Employee Ownership Trusts – Considerations for an early exit

Tax incentives for shareholders to sell their companies to employee ownership trusts (EOTs”) mean that EOT sales have been increasing in popularity as exit routes.

The sale of all or a majority of shares in a trading company to a qualifying EOT is subject to zero Capital Gains Tax (CGT) provided the EOT meets a certain criterion at the point of sale and for a period of two years thereafter. If the conditions are met throughout the two-year period, the CGT bill the founders would have been responsible for on their exit passes to the EOT, thus making it possible for the founders to exit tax free.

The EOT structure brings plenty of benefits to the employees and the company too. Once the company is owned by the EOT, it can pay yearly bonuses to the employees which are free of income tax and a corporation tax deduction for the value of the bonuses paid by the company to the employees is available to the company.

Due to the two-year time parameter and the construction of these tax reliefs, it is highly unlikely that the trustees of an EOT would choose to sell the trading company shortly after the EOT acquires it (or a controlling interest in the trading company, as it is often the case).

Considerations trustees of Employee Ownership Trusts need to take into account when deciding to sell or not

But what if a third-party makes a very generous offer to the trustees of EOT? What would EOT trustees have to take into account in deciding whether to sell or not?

Tax consequences of an early sale

If an EOT sells a trading company within two years of its acquisition, the CGT tax relief from which the founders originally benefitted is lost and they become responsible for the CGT on the increase in value of the shares from when they acquired them and the disposal value to the EOT. This would then leave the EOT responsible for the CGT chargeable on its own gain only.
In circumstances where the founders retained a minority shareholding in the company, the additional challenge trustees are likely to face is the conflict of interest that arises between the interests of the EOT (and the employees) and the interests of the (now) minority founders. Facing such a considerable tax bill, could mean the founders, subject to having the necessary rights under the articles, are likely to oppose or delay the sale, in order to avoid their CGT liability crystallising.

If the sale does go ahead, employees could benefit from a share of the net sale proceeds, but unlike the yearly bonuses, these are subject to income tax. So, save for reducing the tax payable by the EOT in the event of subsequent sale, an early exit may not be very attractive to the parties involved unless the ultimate sale price is substantially better than a number of years of trading profits and bonuses.

Trustee considerations

The underlying principle of the EOT structure, is to run it in the best interests of its beneficiaries i.e., the employees. Therefore, the main consideration for trustees, when accepting an offer to sell, is to assess whether a sale offers employees a better return than retaining ownership of the company. The trustees will also need to weigh up the costs of the transaction and the willingness of the parties to join in the sale.

If the minority founders exercise any rights they have not to sell their own shares, and bearing in mind that a third party buyer may be unwilling to buy just the EOT shares, the trustees may consider providing them with an incentive by contributing some of the EOT sale proceeds to the founders’ tax bill. It is worth noting that if the EOT sells before the two-year qualifying period ends, it will be liable for a lower CGT bill than it would have had it done so after the two-year qualifying period. As such, contributing to part of the founders’ CGT bill may prove to be more cost effective then being responsible for all of it.

In assessing whether the sale price is sufficient to cover the costs of sale and still be a financial incentive to everyone involved, the trustees should seek the advice of a financial expert who can provide an educated opinion on the current value of the trading company and its financial forecast if the trustees decide not to sell. This would provide a good way to benchmark the third party offer to work out if it is generous enough to outrun the costs of the transaction.

Employee considerations

Getting employees on board with the EOT structure can be a challenge and it may be unlikely for them to get comfortable with a potential sale to a third party. In all likelihood, the idea sold to them when the EOT was set up was that it would be there long term and that, in addition to having the opportunity to own the company they work for, they would also benefit from it financially by receiving a yearly tax-free bonus.

Selling the company means employees will be paid their individual share of the sale proceeds net of income tax and NIC (including employer’s contributions) estimated to be around 49% of their entitlement, so the tax treatment of their sale proceeds will most likely not act as an incentive. Add to this the uncertainty around the company being owned by a third party and this may not make the sale sound ideal to employees. Trustees may therefore choose to consult employees ahead of accepting an offer.

Overall, there are numerous factors to be taken into account before trustees of an EOT should make a decision to sell. Sound financial and tax advice will be paramount to the process. In addition, the trustees might also opt to seek legal advice or even a court ruling confirming their proposed decision has been taken in conformity with their fiduciary duties. This would validate their decision and remove any prospect of challenge.

If you are thinking of selling your company to an employee ownership trust or have any queries on the trusts generally please contact a member of the Corporate team.