In short:
Employee Ownership Trusts can provide certain tax advantages when selling a business.
Sellers can be liable for the capital gains tax they save on for four years after the sale.
While selling to an EOT guarantees a fair price for a business, it’s often not the best price that could’ve been achieved.
Employee Ownership Trusts can be an effective tool for exiting a business for many owners. There are potential tax breaks to be had, and existing staff get to keep their jobs.
Given this, EOTs can understandably make for a very attractive option for directors looking to move on. It’s important to understand, however, that this option isn’t completely without its drawbacks, nor does it make sense for every type of business.
Let’s take a look at Employee Ownership Trusts as a vehicle for an exit strategy and examine the benefits as well as the disadvantages of going down this route.
What is an Employee Ownership Trust?
Employee Ownership Trusts (or EOTs) were introduced in the Finance Act 2014 as an initiative created to allow employees to assume control of the business they work for. This allows exiting business owners to easily secure a sale of all or part of their shares in the company while knowing it’s still in good hands.
How do Employee Ownership Trusts work?
In cases where a business is owned by an Employee Ownership Trust, the company isn’t directly owned by the employees themselves. Rather, the shares are owned by a trust which holds them for the employees instead.
The trust acts as a majority shareholder (EOTs must hold a minimum of 51% of a company’s shares).
Because the trust, when initially set up, doesn’t have any capital to purchase the shares, the transaction is usually made with the proviso that the EOT pays the outgoing owner over a period of time using money from its profits, though sometimes a loan is used instead.
Although the trust now legally owns the company, the directors of the trust aren’t necessarily the directors of the company. Instead, they have the power to hold the directors of the company to account and can even appoint or remove directors as they see fit.
This gives employees an enormous amount of power, as it is they who have the power to elect the directors of the trust.
Benefits of Employee Ownership Trusts
There are plenty of benefits to EOTs for employees, but what about the departing owner? Why might they opt for an EOT?
It’s an easy sale
Selling a business is a difficult task. While hiring a specialist business sales team to help can improve your odds significantly, there are still many businesses that never sell.
With an EOT however, your purchaser is right under your nose, and as long as you’re happy to receive the payment over the course of a few years, you’ll usually receive a fair price too.
Tax benefits
When sold to an EOT, a business accrues no capital gains tax.
Business sales expert, Rick Smith explains that “this alone can be a huge driver for owners to choose an EOT, as some business sales can accumulate a very large tax bill which is then deducted from the amount the owner receives”.
There’s scope for staying involved in the company
It’s not always easy to say goodbye to a venture that you’ve invested so much time, effort and money into.
EOTs only require 51% to be sold to them, leaving owners able to stay involved in whichever way suits them best. Some may choose to carry on being a director or minority shareholder, while others might prefer to work part-time within the business.
Maintaining strong professional relationships with employees
An EOT ensures that employees jobs are safe during a takeover when other sales methods do not.
Not only that, but employees often become more productive as a result of finding themselves working for themselves. They’ll have access to profit bonuses that they may have missed out on before.
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Employee Ownership Trust disadvantages
All sounds fantastic, right?
Before you go rushing off to sell to an EOT though, it’s worth looking at some of the issues associated with them too.
Deferred payments
Occasionally, an EOT might be set up using funds obtained from a business loan. In such scenarios, the outgoing owner should receive their payment in full.
However, the majority of EOTs are completed with the trust owing the outgoing owner payment for the business over several years.
This can be problematic for some business owners, who may have the business sale money earmarked for another venture, or even retirement.
Smith adds that “Plainly speaking, if the owner is looking for a lump sum in full for the business, an EOT is probably not the best route to take.”
What if the company’s profits nosedive?
Assuming that the departing director has sold all their shares, it shouldn’t matter, right?
Unfortunately, it does. EOT repayments are pulled from the company’s profits. So, no profits equals no payments.
“Those that have kept hold of some minority stake may be able to influence matters somewhat, but without full ownership anymore, they’ll be dependent on their old employees to steer the ship back around” explains Smith.
May receive a smaller fee than otherwise possible
While an EOT guarantees a fair price for the business it purchases, it’s not necessarily the best price that could have been achieved.
By listing on the open market, directors allow the business to be seen by many more potential investors. If your business would make for a great strategic acquisition for a larger rival, for example, you may be able to command a much higher fee.
Tax implications
The removal of capital gains tax in the sale is an obvious boon, but the money saved here is not unconditional.
Smith warns that “should the business be sold by the EOT again within the following four years, the original seller would be liable to pay the EOT the amount of money saved in unpaid capital gains tax.”
Previously, this period of time only lasted until the end of the current tax year, but was changed in 2024’s Autumn Budget as a measure against using EOTs as a tax avoidance vehicle.
Administrative and setup complications
An employee ownership trust is not a simple thing to set up.
There are multiple legislations and regulations to adhere to, and that’s after the struggle in finding the employees who are both willing and able to be part of it.
Even after completing the sale, there is several ongoing administrative duties needed to keep the EOT tax compliant and above board.
Opposing viewpoints
Should the seller decide to stay on as a minor shareholder or similar, they now run the risk of butting heads with the EOT. Newly appointed directors often like to make their mark by applying changes, and these have the potential to create conflict among shareholders.
There are few employees that work for a company for years without having ideas for how they would improve operations. These changes may be beneficial or impractical: either way, the ex-owner will need to be open-minded about them.
What happens if an EOT goes bust?
In much the same way as a normal business, an EOT-owned business would have to look at insolvency routes such as dissolution or liquidation.
If the original owner (who sold the company to the EOT) hasn’t been paid yet, then they would join the list of creditors that a liquidator that is paid out from the liquidation of any assets.
What happens when an employee leaves an EOT after the sale is concluded?
Nothing.
As employees don’t own any shares directly, their exit is the same as any other. They are neither entitled to, or liable for anything.
How does an EOT benefit employees?
If employees don’t actually own any shares, how do they benefit from the arrangement?
Well, as well as having a voice in how the business should be run, they are also entitled to a share of its profits.
How are profits distributed in an EOT?
It’s important to remember that if an EOT takeover wasn’t funded by a loan, then its profits will first be used to pay off the seller of the business. The profits that the company make determine how much the seller is paid in each instalment, and how long it takes to the seller in full.
Once the business has been paid for, however, the profits become shared out among the employees of the business.
Employees will find that the first £3,600 in profits they receive each tax year is exempt from income tax too.
Looking at business sale options?
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Speak to one of our friendly advisers today on 0800 975 0380 or email advice@forbesburton.com for practical and helpful advice.
