Succession Planning with Employee Trusts
Individual shareholders in private companies sometimes get locked-in if they would like to obtain value from their shares, but have no obvious means of doing so. It is rare for a private shareholder to sell a minority holding to a third party, so the shareholder may have to wait for a company sale or flotation. This may not happen for many years, if ever.
If the shareholder sells back to the company, this may result in the whole of the value of the shares in excess of the original subscription price, perhaps nominal value, being treated as a taxable dividend(1).
An employee trust can offer a viable solution. In outline this works as follows:
- The company provides funds to the trustees. Alternatively, if the company is non-close it can underwrite borrowing by the trust, from a bank or other third party.
- The trustees use these funds to acquire shares from the retiring shareholder on arms' length terms. The selling shareholder should be liable only to Capital Gains Tax (CGT). CGT rates are much more favourable than Income Tax or dividend rates. The highest CGT rate is 28% for higher rate taxpayers; 18% for standard rate taxpayers, and falls to an effective rate of only 10% on the first £10m of gains where the taxpayer has held 5% or more of the share capital, carrying at least 5% of the votes, for at least a year before sale(2).
- The shares can then be used for the purposes of an employee share scheme. If established under a government sponsored scheme such as the Enterprise Management Incentive (EMI) or the Share Incentive Plan (SIP), the incentives will be taxed at low rates (or possibly escape tax altogether).
3-way tax benefits
A tax-advantaged result is therefore available for the selling shareholder, for the company and for its employees. Where at least 10% of a company's share capital is passed into a SIP, the vendor(s) may roll-over their gains into other capital assets thus deferring any tax liability for possibly many years. The company will also receive full Corporation Tax relief on the employee benefits provided.
However, care must be taken to ensure that no unexpected tax charges arise, especially in connection with the Third Party Remuneration rules introduced in the 2011 Budget, or (in the case of close companies) in relation to Inheritance Tax. Generally, if transactions are at arms' length, and conventional share schemes are used, problems should not arise. However professional advice in this area is essential.
HM Revenue & Customs generally attaches much lower values to private company shares than to quoted shares on the grounds that private company shares cannot be traded. If the sale has taken place at a price higher than HM Revenue & Customs consider fair, they may seek to assess the difference to Income Tax. This can limit the proceeds that a private shareholder can obtain on a sale into trust. However, the employee trust can also be used to create an internal market for the shares providing an opportunity for employees to realise value for their shares. The existence of an internal market removes part of the justification for discounting the value of private company shares and can therefore result in a higher value.
Implementing a succession plan
If you would like further information on any of the matters raised in this article, please call us on 020 8949 5522 and ask to speak to any of our advisers. More detail on the benefits of transferring companies to full employee ownership is given in the article All together now in the Professional Focus section of our June newsletter, supplied by Baxi Partnership.
(1) This may be avoided if the shares have been held for at least five years, the sale is substantial and the shareholder retains less than 30%. of the equity.
(2) HM Revenue & Customs can in principle attack any arrangements they regard as tax avoidance, but we are not aware of any such action in relation to a bona fide sale to an employee trust.