EOTs for smaller businesses: what are 5% participators, and why do they matter?

If you are thinking about selling your business to an employee ownership trust, or EOT, you need to understand the rules about “5% participators”. These rules can be very important. In some cases, they can stop you selling your business to an EOT altogether. They can also affect the tax benefits after the sale has taken place.

These rules are most likely to be relevant for:

• very small businesses;
• businesses that employ family members; and
• businesses with more than one class of shares.

We explain what a 5% participator is and give some examples of when the rules can cause problems.

We also explain when these rules can affect an EOT sale.

Before you go ahead with an EOT, it is important to know whether these rules could affect you or your business.

What is a 5% participator?

For EOT purposes, a 5% participator is someone who:

·       already owns 5% or more of the company’s shares;

·       has the right to buy 5% or more of the company’s shares, for example through share options; or

·       would be entitled to 5% or more of the company’s assets if the company was wound up.

A person can also be treated as a 5% participator if they own, or have rights over, 5% or more of any one class of shares in the company.

Why do 5% participators matter?

The number of 5% participators in your company can matter before the EOT sale, and after it.

A: Before you sell to an EOT

In some cases, having too many 5% participators can mean that the sale does not qualify for EOT tax relief.

This is because of a rule called the “limited participation requirement”. Under this rule, you need to count:

·       directors or employees who are 5% participators; plus

·       any directors or employees who are connected with them, such as spouses, children or other relatives.

Together, these people must not make up more than two-fifths, or 40%, of the total workforce. This calculation is known as the “participator fraction”.

If the participator fraction goes above 40% at any time in the 12 months before the EOT sale, a seller who owns 5% or more of the company will not be able to claim capital gains tax relief on the sale.

B: After you sell to an EOT

If the participator fraction goes above 40% after the sale, but before the end of that tax year, the capital gains tax relief already claimed may be clawed back.

There is also a rule about the EOT trustee board. The 5% participators must not make up the majority of the trustee board, either at the time of the sale or afterwards. If this rule is not met, the EOT may be disqualified and the tax relief may be clawed back.

Some examples of how the limited participation rule can work in practice

Example: very small businesses

Company X has 5 employees. Three of them are shareholders, and each owns one third of the company. Each of those shareholders is a 5% participator.

The participator fraction is 3 out of 5, or 60%. This is above the 40% limit, so the limited participation requirement is breached.

Example: businesses that employ family members

Company Y has 14 employees. There are four shareholders: Anne, Barbara, Christine and Davina. Each owns 25% of the company, so each is a 5% participator.

The participator fraction is 4 out of 14, or about 28.5%. This is below the 40% limit, so the limited participation requirement is not breached.

However, this changes if family members also work in the business. For example, if Anne and Barbara’s husbands both work for the business, and Christine’s daughter and Davina’s son also work there, those connected people must also be counted. This means there are eight people to count. The participator fraction becomes 8 out of 14, or just over 57%, so the requirement is breached.

Example: businesses with different share classes or share options

Company Z has 35 employees and 1,000 Ordinary Shares in issue. There are 5 shareholders who each own 200 Ordinary Shares. Each shareholder is a 5% participator.

Company Z has also set up a share option plan for employees, using a new class of B Shares. Ten employees have options. Each option gives the employee the right to acquire 10 B Shares. In total, there are options over 100 B Shares. If all options were exercised, there would be 1,100 shares in issue: 1,000 Ordinary Shares and 100 B Shares. Each option holder would own less than 1% of the company’s total shares.

However, each option holder would have rights over 10% of the B Shares. Because this is more than 5% of one class of shares, each option holder is treated as a 5% participator.

This applies even before the options are exercised. A person only needs the right to acquire shares. They do not need to already own the shares.

This means Company Z has fifteen 5% participators: the 5 existing shareholders and the 10 option holders. With 35 employees, the participator fraction is 15 out of 35, or about 43%. This is above the 40% limit, so the limited participation requirement is breached.

Next steps

These rules are important if you are thinking about putting an EOT in place.

They are also important if you are thinking about giving employees share options or other share-based incentives, and an EOT might be a future exit route. Careful planning can help you avoid accidentally creating problems with 5% participators later on.

Our team has deep experience in employee share ownership, including reviewing and designing share plans before and after an EOT sale. If you would like advice on this topic or have any other employee ownership queries, please contact us at enquiries@rm2.co.uk to arrange an initial consultation with one of our friendly experts