KNOWLEDGE BASE

By Ben Hart,

Employee Ownership Trust – what are they and can they help your business?

An Employee Ownership Trust or EOT is a model of ownership for businesses, small or large, in which the majority of the shares are owned by a trust collectively by, and for the benefit of, the company in question’s employees. Almost certainly the most well-known example of a business built around a similar model is John Lewis, more formally known as the John Lewis Partnership, and whose employees, known within the company as partners, enjoy a number of benefits related to their collective ownership of the company shares, most notably a generous yearly bonus.

Employee Ownership Trusts have a number of benefits, social as well as financial, with various tax incentives, including legislation in Schedule 37 of the Finance Act 2014, brought in by the then Conservative / Lib Dem coalition government, and pet project of Deputy Prime Minister Nick Clegg, who wanted to encourage the growth of a so-called ‘John Lewis Economy’. The government’s aim of this laudable ambitious new EOT business category, which in essence is a special form of employee benefit trust, is to encourage shareholders to set up a corporate structure based around – or similar to – the John Lewis model.

How did they do that? By offering tax incentives and creating a simpler model of transferring shares to individual employees – certainly far simpler than allocating shares to employees at an individual level. The government believed, and with good evidence, that employee owned businesses led to greater productivity and greater resilience on the part of the company to weather difficult financial conditions.

An employee owned company is for all intents and purposes a normal limited company, run on a commercial basis to turn a profit. The big difference lies in the fact that the majority of the shares are held by the company’s employees, for their “long-term benefit”, so any profits made will benefit the employees as a whole, rather than a small group of executives at the top of the company, or any other shareholders not involved in the actual running of the business.

A new business can be started around such an employee ownership model, should the founders wish to go down that route from the outset. Or an existing company can convert to this model by setting up an Employee Ownership Trust. This can be as part of a business owner’s exit or succession planning, or simply for the business owner to take advantage of the incentives offered by the 2014 Finance Act mentioned above, as well as other benefits that an EOT can offer.

The John Lewis example

The Employee Ownership Trust model was based around the John Lewis Partnership’s long-running and successful business ownership model, whereby its employees – referred to within the company as partners – hold shares in the business, held collectively in trust by the John Lewis Partnership, so shares cannot be sold by any individual partner, but each partner receives economic benefits based upon their ownership of the shares – most notably by way of a yearly profit share, varying year by year but usually between 10 and 20 percent of the partners’ yearly earnings – very generous compared to the benefits enjoyed by employees at other retail outfits with more traditional ownership models such as Sainsburys or Tesco.

The John Lewis Partnership is of particular note in that it was originally established in 1929, almost a hundred years ago. It is well worth checking out its written constitution as this sets out many principles which are relevant to today’s modern partnership businesses, whether organised as EOTs, LLPs or some other form of shared ownership model. John Lewis is far from the only example but stands as a great case in point of a successful implementation of such a model of employee ownership – Aardman Animations of Wallace & Gromit fame and Riverford Organics are also majority owned by their employees. 

Benefits of an Employee Ownership Trust

EOTs offer a number of tax incentives that we will discuss further, but there are plenty of other benefits to this kind of ownership model, both for the company owner and the employee, as well as the community at large.

A lot of surveys have shown that employee-owned firms perform better than companies with more traditional models of ownership. Employees who own a stake of their business are always going to be more motivated and harder working if they are to receive a proportion of the fruits of their labour, not just a fixed salary, with employees working together towards a common goal, encouraging collaborative thinking and a communal, collective way of working.

As a purely anecdotal example, many readers will no doubt have noticed the difference in attitudes between John Lewis or Waitrose (part of the John Lewis Partnership) partners and employees working in other shops that are based around a more traditional ownership model, whose response to an enquiry might consist of an incoherent grunt or perhaps the classic “I dunno, I just work here” line.

Employee Ownership Trusts tend to have more committed and engaged team members, and often also find it much easier to find and retain good, hard-working people, with less absenteeism, as the model offers significant team benefits not found elsewhere in a traditionally owned private or public company, including tax free (albeit limited to £3,600) annual bonuses. EOTs act as a fantastic pull to attract the best and brightest talent, by offering a share of ownership in return for hard work.

Owners wishing to retire, and / or looking for a succession strategy may find that converting their business to an Employee Ownership Trust, effectively selling it to their former employees, with the owner receiving full market value for their shares, can help preserve the business culture, as well as helping to ensure a strong and resiliently performing business into the longer-term.

If you want to leave your business, which you may have dedicated the best years of your life to building and maintaining, and wish to see it thrive into the future, and want to leave it in the hands of people who care about it, and aren’t just looking to asset strip the whole place, who better to sell to than the employees themselves, whose blood, sweat and tears go into running the place daily, and who know the business inside out? Employees who own a share in the business in which they work will always be more enthusiastic, and genuinely care about the business, as they see a direct benefit to themselves, and a direct correlation between the work they put in, the strength of the company, and the financial benefits they receive as a result of their partnership status.

In most small businesses, the owners will generally want to sell up and leave eventually, and if there are no family members to pass the business on to, or buyers available to sell to, selling to employees by setting up an EOT can be a great exit strategy. The process of leadership succession can be gradually implemented, over time, and a retiring owner can be paid market value for their shares, and with no Capital Gains Tax. We’ve included some more information on the tax incentives offered by the government below.

For new companies just getting off the ground, the Employee Ownership Trust has its unique benefits too. Team members may be prepared to forgo short-term benefits, for example by taking a lower salary initially, to help the company grow, knowing that they will directly benefit in the long run if the company is successful. EOTs also share the burden of starting a new business out across the pool of staff – starting a new business is hardly easy and having a team of motivated partners will indeed lighten the load and increase the chances of a successful outcome. 

The technical details

As we mentioned earlier, an employee owned company is a normal limited liability company that is run on a commercial, i.e. profit driven basis. The big difference is that the majority of the shares are collectively owned by a trust for the long-term prosperity of the employees as a collective group. Employee Ownership Trusts are distinguished from other types of so-called employee benefit trusts, which are known as EBTs. In fact, EBTs are rather infamous as being used for tax-avoidance purposes, with typically the shareholders being the only employees to benefit!

By way of contrast, the EOT provides indirect ownership to a majority of non-shareholder employees with the employee owned company shares held in a legal trust. In order to sell a business to an Employee Ownership Trust, the following conditions must be met.

  • The company whose shares are transferred must be a trading company or the principal company of a trading group.
  • The trustees must retain, on an ongoing basis, at least a 51% controlling interest in the company.
  • The number of continuing shareholders (and any other 5% participators) who are directors or employees (and any persons connected with such employees or directors) must not exceed 40% of the total number of employees of the company or group. This is to show that there has actually been a significant change in ownership, which can be an issue for smaller companies with a small number of staff compared to the number of shareholders who are employees/officeholders.
  • Trust property must generally be applied for the benefit of all eligible employees on the same terms, but the trustees may distinguish between employees on the basis of remuneration, length of service and hours worked.

There are two tax breaks offered by the government to encourage the adoption of such an egalitarian model as an Employee Ownership Trust:

  • Those selling shares to an EOT may do so free of Capital Gains Tax. This applies to the original owner of the business who is transferring ownership to the EOT – so if a company owner is retiring and chooses to sell their company to the employees using the EOT model, they will not be liable for any Capital Gains Tax.
  • Once a company is owned by an EOT, it can pay annual bonuses to its employees free of income tax. This is subject to an upper limit of £3,600 per employee, per year, and is a cash bonus and not a dividend, meaning it can be paid whether or not the company has made a profit or has any distributable reserves. Note though that the bonus will still be subject to both Employers and Employees National Insurance Contributions, which is another form of taxation on earnings.

It is a shame that the £3,600 upper limit has been imposed as it rather sends the wrong signal regarding what shared ownership is all about, almost implying that the anticipated profit share or bonus is likely to be trivial. By way of contrast, HMRC’s rules for LLPs require a minimum expected variable profit share of 25% of an individual’s fixed pay to reflect a genuine shared ownership or partnership model.

When an EOT is created and acquires a controlling interest in a company from its current shareholders a price will be agreed, based on an independent assessment, which must not be more than market value. Payment will usually then be made in instalments, with the EOT being funded by the company from its future profits. A benevolent company owner may give their shares to the EOT for nothing, but we expect that in most cases they will naturally want to be paid at something approaching full value.  Sometimes it is possible to arrange an external loan which will enable the purchase price (or at least part of it) to be paid in one go.

The Employee Ownership Trust is run by a board of trustees, whose role is not to manage the company – this will remain the role of the company’s existing management – but to ensure that the company is being led competently and in a way which ensures employee commitment and support.

Conclusion

While Employee Ownership Trusts may sound a little bit ‘commie’ in thinking – workers owning the means of production? What is this, Marxism? – bringing back memories of the old worker owned cooperatives that operated in Socialist Yugoslavia; The John Lewis Partnership provides but one of many examples that provide proof that, far from being antiquated, obsolete modes of thinking, a modern company with a model based around employee ownership can compete and thrive in the corporate world of the twenty-first century, to the mutual benefit of both the founders of a company and its employees.

The EOT model offers many benefits and may well be attractive to business owners looking to solve the succession problem and sell a majority share in their business tax free. An alternative which does not involve selling the company, at least not straight away, is to establish a partnership model using a Limited Liability Partnership. This can offer very similar benefits to shared ownership with all team members being treated as business owners and behaving as business owners – a true partnership – even with the founders still owning the ‘bricks and mortar’.

Either way, here at Optimal Compliance we have over thirty years’ experience working with small businesses and helping start-ups get off the ground. For further information regarding the LLP partnership model, see our website article here.

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