An Introduction to Employee Trusts

What is an Employee Ownership Trust (EOT)?

An employee ownership trust (EOT) is a trust set up by an organization’s existing owners that allows it to be owned by its employees. Employee ownership trusts are often established as part of a succession or exit plan, or the company owner or owners are starting a new business they want to be employee-owned.

The Finance Act of 2014 created the employee ownership trust as a means to get more companies to be employee-owned.

The primary advantages of employee ownership trusts involve the tax incentives they entail. An employee ownership trust provides business owners with the following tax breaks:

• Shareholders can sell their shares without being liable for capital gains tax.
• If a company is in an employee ownership trust, annual bonuses can be freely given to employees without income tax becoming a factor.

A few noteworthy conditions apply to these tax incentives:

• A minimum of 50% of company shares must belong to the employee ownership trust.
• Any benefit given to employees from ownership trusts must be provided under the same terms.
• The entity selling shares must be a trust or an individual but not a company.
• The shares cannot be preference shares but rather ordinary shares.
• The company must either be the principal company of a larger trading group or a trading company itself. Essentially, over 80% of the organization’s activities must involve trading.
• The employee ownership trust must continue to acquire controlling interest the company didn’t possess previously.
• After the shares are sold, more than 60% of the company’s employees mustn’t be majority shareholders.

An employee ownership model opens the door to achieving benefits for the company, the employees, and the community. The EOT model features the following qualities compared to an employee ownership model that involves direct employee share ownership:

• An EOT can be used to fund a transition of a company to employee ownership with the use of business contributions rather than employee contributions.
• An EOT provides a consistent long-term structure for employees and ensures the best interests of the current and future staff members are looked after. It facilitates a measure of collectiveness in the company.
• An EOT simplifies the overall administrative tasks, including tax, of the business.

Who Funds Employee Ownership Trusts?

An employee ownership trust will typically get controlling interest from the company’s existing shareholders.

Based on assessment, the shareholders will agree on a price lower than the company’s market value. The company is then essentially funded by the future profits of the company in monthly installments.

A company owner can also sell their shares to the employee ownership trust, but they commonly like to be paid instead. The purchase price or the majority of it can also be paid once-off if the shareholders are able to acquire an external loan or if the owner of the company makes the decision to offer seller financing.

Who Will Manage the Employee Ownership Trust?

Employee ownership trusts are typically managed by the trustees. Managing the EOT is not the same as managing the company, which remains the responsibility of the management team, but it rather involves ensuring the company is well-managed to promote employee engagement and loyalty. An employees’ council is often established to see to this duty.

Tax Benefits Associated With Employee Ownership Trusts

Capital Gains Tax Relief

The selling of controlling interest in a company to an EOT is free of capital gains tax.

For this tax benefit to be activated, an organization must meet the requirements listed below:

• The company must be the principal company of an established trading group, or it must be a trading company itself. Any company that possesses land, cash, or other investments of a significant nature cannot be classified as a trading company.
• The employee ownership structure must adhere to the all-employee benefit requirements, which are discussed below.
• Before the transfer to an EOT is completed, the EOT must not hold a controlling interest of over 50%. However, controlling interest in the company must be allocated to the EOT at the tax year end when the transfer occurred.
• An additional requirement applies when a transferor holds 5% or more interest in the company within a year of when the transfer occurs. This requirement specifies that the number of employees holding 5% or more interest in the company may not be more than two-fifths of the overall workforce.
• For example, suppose a business has three people who are either employees or directors, each holding over 5% of the shares, and there are nine employees in total. The ratio would then satisfy this additional requirement, being three to nine. However, suppose one of the nine employees is the child of the Shareholder Employees. This person is then considered one of the shareholders, yielding a ratio of four to nine, which doesn’t meet the additional requirement. In that case, none of the selling shareholders qualify to claim the capital gains tax relief.

All-Employee Benefit Requirements

If individual employees receive benefits from the EOT, such as shares or cash, the benefits must be granted in favor of all the eligible employees under the same terms. This is called the equality requirement.

Therefore, employee trusts may not skew any benefits in favor of certain employees. However, the EOT may allocate specific benefits of varying amounts based on reference factors, including hours worked, length of service, and salary.

The “employees” of the company may also include the dependents of employees that are deceased. Any participating employees holding over 5% of the company’s shares cannot be deemed a beneficiary of the employee trust.

Annual Bonuses Free of Income Tax

Annual bonuses given to the employees of companies that are controlled by employee trusts are not subject to income tax. This benefit excludes national insurance contributions.

 Income Tax Relief Conditions:

• The company must be a member of a trading group or a trading company itself.
• In a group company, a controlling interest in the principal company must be held by an employee trust for a minimum of 12 months. In independent companies, the controlling interest must be held by the EOT.
• Provisions that apply to the equality requirements for capital gains tax largely also apply to income tax relief.
• A ratio of two to five for directors and their relatives to the total employees and directors may not be exceeded.
• For every employee, a bonus maximum of £3,600 that is income tax-free applies for every tax year.
• The annual bonus cannot form part of the regular salary, cannot be provided by service companies, and must adhere to the following arrangement:
  • All employees of the company that participates in this arrangement must do so on the same terms, although service awards can be based on hours worked, service length, and salary.
  • All employees of the company have to be eligible to partake in any service award, but employees that haven’t been working for the company for more than a year may be excluded.

Advantages and Benefits of Using an EOT

The regulations of an employee stock ownership plan (ESOP) do not apply to an EOT. Whereas an EOT provides employees with benefits every year and is not classified as a retirement plan and, therefore, not subject to ERISA, an ESOP is considered a retirement plan that is subject to the Employee Retirement Income Security Act that is regulated by the Department of Labor and the Internal Revenue Service.

An EOT is thus much easier and more affordable to administer, as no report filing and yearly evaluations are required.

As an EOT intends to own a company for the foreseeable future, it is favorable to the business owner who wants to preserve the local employment in the company, benefit the community in which the business operates, and protect the company against a sale to a larger company, investor, or competitor. In contrast, ESOP trustees must consider offers and sell if the trustees deem an offer to be in the best interests of the company’s financial future.

The shares of employee trusts are not designated to individual accounts, so they will never have to be repurchased from employees leaving the company. Evading the repurchase obligation effectively prevents future cash flow planning issues, which commonly arise in ESOP companies.

The employee ownership structure can be likened to that of a traditionally owned company. Although the range of employee control and input may vary, the company will still operate under regular structures.

Therefore, an EOT is the best option for companies that want to remain employee-owned and locally controlled.

The following are the primary benefits of an EOT:

Tax Benefits: 

Employees can receive annual bonuses free of income tax, and the sale of shares is capital gains tax-free.

The EOT is an established buyer:

Whereas regular sellers must first find an interested buyer before being able to sell the company, the trust allows sellers to sell their shares without having to find a suitable buyer.

Succession planning:

The trust eliminates the need for business owners to search for a buyer who plans on running the company similar to its existing standards. With a trust, the ownership can partially belong to the current business owners, leading to a smooth transition and lesser disruption in the company’s daily operations.

Price:

The selling of a company typically involves a great deal of obstacles. With an EOT, the price is determined by executing a professional valuation. The process is thus much easier in that the trustees can assure themselves they’re not paying too much for the business.

Staff Benefits:

Many people would say that placing the ownership of a company in an EOT can be described as philanthropic. Employees will feel appreciated and valued, resulting in overall better employee morale.

Retaining and Gaining Employees:

When a company is owned by an EOT, employees will quickly recognize the opportunity for growth and progression in the company, resulting in higher employee retention and more attractive employment offers for those who are experts in their fields.

Seller Involvement:

The seller of the business can remain highly involved in the company and retain minority shares. They will remain directors and receive pay at market rates, provided the conditions are met.