27 November 2023
Unlocking The Potential:
Exploring the Advantages of Employee Ownership Trusts for Law Firms
Together with John Dunlop, Tax Partner at DAC Beachcroft, we explore the advantages of Employee Ownership Trusts (EOT) and how they offer solutions to challenges currently confronting law firms nationwide:
· What to do when the founders wish to retire
· How to encourage the next generation, and beyond
· How to ensure Professional Indemnity Insurance (PII) is managed properly
· Can the founders retain an element of control whilst their role changes and can this be done in a tax efficient way?
Throughout a number of EOT discussions with law firms and other people-centric businesses, there has been a common question about EOTs; why haven’t we heard of them before?
This article aims to address this awareness gap. Please contact Ben Waterton to find out more, or for additional information on this topic online, please read the full PLC article here written by John Dunlop.
What is an EOT?
The EOT regime was created by the Liberal Democrat / Conservative coalition government in 2014 and in our view sits perfectly within the Co-operative movement within the Labour party. HMRC are currently consulting on tweaking certain aspects of the EOT legislation but it's clear to DAC Beachcroft that they are here to stay.
An EOT is a special type of trust set up for this specific purpose which acquires a 51%+ controlling interest in a trading company / group. The Beneficiaries of the trust are (with certain exceptions) the employees of the business who share in the surplus profits of the business.
The consideration paid by the EOT is, up to, the market value of the business. In theory bank finance is possible, but this will never be 100% and there will always be a degree of self-funding. This self-funding is commonly known as Vendor Finance.
What about tax?
The legislation specifically contains two key exemptions from tax:
· Any sums which the EOT pays to acquire the controlling interest in the trading company is tax free; and
· Qualifying bonuses paid to staff are tax free up to GBP3,600 per person per year (but there is NIC).
How does this help with transition?
Generally, the founders will stay with the business for a number of years post-sale. Initially they retain effective control of the business and the trust, but with time we see this transitioning to the next generation who are given the opportunity to 'step up'. The beauty of the EOT model is that from a control point of view it allows this stepping up to take place gradually and at a pace that works for each business. As per HMRC's recent update, the consultation currently is being undertaken from 6th April 2024, this may change so that for subsequent trusts there will need to be more independent trustees. We expect there to be a rush of new EOTs before any change comes into effect.
More than 1,000 businesses have become EOT-owned and according to research by the Employee Ownership Association, the upper end of the employee ownership sector outperforms the rest of UK business in terms of productivity at "two or three times the national average".
Run off insurance?
Every law firm owner appreciates that they need professional indemnity insurance but it's only as they approach retirement do they start to think about the costs of PII should the firm need to be wound up. There is no precise formula but if instead of selling to an EOT, the firm is simply closed, the cost of run off insurance can be something like three times the normal annual premium. Frequently this acts as a block on owners of some firms being able to close down the firm and retire; they have to keep working to effectively fund the insurance.
This is where an EOT comes into its own. By selling to an EOT, the firm does not come to an end with the business continuing to trade. This avoids having to pay the run-off insurance.
Our workshops will run through a practical example but we commonly see that the law firm founders are able to take out five or six years of post- corporation tax profits from the business free of tax. Founders commonly see this as the period in which they can transition from five days per week to retirement. The only caveat is that in calculating the profits one must factor in an arm's length salary for the founders.
Tax Liability Insurance?
Tax liability insurance is an increasingly popular tool for M&A transactions, especially in the UK. It can be used to help ring-fence remote (but high potential quantum) tax issues identified during or after the sale of a business to an EOT.
Whenever your tax advisors spot a grey area of tax law (a question of interpretation), and there is a risk that HMRC could challenge the intended tax implications of the sale, a one-off tax insurance policy can give sellers the certainty required to enable a clean exit, avoid residual post-sale liability, maintain valuations, and secure the full tax benefits of an EOT.
Gallagher’s specialist Transactional Risk team are available to discuss any specific enquiries you may have.
This article is written as an introductory piece only and should not be taken as advice. Whilst John is able to give legal and tax advice, Gallagher is unable to give such advice but would be happy to discuss any aspect of your insurance needs. If you have any questions please contact John Dunlop below.
Let's talk
The Walbrook Building 25 Walbrook London, EC4N 8AW
In Collaboration With
John Dunlop
Tax Partner, Corporate DAC Beachcroft
JDunlop@dacbeachcroft.com
Arthur J. Gallagher (UK) Limited is authorised and regulated by the Financial Conduct Authority. Registered Office: The Walbrook Building, 25 Walbrook, London EC4N 8AW. Registered in England and Wales. Company Number: 119013.