Succession planning: Employee Owned Trusts

Colander Associate, Michael Holmes explores strategies for passing on the business to the next generation...

Employee Owned Trusts

Introduction

A lot has been written about succession planning but the reality is in today’s market that a lot of the ways shareholders would sell their business in the past are no longer available to them. There is little to no market for outsiders buying professional services firms at present and management buy-outs have become unaffordable as the next generation have high mortgages and school fees.

In 2012 the Government, in the guise of Deputy Prime Minister Nick Clegg, commissioned the Nuttall Review on employee ownership as they recognised the problems shareholders were having selling their businesses. The Government sees employee ownership through trusts as a way of ensuring the long-term viability of a business and removing the regular issue of shareholders trying to sell the business on each generation.

It was recognised that the current trusts, Employee Benefit Trusts (EBT), were not attractive enough to shareholders to consider them as a vehicle for succession planning. The Government decided to evolve the EBT into a vehicle called the Employee Ownership Trust (EOT). The main differences between an EOT and an EBT is that the EOT allows the shareholders to receive the proceeds from selling the business completely tax free.

What is an EOT?

An EOT is a separate legal entity (company) that purchases the shares from the current owners of the business and holds them in trust on behalf of the employees (or sometimes may directly give shares to employees). As the EOT owns the business, all profits are passed to the EOT from the operating company by way of a dividend or more tax efficiently as a gift. The EOT then pays a profit share to the employees of the operating company. (This profit share can be paid through the operating company and used to reduce corporation tax)

The EOT is run by a Trustee Board, the original trustees are appointed by the Board of the operating company. Subsequent trustees would usually be appointed by the Board of Trustees in consultation with the Directors of the operating company.

It is quite normal for people to be both Directors of the operating company and a trustee of the EOT.

There are certain rules that apply before an EOT can be set up but the ones that would affect most companies are the following: -

  1. At least 50% of the shares in the operating company must be held by the EOT.
  2. Every employee who has served more than twelve months with the company must receive a profit share. The calculation of the profit share must be done in an obviously fair and reasonable manner.
  3. The current shareholders can be Trustees but must not be a majority of trustees.
  4. There must be at least one independent trustee who has never been an employee of the business

What are the main advantages of an EOT?

There are many advantages but the most often quoted ones are as follows: -

  • Shareholders can receive payment for their shares from the EOT completely free of any tax under the legislation introduced in the Finance Act 2014
  • Employees can receive their first £3,600 of profit share completely free of any income tax and when paid to them out of an EOT. (Although National Insurance Contributions still apply)
  • Employees do not have to contribute any money in order to “own” shares in the business.
  • Employees tend to be more motivated under an EOT as they share in the profits of the business (e.g. John Lewis Partnership) therefore the business makes more money.
  • Culturally the idea of Employee Ownership fits professional service firms with their origination out of Partnerships and their highly skilled/educated workforce.
  • The EOT can pay the shareholders for their shares in the operating company over a period of years out of the dividends (gifts) it receives. Effectively there is a sale purchase agreement between the EOT and the previous shareholders.
  • Owners of businesses feel that this is a proper reward to employees who have given long service to firms they have owned.
  • If 100% off shares are transferred into an EOT it effectively removes ownership and valuations as an issue for the life of the business.

What are the main disadvantages of an EOT?

  • Employees have “indirect” ownership of the company, i.e. they do not actually become shareholders themselves. So the next generation do not control the company in the same way as the previous shareholders and cannot receive dividends.
  •  There needs to be an element of trust that the trustees will act in the way intended.
  • Current shareholders effectively lose control of the business although the firm may well be managed by the same people as previously.
  • Shareholders are taking a risk as the profits in the business may not be enough to pay off all of the sale price in a reasonable timeframe.
  • There can be a difficulty in agreeing the value of the business and hence the funds the shareholders receive from the EOT.
  • The value received may be less than if the business was sold on the open market.

Summary

An EOT could potentially be a good fit for many professional service firms as part of an overall strategy for passing on the business to the next generation but in order to investigate this further the company would need to take both appropriate tax and legal advice. If the EOT is considered a favourable route it would benefit the current shareholders to maximise the profits in the business over the next few years in order to create best value for their shares before conversion to an EOT is enacted.