As EOTs gain in popularity, there are issues that need to be addressed to prevent them being abused
Employee ownership has caught the attention of a good number of advice firm owners over the past 12 months. Given the large number of business owners who seek advice, it is entirely right advisers should understand it from a planning perspective, but some are interested in its use within their own firms too.
Employee ownership trusts have a number of positives for business owners. The sale to the trust is entirely free of capital gains, inheritance and income tax, both on disposal to the trust and on receipt of the money by the former shareholders.
EOTs can pay tax-free cash bonuses to employees of up to £3,600 each per annum. They are also flexible; not all shareholders need to exit. At their best, they force business owners to think more deeply about their firm, employees and retirement, and accept that even a capital event is just another way of providing an income for life.
That said, there are a few issues which need to be addressed to avoid EOTs becoming abused in the same way as their predecessors, employee benefit trusts:
1. Attracting the wrong sort of business
It takes a degree of scale, planning and investment in the personnel of a business to make it suitable for an EOT. The tax advantages are a huge lure alone. But even without this, there is a danger poor-quality firms (advice firms with huge liabilities and a poor complaints record, for example) will be attracted to them.
Those who could not sell on the open market where due diligence would disqualify a sale, or at least severely impair value, might find it easier to get an accountant to sign off on a middle-of-the-range value for submission to HM Revenue & Customs for an EOT.
Neither the accountant nor HMRC would have the information or expertise to flush out the problems in the way a trade sale would.
Sale to an EOT could become the best option for low-quality firms, and that does not bode well for the long-term future of them.
2. What is in it for the next generation?
You are in your early 30s, career taking off, big new mortgage, first child born and still paying off your huge student loan. The last thing you want is to be saddled with more debt. EOTs provide a neat way of avoiding the personal debt many succession plans require but they can also stymie those left to run the business, as repayment of the debt to pay off the original shareholders takes precedent over more expansive plans. The need to repay the debt could leave the business with fewer choices and less flexibility than it had before.
It may also breed resentment. Once the business is owned by a trust, nobody real owns it and nobody else will have a capital event from sale, other than the original shareholders, completely tax-free.
Even with the best intentions, some employees will want a capital event themselves, especially in professions such as advice where large capital sums are paid out.
3. What has changed at the top?
A friend of mine works in an EOT and is entirely dissatisfied with it, as the shareholders have failed to address the points above and retain de facto control over the business via the trust. He has been asked to take on more responsibility for no more money as the firm is constrained by the debt. It needs a radical overhaul but there are not the skills, leadership, structure or motivation.
Nothing has improved for him or anyone else in the firm because the EOT was simply a tax-efficient way for the partners to extract money from a business that nobody was prepared to buy them out of due to all its inherent problems. This situation is the result of the problems I have already outlined, but one which could become the norm as EOTs grow in popularity.
Barriers to overcome
The good news is that these are not problems which go unacknowledged. In my conversations with organisations such as the Employee Ownership Association, they can see employee ownership will only become recognised by the bigger and better law firms and accountancy practices if it is regarded as a credible option for good-quality firms with little threat of future HMRC concern.
Ovation Finance founder Chris Budd almost exclusively focuses on operational and organisational issues, not tax advantages, in his Eternal Business Consultancy on EOTs. However, at some point, there may be a need to bring the wrong behaviour into line to avoid EOTs becoming a tax fiddle for the otherwise unsellable. I am not sure where this will come from.
There seems to be a reliance on accountants and solicitors to police this, but some of the bigger ones are not recommending EOTs right now and may have a bias towards their corporate finance teams for more traditional sales (and fees).
It was not that long ago we were told advisers would not get involved in volumes of “rubber-stamp” defined benefit transfers because of the risk. There are always people prepared to take the chance.
Phil Young is managing director of Zero Support