EOTs Going Wrong – an update

The overwhelming marketing content related to employee ownership trusts (“EOTs”) talks about the great benefits of employee ownership and highlights the tax savings for the sellers. However, very little mention is made of how things can go wrong and what can be done to reduce the risks.

In my articles from May 2024 and August 2023, I looked at some of the situations where EOTs have not gone as well as the sellers and the management team in the businesses had hoped at the time of the transition. EOTs continue to be a popular exit route for business owners, and I continue to receive a steady stream of enquiries relating to things going wrong; therefore, I thought it would be a good time to revisit the common themes from the enquiries.

Common themes

The main reasons for problems with EOTs fall into two main themes:

• Structural issues involving the relationship between the parties
• Legal issues regarding the transaction and compliance with the EOT legislation

Structural issues

The structural issue themes usually revolve around the relationship between the sellers (usually the founders of the company), the management team whose job is to take the business forward, sometimes working with the sellers who have stayed on in the business, and the trustees of the EOT.

The founder not “letting go”

This is what I sometimes call the “Elsa syndrome” and reflects the founder continuing to operate after the transition in the same way as they did before the transition (although Elsa does learn to let go eventually). There is no recognition that the founder has to report to the EOT trustees who have the power to change the directors of the trading company.

Even when the founder has stepped back from day-to-day operational activities, they may question the ability of any new management team to run the business and try to use any “negative control” provisions in the sale agreement or articles of association of the trading company to hamper the running of the business. There may be a reluctance to adopt new or different business practices.

Valuation and inability to pay

The changes brought into effect from 30 October 2024 requiring the trustees to take all reasonable steps to ensure that they are not paying more than market value for the shares, should prevent wildly optimistic valuations. However, we have seen some odd-looking valuations since October 2024, including one where the valuer wanted to include money held within an employee benefit trust (“EBT”) as part of the cash reserves of the company. I am sure liquidators would love to be able to access cash held within an EBT if the trading company becomes insolvent; they would expect robust resistance from the EBT trustees.

Pre-30 October 2024 valuations can still cause problems, particularly if the valuation is not backed up by a robust cash flow forecast showing the affordability of the deferred consideration. However, there can still be economic or tax changes that have altered the business plan – how many businesses could have foreseen the impact of US tariffs on global business? The ability to pay is key to a successful EOT. It is no good putting the management team under pressure to pay the unaffordable. The employees will not be motivated if they see no reward from employee ownership, a lack of investment in the business and all the spare cash being paid to the former owner. The sellers could be left with nothing if the management team and the employees decide to “walk away”.

Agreeing a “down-valuation” can be tricky. HMRC may look closely at the original valuation with the ability to charge income tax on the seller on any excess valuation, even if the money is never paid. Releasing part of the consideration could create an inheritance tax issue for the sellers due to complicated tax rules involving close companies. Any reduction in the consideration needs to be documented and justified in reasonable detail.

An inability to pay the deferred consideration usually results in the emergence of the Elsa syndrome in one form or another.

Interest on deferred consideration

The charging of interest on the deferred consideration raises questions regarding the structure of the transaction. The EOT trustees have to ensure that no more than a commercial rate of interest is paid for EOTs acquiring shares after 30 October 2024. What is a commercial rate of interest? A recent set of paperwork for review had interest at 3.5% above base rate on the deferred consideration; an annualised interest charge of more than £330,000, which would be subject to income tax in the hands of the sellers. The default interest rate was set at 9% above base. As an adviser, I have to question the affordability and ability to pay. A large number of sellers choose not to charge interest on the deferred consideration, taking into account of the relief from CGT on the consideration for the shares from the EOT and the fact that income tax is payable on any interest received from the EOT.

Rolling up the interest until the end of the payment term can result in a huge lump sum, particularly if the rolled-up interest is compounded (with interest being charged on interest). The lump sum is subject to income tax and is not CGT-free.

Technical issues with the EOT paperwork and running the EOT

There are a large number of traps that can catch out advisers and their clients.

Trading requirement

The company or the group must be a trading company. In very simple terms, a trading group requires subsidiaries to be at least 75% owned. An interest in a partnership, including a Limited Liability Partnership (“LLP”), is treated as an investment, as is a shareholding in a 50:50 joint venture company. A partnership or a 50:50 JV company is not fatal to an EOT provided the “investments” account for less than 20% of the value of the whole group (using different measures, including profit, turnover and use of resources, including employees). However, the existence of an LLP, a company with less than a 75% shareholding or a 50:50 JV company should be a “red flag” at the outset.

Call options over the shares

The EOT must be entitled to control the shares it has acquired; it cannot give up control on an involuntary basis. An option in favour of the sellers (known as a call option) to reacquire the shares for a nominal amount in the event that any of the deferred consideration is not paid would breach the “controlling interest requirement”. The result is that the EOT does not satisfy the requirements for the tax relief from the outset – no CGT relief for the sellers and no income tax-free EOT bonus for employees. It does not matter that the option is never triggered; its existence is enough to prejudice the EOT.

Granting share options over shares held by the EOT

It is increasingly common for companies to grant share options to senior staff after the sale to an EOT to encourage the senior staff to stay and increase the value of the business. The option cannot be satisfied by the transfer of shares from the EOT as this would breach the “equality requirement” which requires all employees to be treated equally (subject to salary, length or service or hours worked). A discretionary share option to a handful of senior staff would breach the equality treatment.

Payment of the EOT bonus

Sellers and their relatives are “excluded participators” and cannot benefit from the capital value of the EOT fund. However, there is no such restriction on the payment of an EOT bonus, which must be paid to all qualifying employees, including any excluded participators. The sellers can waive their entitlement to the EOT bonus. From 30 October 2024, EOTs can provide that all directors are excluded from receiving the EOT bonus – a bit tough on directors who did not sell any shares to the EOT. Not paying the EOT bonus correctly can prejudice the income tax-free status of the bonus, leaving unhappy staff and the employer facing a tax bill from HMRC for not deducting income tax via PAYE.

In the case of fundamental breaches of the EOT legislation, there will have been a sale of the shares to a trust that cannot be undone. The ability to claim relief from CGT on the sale may be lost for the sellers. However, the ability to pay income tax-free EOT bonuses may be possible in the future.

We can help

In addition to advising on more than 30 transitions to EO, we have assisted trustees, management teams and sellers navigate difficulties arising from their EOT paperwork. In some cases, there may be no solution to a fundamental breach of the EOT legislation and it is a matter of making the best of the situation. It may be a case of understanding the current position and preparing for the future operation of the EOT and the trading company or group.

Please contact Andrew Evans or Debra Martin should you have a need to discuss the issues raised in this article.