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Employee ownership trusts

A tax-efficient succession strategy

John Manis, Partner, Tax

In 2014, the UK government introduced new tax reliefs to promote employee ownership. Qualifying companies can now be sold to an “employee ownership trust” or “EOT” free of capital gains tax. EOT-owned companies can also pay employees tax-free bonuses of up to £3,600 each per year.

EOTs offer a unique opportunity for company owners to sell their businesses tax-free while facilitating greater employee engagement, higher productivity, and lower staff turnover. The structure has become increasingly popular. Over 300 business became employee-owned in 2023 and the total number of employee-owned businesses in the UK now exceeds 1,400.

With changes to capital gains tax rates (“CGT”) reportedly under consideration by the new Government, currently an EOT sale should secure the benefit of full CGT relief, irrespective of any future changes in law.

Key features

A sale to an EOT does not involve an external buyer. Instead, a trust for the benefit of a company or group’s employees is set up to act as the EOT and purchases a controlling stake in the business.

The most common approach is to fund an EOT sale using the company's future trading profits. However, it is also possible to use bank borrowing to finance part of the sale consideration.

Typically, the sale is structured as follows:

Existing shareholders sell their shares to the EOT, with part of the consideration potentially paid upfront if funds are available.
The balance is deferred and payable in instalments, funded by the company's trading profits after corporation tax.
It is possible for an LLP or other professional partnership to be sold to an EOT, but it must first convert to a company structure.

Once the sale consideration has been fully paid, the profits of the business can be shared out amongst employees. It is also possible to implement tax-efficient share schemes for senior management.

As companies seek alternatives to traditional exit strategies, EOTs offer a compelling option that balances tax efficiency, employee engagement, and business continuity.

Advantages

CGT: Provided qualifying conditions are met, UK resident taxpayers can sell their shares to an EOT without incurring any liability to CGT. This is especially beneficial for owners who would otherwise be subject to CGT at the full rate of 20%. A sale to an EOT can also protect selling shareholders against any future changes in capital gains tax rates or reliefs

Market Value Sale: Shareholders can sell their shares at market value without the need for an external third-party purchaser, although an independent valuation is required.

Simplified Process: The sale to an EOT is generally more straightforward, quicker, and less costly than a sale in the open market, with lower transaction costs and fewer due diligence requirements.

Business Continuity: The day-to-day running of the business can continue, with directors maintaining their roles and receiving arm's length remuneration packages. EOTs enable a seamless transfer of ownership, minimizing business disruption and preserving the business’s culture and ethos, while also creating an inclusive and transparent governance model.

Employee Engagement: The structure rewards long-term loyalty and encourages higher employee retention during a transition of ownership. Employees benefit from the future profits of the business, often leading to higher productivity and accelerated growth.

Requirements for tax free sale

To qualify for a tax-free sale to an EOT, several conditions must be met. The main conditions are:

A controlling interest (over 50%) in the company must be sold to the EOT
The EOT must hold the shares for the benefit of all employees excluding, broadly speaking, those who sold more than a 5% stake
The company must be a trading company or the principal company of a trading group, excluding businesses with primarily passive income such as property investment
The number of shareholders who are employees or directors (and their connected persons) must not exceed 2/5 of the total number of employees prior to the sale.