Can Employee Ownership Trusts (“EOTs”) provide an alternative to family succession?

Known for their adaptable nature, innovative spirit and contribution to the economy, the importance of the successful continuation of our family businesses cannot be overstated.

Retaining the ownership and running of the business within the family is often considered a benchmark of success but isn’t always straightforward. The next generation, assuming there is one, often lack the desire or skillset to lead the business or may just wish to pursue their own interests.

So, what are the options?

If family succession is not possible, potential alternatives might be a Management Buy-Out (“MBO”) or a third-party disposal.

Management Buy-Out (“MBO)

MBOs can be highly leveraged, with business owners seeking a higher upfront return to reflect that they will no longer be involved in the business. This can put significant stress on both the business and the MBO, often with substantial personal risks. Whether an MBO is appropriate will depend to a large extent on the appetite, experience and aspirations of the management team.

Third-Party Disposal

Whilst a third-party sale may achieve an optimal financial outcome, the emotional aspects of selling a family business, which is often engrained in the local community and built on relationships spanning generations, should not be underestimated.

Increasingly, we are seeing family business owners considering EOTs as an alternative.

What is an Employee Ownership Trust?

Broadly, an EOT enables a company to become owned by, and for the benefit of its employees in a tax efficient manner. The day to day running of the company can continue to be performed by the management team. A board of trustees is appointed to the EOT, however, to align the values and culture of the company for the benefits of the employees as a whole.

Why choose an Employee Ownership Trust?

There are a variety of reasons for the increased popularity of EOTs, some of the key factors are listed below:

• If structured correctly, the sale of a controlling interest in a company to an EOT will be entirely free from Capital Gains Tax (CGT) as compared with CGT rates of up to 20% on a third-party sale/MBO
• Employees can be paid a tax-free bonus of up to £3,600 per annum by a business that is held by a qualifying EOT
• Owners can retain some involvement in the business, which can soften the emotional aspects of selling the business. Existing management teams can still be involved in the day to day running of the company
• EOTs can provide a quick and streamlined exit route for shareholders.
• EOTs can lead to improved employee retention, engagement and morale as they have a vested interest in the success of the business
• Sellers may be prepared to accept lower upfront payments than under an MBO, with a higher vendor loan. This can reduce the stress of third-party debt for the business and MBO team

Is an Employee Ownership Trust a suitable alternative?

The merits of an EOT means it should warrant serious consideration when the succession path is not clear. The tax advantages are attractive but should not be the driver for a transition to an EOT.

A starting point for evaluating an EOT is assessing whether the various EOT qualifying conditions can be met. These include:

• the business must meet the definition of a trading company or group for tax purposes
• the EOT must retain a controlling interest in the business
• the selling shareholders cannot constitute more than 40% of the total number of employees of the company or group. There are provisions which attribute rights to persons connected with the selling shareholders when evaluating the 40% threshold.
• Tax free bonuses have to be paid to employees on the same terms (although there is scope for differentiation according to set criteria)

HMRC has recently launched a consultation on EOTs and it will be important to carefully consider and keep abreast of any rule changes. For instance, one of the specific proposals in the consultation is that more than half of the trustees of the EOT should be persons who are not the former owners or persons connected to them.

Once the decision has been taken to proceed with an EOT it critical that employees are onboard from the outset and fully understand what the change in structure will mean for them.

Early consideration needs to be given to identify the employees who have the skills and desire to act as trustees and directors.  This can provide a great opportunity for employees to take on greater leadership responsibility, and their role will be vital to the future growth and success of the business.

How can AAB help?

We understand that conversations around family business succession can be difficult. We also understand that the goal for most family businesses is continuity, with no desire to relinquish control outside of the family.

Getting the correct technical advice is important, but the real value comes from getting wider guidance and support at every stage of the transition. Whether this is fielding questions from employees to allow them to fully understand the process, or working closely with your lawyers to ensure the EOT is implemented correctly, we will be with you throughout the journey.

If you have any questions about the support, we can provide to your family business please do not hesitate to get in contact with Lyn Calder, Alan Campbell, or your usual AAB contact.