the original sellers’ base cost. So the tax on the gain has only been deferred, not avoided. Worse, if the sellers would have qualified for business asset disposal relief (the 10% effective rate of CGT) the trustees will be paying CGT at a much higher rate. If it likely that the trustees will eventually seek an exit, an offshore trust should be used – but that may be much more expensive than UK resident trustees.
• Management succession and long-term strategy may suffer. The sellers may be primarily focussed on paying out the deferred price for their shares, and may then retire, or lose interest. External funding may be harder to obtain through borrowing or equity investment.
• If the price is set high, the trustees may struggle to justify the EOT as benefitting employees, or to deliver any actual benefit to them. At least in the early years, any money available is likely to go to fund the purchase price.
• The sellers depend on the future prosperity of the company to enable it to fund the instalments of the sale price. If it does not perform, they could lose their money or have to extend the payment schedule.
• If the sellers retain a shareholding, or management are given equity, they may not be able to realise its full value if the EOT does not want an exit, and the EOT is the only possible buyer for the minority stake.

My 40 years of legal experience acting both on corporate sales and employee share incentives makes me ideally qualified to advise on EOTs. They provide an attractive alternative to a trade sale, an MBO  or an exchange of equity for debt.