How does it work?

Similar to how a typical sale is structured, the seller (outgoing shareholder or shareholders) will sell their shares to a buyer, being the EOT in this case. In most instances, the EOT is normally a newly incorporated company (a corporate trustee) as a vehicle specially for this purpose. The corporate trustee will come with its own board of directors which essentially step into the shoes of a majority shareholder going forward. It is important to note that the day to day running of the business continues to remain with the board of directors of the company, or companies where a group exists.

In return the EOT will agree to pay market value for the shares to the outgoing shareholder, normally substantiated with an independent valuation exercise. Due to the EOT having been recently setup, it is unlikely to have any funds of its own to pay the consideration for the sale. Typically, the EOT will owe this amount to the outgoing shareholder, and it will be paid over a number of years through the profits generated by the company (referred to as vendor financing). However, in recent times external finance is becoming more commonplace, where a third party such as a bank, will lend to the EOT to pay off the outgoing shareholder so that any outstanding loans are repaid with the ongoing profits of the business similar to vendor financing.

Conditions

In order for the EOT to be qualifying and the structure to have access to the tax benefits for both the outgoing shareholder and employees, there are a number of conditions that have to be satisfied. Broadly these are:

The company must be a trading company or a trading group;

A UK tax resident EOT must control (so >50%) the trading company or group;

All eligible employees must be treated equally, and on the same terms when applying settled property (i.e. the shares), with the only variations based on remuneration, length of service and hours worked;

the EOT must be independent and cannot be controlled by outgoing shareholders e.g. for example by the majority of the board of a corporate trustee being the outgoing shareholders;

Any individuals that hold more than 5% of the share capital (or are entitled to acquire more than 5% say under a share option) should in total, along with any persons connected to them, not exceed 40% of the workforce of the company.

A breach of any of these conditions is likely to result in the EOT no longer being qualifying and a tax charge with withdrawal of any ongoing tax benefits.

Advantages

There are a number of advantages to an EOT structure:

0% tax on the disposal for the outgoing shareholder assuming all the qualifying conditions are met and continue to be met for 4 tax years after the tax year of sale.

No IHT charge on the transfer of shares to an EOT.

Employees can be paid up to £3,600 per annum tax free.

Typically seen as a ‘friendly’ transaction with potentially lower professional fees and a decreased likelihood of the sale/ exit failing.

Employees continue to work in a business that is known to them with guaranteed degree of security and stability.

Employees will share in the success of the company by way of financial incentives, therefore likely to be motivated in driving the success of the company in the future, leading to more engagement and retention.

It has also been shown that businesses that are owned by EOTs normally demonstrate a higher level of commitment to CSR and overall contribution to the wider economy.

Pitfalls

Although an EOT structure is attractive, the requirements for a qualifying EOT are inherently complex, making it easy to trip up and incur an unexpected tax charge. Even where this is not the case, the rigidity may not be suitable in certain businesses or industries.

Other common issues can be small family businesses that exceed the participator fraction and incoming management not being suitably equipped and/ or incentivised to drive the business forward.