Legal update: Employee Ownership Trusts – where are we?

Published: Thursday 14 July 2022

Employee Ownership Trusts (EOTs) were first introduced in 2014. It was the Government’s wish at the time to promote the concept of stronger teamwork and genuine employee ownership to achieve greater success and sharing of financial rewards as a result.

The popularity of EOTs has grown significantly over the last few years, and by January 2021 an EOT was used in one in every 20 private company sales.

The first law firm entirely owned by employees appeared in 2018. Before then we had seen variations of employee ownership via different trust arrangements, but this was the first significant move away from the traditional business models that we have become accustomed to in the legal sector.

However, since then there have only been a handful of firms that have converted to EOT ownership, and not all of those have become fully owned by the EOT.

This article explores the reasons for this, explains the drivers behind the choices available and considers the oftenoverlooked practical issues of running an EOT business.

Background

An EOT is an employee benefit trust established for the benefit of all employees of a company, and that trust then controls the business more generally.

There are certain statutory criteria that an EOT must meet. The main one is that the EOT must have a controlling interest in the company, which means that it must hold more than 50% of the share capital and voting rights in it and be entitled to more than 50% of the profits available for distribution and assets on winding up.

Through the EOT model, employees become owners of a majority of shares in their company through the trust. The most common example is John Lewis, but there have been other high profile EOTs in recent months, showing that this business model is gaining momentum.

Why are they so attractive?

Looking at taxation first, provided the EOT satisfies certain conditions, then the seller will not pay any form of tax on the proceeds from the sale of their shares to the EOT, therefore saving tax at potentially 10% or 20%.

This exemption from taxation is not automatic and has to be claimed, and it is common to make the claim on the tax return where the sale is reported. Depending on the timing of the sale, that could be 22 months after the sale took place, meaning that if legislation changes before the claim has been made, then the exemption might disappear. It is therefore recommended that a claim is made quickly after the disposal takes place. 

However, if the main driver behind an EOT structure is taxation, then the business may be starting from the wrong place. While it is difficult to ignore the attractiveness of paying no tax, any long-term structural decision should be based upon what is most appropriate for the business as a whole, to ensure that it can continue to thrive without any unnecessary restrictions.

For many, the appeal of an EOT is that it offers a solution to succession planning. Succession has been, and will continue to be, one of the most significant challenges within the profession, no matter the size of practice. An EOT may be seen as an easier answer to deal with succession planning since there is no
significant change in the day-to-day operations and it can be less disruptive than selling to a third party.

For some, there may be an opportunity to realise more value than they would if they sold to a third party, though a  robust valuation of the practice has to be undertaken by an independent third party and has to be affordable to the EOT.

Attitudes towards the ultimate ownership of a law firm continue to evolve and in some cases direct ownership is becoming less attractive to the next generation. That does not necessarily mean that they do not want to be involved in managing the business though, and an EOT can help deal with this challenge.

Another issues is that the ability for individuals to borrow money to buy shares in a company is becoming more and more challenging, and an EOT takes that pressure away, since the funding comes from within the business itself.

Why now?

As with other new types of business model, the legal sector tends to be one of the slower adopters in comparison with other industries. We saw this when LLPs were introduced in 2000, and it was a number of years before the legal sector felt confident in adopting the model.

Although EOTs have been around since 2014, it is still relatively early in terms of assessing the long-term impact of an EOT on the success of a firm.

Much of the answer to the question of “why now?” seems to be that it can be a solution to the challenging market that many firms find themselves in relation to the ‘war on talent’. Retention and recruitment is, for firms of a ll sizes, their biggest challenge. An EOT can be an effective mechanism for rewarding employees and
giving them a sense of ownership, without them needing to acquire shares directly. Research has shown that this encourages retention and leads to performance
improvements, as employees see that they have an opportunity to benefit from a growth in their firm.

There is a tax benefit for employees too, as there is an opportunity to pay them a tax-free bonus of up to £3,600 per annum, although it is still subject to national insurance.

How do EOTs work in practice?

First of all, an EOT needs to be created as a standalone entity. Consideration needs to be given to who will be the most appropriate trustees, bearing in mind that their primary purpose will be to act in the best interest of the beneficiaries (i.e. all employees).

If the trading entity is currently an LLP or unincorporated partnership, that business needs to incorporate into a limited company first, as it is only the sale of shares in a company to an EOT that benefits from the tax relief.

That company will also need to register with the SRA as an alternative business structure in advance of any EOT involvement, and this will need to be factored into the timetable.

The next step is for the owners of the company to sell either all or part of their shares in the company to the EOT. If they are not selling all of their shares, the EOT must acquire more than 50% of the shares, and the consideration paid for those shares should not exceed market value.

The payment for these shares by the EOT may be partly paid upfront if the business has available cash or bank borrowing has been accessed, or by a series of instalments over a period of time (i.e. out of future profits generated from the company).

The trading company will continue to trade, and if any of the original owners remain, they will be on the payroll and be paid a market rate salary for their role.

As with all trading companies, the profits in the company are subject to corporation tax, currently at 19% but due to increase to 25% from 1 April 2023. After paying corporation tax, the cash generated in the company from the remaining profits can be used for three main purposes:

  1. Paying off the amounts due to the former owners. The limited company is permitted to pay lump sums of money to the EOT to allow the EOT to pay the owners.
  2. Retention and ongoing investment in the practice.
  3. Repayment of any pre-existing debt within the practice.

The business may also wish to use some of its profits to reward the employees, although the difference here is that bonuses paid to employees would be deductible for corporation tax.

It is therefore important when looking at the value to be paid for the practice to consider how the repayment of the shares interacts with the future plans of the business. This is where valuations are important, in order to ensure that the amount to be paid and the period of time over which it will be paid is reasonable and affordable in the context of the future profitability of the practice.

Key contacts

Content image: /uploads/team/unknown.jpg Jon Cartwright
Jon Cartwright
Partner
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Content image: /uploads/team/unknown.jpg Patricia Kinahan
Patricia Kinahan
Partner
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Content image: /uploads/team/unknown.jpg Andy Harris
Andy Harris
Partner
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Content image: /uploads/team/unknown.jpg Ian Johnson
Ian Johnson
Associate Partner
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