Is my company too small for an EOT? – Three key questions for family-owned businesses
Transitioning to an Employee Ownership Trust (“EOT”) can be the perfect solution for smaller family-owned businesses looking at succession planning.
However, there is a specific qualifying point that occasionally presents an issue for these types of businesses. This is known as the “Limited Participation” requirement.
We recommend three key questions to ask before you embark on an EOT transition, to make sure your company meets this requirement – and that it continues to do so afterwards. Even if your company qualifies at the time of transition, it is very easy to fail the Limited Participation test after the transition. This could result in a clawback of capital gains tax relief from the selling shareholders, or the EOT itself.
1. How many shareholders and employees do you have?
An individual who holds 5% or more of the shares in a company is known as a “Participator”. If Participators make up more than 40% of the business’s workforce, this will mean that the company will not meet the Limited Participation requirement. This measure is called the “Participator Fraction”.
For example: Briggs Limited has 12 employees. There are 5 shareholders, each holding 20% of the share capital, all of whom work in the business. The Participator Fraction is 5/12 = 41%. Briggs Limited will not qualify for an EOT.
The Participator Fraction must be met for at least 12 months prior to the EOT transaction, and this must remain the case until the end of the tax year of the transaction (and for a further tax year for capital gains tax relief not to be lost for selling shareholders).
2. Do you employ family members, even if they don’t have shares?
Any employees who are “connected” with Participators are also counted as Participators, even if they hold no shares themselves. If, for example, you employ your spouse or children, your company can also fall foul of the rule. Furthermore, the definition of “connected” is very wide, including uncles, aunts, nephews and nieces.
For example: Boggs & Daughters Limited has 12 employees. There are 2 shareholders, Mr and Mrs Boggs, holding 50% of the share capital each. Mr and Mrs Boggs employ their 2 daughters, and a nephew, in the business.
Mr & Mrs Boggs are Participators and, by family connection, so are the daughters and the nephew. Hence there are 5 Participators. The Participator Fraction is 5/12 = 41%. Boggs & Daughters Limited will not qualify for an EOT.
If the Company did qualify and sold to an EOT, note that if the company is sold on in the future the daughters and nephew, being Participators, would then be excluded from benefitting from that sale via a distribution from the Trust.
3. Do any of your employees have share options?
Finally (and perhaps quite unsportingly), you don’t actually have to own shares directly, or even be a family member, to be treated as a Participator. Any person who has the right to acquire 5% or more of any class of share in the company will also be treated as a Participator.
For example: Box Co Ltd has 12 employees. There are 4 shareholders, each holding 25% of the Ordinary Shares. Enterprise Management Incentive (EMI) options have been granted to two key employees, over non-voting B Shares. The options give each of the two employees the right to acquire 50% of the B Shares in Box Co – although their overall percentage of the entire share capital would be very small.
The four existing shareholders are Participators. The two optionholders are also Participators – even though they do not hold shares directly. Hence there are six Participators. The Participator Fraction is 6/12 = 50%. Box Co Limited will not qualify for an EOT.
To add insult to injury, if the Company did qualify and sold to an EOT, note that if the company is sold on in the future the two optionholders, as Participators, would then be excluded from benefitting from that sale via a distribution from the EOT.
Finally, it’s also possible to fall foul of the Limited Participation rule after the EOT transaction, for example if a new employee share scheme is introduced for a number of key employees which uses a different class of shares.
These are extremely common scenarios in smaller family owned businesses. Even if a company is wholly owned by mum and dad, if they employ family members then this can create an issue in terms of qualifying for an EOT, and may be a showstopper.
Furthermore, when privately owned businesses set up share schemes, it’s more likely than not that they will create a different class of shares for use in that share scheme. This might be to ensure those shares don’t carry votes, or to enable different classes of dividends to be paid on “founder” and “employee” shares. Even if this doesn’t prevent the company from qualifying for an EOT, it can create a severe – and, in RM2’s opinion – very unfair disbenefit for employee option-holders with a potentially tiny percentage of the overall share capital.
Good EOT advisers should be alert to these pitfalls at an early stage, as potentially an unwitting selling shareholder could lose their 100% capital gains tax relief if the Limited Participation test is not met, which would be an unpleasant surprise.
The devil’s in the detail as they say… fortunately here at RM2 we thrive on the detail. If you would like to speak to us about moving your company towards employee ownership contact us at firstname.lastname@example.org and we can arrange a call for you with one of our specialist team.
Please note that this blog article provides an overview of current legislation only and detailed guidance should be sought in all situations.