EOTs: the benefits for your firm

John Dunlop assesses whether firms should be considering a tax-free Employee Ownership Trust (EOT)

Law firms whose original founders are approaching retirement are perfect candidates for an Employee Ownership Trust (EOT). Quite frequently, such founders will be grappling with a crucial succession plan for their firm, and this is where an EOT comes to the rescue.

The beauty of an EOT is that it can give the perfect solution to the founders: an orderly transition so that the next generation are encouraged to step up; with a combination of a motivated workforce; and tax-free release of funds. It works for all types of partnership as well as the corporate form of law firm. To take advantage of everything an EOT has to offer, the business vehicle must be that of a company but moving from a partnership into a company should be relatively easy. 

While the author is not a share valuer, it is not too aggressive to see a business with stable recurring revenues and consistent profits being valued at, say, six times adjusted EBIT. Should there be no real interest costs, this translates to eight times post corporation tax profit figure (being the dividend stream).

To get to the true profit figure, adjustments need to be made should the founders’ salaries not in reality be a true reflection of what it would cost to replace them. It is after all not unusual for director shareholders to extract the overall profits from a business by way of a mixture of a low base salary and deal with the variable profit element by way of dividends.

Should the company be sold for such eight times multiple and the profit line stays flat, the first eight years of post-tax profits will be used to fund the purchase price. After that eight-year period has elapsed with a traditional sale, the profits would then flow to the buyer.

EOT as an alternative

The founders should be considering the alternative of creating an EOT so they can sell the company to such EOT, such that it could provide the perfect solution to the founders’ key troubles. To put some colour to this concept, let’s use an example of a company with £1m of maintainable post-tax profits and the above eight times valuation multiple.

On the sale to an EOT (for £8m), the company’s post tax profits of £1m each year are given by way of capital contribution to the EOT to fund its payment of the consideration. This is the amount which would otherwise have been distributed by way of dividend to the shareholders. The founders would have paid nearly 40 per cent tax on such sums. 

If the founders are prepared to compare like for like, they will see that this effectively allows them to take eight years of profits out of the business free of income tax. In this worked example, they save somewhere in the region of £3m depending on their marginal tax rate.  It also allows them to hedge against an increase in tax rates should there be a change in government or taxation policy; all whilst retaining control. We find that founders usually see this as a fair return; once eight years have elapsed, they will be happy that the business has transitioned to now be fully in the hands of the employees. 

At the eight-year mark point it has become a perfect analogy to the John Lewis model. The business is owned by the staff and as a collective they share in the surplus profits.  This does not mean every employee automatically gets the same equal share. 

In practice, we see that most EOTs apply one of the legislative alternative models for the sharing of profits. Most popular should be the surplus profits being shared with each employee getting a pro-rata share based on the percentage their salary compares to the aggregate salary of all staff. 

This passing of the business to the staff is the quid pro quo of the tax-free status.

The trade-off for the business’ tax-free status is the transfer of ownership to the eligible employees. It has been purposefully designed to encourage employee ownership which is generally perceived to be good for everyone. This is because of the EOT-owned business’ increased profitability and attractiveness to employees and clients. 

The core of any EOT is the Trust Deed, which sets out who the beneficiaries are and how the profits are distributed among them. The other critical documents will be the Sale and Purchase Agreement and a Shareholders’ Agreement should the founders retain shares.

Traps

There are a few traps along the way but these can normally be easily overcome and managed:

·        It does not work for a business if the shareholders are essentially the same people as the employees. If this appears to be a risk, there is a formula in the legislation to run through to double check whether the rule is breached.

·        The tax-free status is essentially revoked if the EOT sells on the business before the next tax year (6 April to 5 April) has commenced and finished. 

·        Various tax clearances are needed. As part of this, HMRC insists on being told that the price is equal to or less than the market value of the shares being sold. In any event, selling for more than market value exposes the trustees to a breach of trust claim by the beneficiaries.

·        Stamp duty is payable by the EOT on the price it pays. Don’t overlook this in the euphoria of the EOT launch.

Tips

·        The EOT must hold a controlling interest in the relevant company but does not need to own 100 per cent. Founders often like to hold back some equity for sentimental reasons. 

·        As well as the tax-free status for the capital contributions to the EOT and consideration paid to the shareholders, there is a further tax-free element to take advantage of. Each year, the EOT owned business can give tax free bonuses to each member of staff up to £3,600. There is, unfortunately, national insurance on this. 

·        You can have an EOT probation period of up to one year so that new employees do not share in the surplus profits until this period has expired.

·        One or two banks will lend to EOTs but typically they only lend about a third of the overall value and will charge approximately 10 per cent interest per year. The banks don’t usually ask for personal guarantees but will want security over all the shares. This can become troublesome if some shareholders are resistant to the EOT.  If so, consider the drag provisions in the articles or the Companies Act.

An EOT should definitely be part of the thought process for founders in this scenario. Although tax-free extraction of money isn’t always the best option, it can be hard to overlook the potential benefits.

John Dunlop is a partner and head of tax and the EOT practice at DAC Beachcroft LLP dacbeachcroft.com

The contents of this article do not amount to the provision of legal advice which should be taken before you decide to act (or even do nothing). Any opinions expressed herein are those of solely the author and not of DACBeachcroft LLP. or the Solicitors Journal.