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How to triple the cash employees receive from selling shares with no extra costs

How to triple the cash employees receive from selling shares with no extra costs

Posted on February 06, 2017

The fiendish complexity of the UK’s tax system can obscure just how high UK tax is on employment income. The flip side is that the opportunities under an Enterprise Management Incentive Plan (EMI) are either undervalued or missed entirely.
To understand this, we need to understand just how high the effective tax rates are.

Who pays the highest tax rates?

Not necessarily the highest earners!
The effective tax rate on employment income depends on earnings:
• between £11,001 to £43,000: 43%
• between £43,001 to £100,000: 50%
• between £100,001 and £122,000: 67%
• between £122,001 and £150,000: 50%
• above £150,000: 54%

Why is this so much higher than the rates quoted for income taxes (between 20% and 45%)? We will untangle this mystery later in the blog (see the notes), but in short, the explanation is that income tax is not the only tax on employment income. 

The comparison with tax under an EMI plan

It’s worth repeating that first figure just for emphasis: 43%. For a basic rate taxpayer. Now, compare that to the potential tax rate from selling shares acquired through an Enterprise Management Incentive Plan: 10%, with the first £11,100 tax-free.

How EMI works on a range of salaries

To illustrate this, let’s compare what employees would receive (a) under an EMI plan, and (b) under a plan where sale proceeds are taxed as employment income (and the employee pays the employer’s National Insurance) if they sold £20,000 worth of shares. Let’s do this for employees on a range of basic salaries.

Employee’s basic annual salary Cash after tax, if taxed as employment income Cash after tax under an EMI plan 

How EMI works on a range of salaries

To highlight some figures from that table: the biggest winners under an EMI plan are those with salaries of £100,000 – they receive nearly three times as much cash under an EMI plan. One with £150,000 would be the next biggest winner, receiving just over double under an EMI plan. However, even a basic rate taxpayer gets nearly 70% more under an EMI plan.

Speak to an RM2 associate on 020 8949 5522 or email enquiries@rm2.co.uk to find out how to maximise the benefits.

Notes:

The calculation of effective tax rates

• Here’s how to understand the effective tax rates on employment income:

• Income tax (with rates between 20% and 45%) is just the start. There are three more components:

o employee’s National Insurance (payable at rates of between 2% and 12% - the highest rate here is for basic rate taxpayers)
o employer’s National Insurance (payable at 13.8%)
o the removal of the annual allowance on earnings between £100k and £122 – meaning the actual rate of income tax for these earnings is 60% rather than 40%

• Although in normal circumstances, the employer’s National Insurance is not something an employee has to be pay, in the context of the sale of a company, the amount available for distribution to shareholders is a fixed amount and (one way or another) the employer’s National Insurance reduces the amount that can either be paid to shareholders or paid to employees. For example, it’s common for a bonus pool to be allocated to employees payable on a sale of the company, based on the sale price of a certain number of shares less costs in relation to the sale (which would include employers National Insurance). Therefore, for an employee to receive £100 from the bonus pool, the pool is reduced by £113.80.

• For a basic rate taxpayer who receives £100, the costs are £113.80, and the tax paid to HMRC (income tax of £20, employee’s National Insurance of £12, employer’s National Insurance of £13.80) is £45.80. £45.80 as a percentage of £113.80 is 40.25%, which would be the effective tax rate for a basic rate taxpayer receiving from the bonus pool example above.

• There’s one more twist – if the employer National Insurance is paid by the employee, there is tax relief on income tax, but no relief on National Insurance. Counterintuitively, this increases the effective tax rate: for a basic rate taxpayer who sells shares worth £100, the cost is now also £100, and the tax paid to HMRC (income tax of £17.24, employee’s National Insurance of £12, employer’s National Insurance of £13.80) is £43.04. £43.04 as a percentage of £100 is 43.04%.

• So, what’s the end result? What are the real tax rates on employment income taking into account all three components of those taxes?

• The effective tax rates are: 43.04% for basic rate taxpayers, 50.28% for higher rate taxpayers’ earnings below £100,000 and above £122,000, 67.52% for higher rate taxpayers’ earnings between £100,000 and £122,000 and 54.59% for additional rate taxpayers.


Assumptions

The comparison of an option under an EMI plan and otherwise assumes that, in both scenarios, the employee is granted an option with an exercise price of zero, and that the market value of the shares when the option was granted was zero.

The analysis above represents a simplified scenario and disregards many considerations relating the financial position of the company and the employee (such as other taxes, other tax reliefs and the risk attaching to an investment in shares) that should be considered. The tax treatment described is based on many assumptions which may not be applicable in specifics cases and have not been explained.

 
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