Family Owned Businesses, EBTs and Inheritance Tax
Why companies use EBTs
You have heard about EBTs. Some have been used for failed tax avoidance schemes but this articles explains how you can use one to help. Privately owned companies that operate employee share schemes often find it useful to put in place an Employee Benefit Trust (EBT). This is mainly helpful because private companies, of course, do not have an easy way to buy or sell shares from shareholders, including employees who cease employment. An EBT can provide a trading platform for shares; or simply a warehouse that holds onto shares until they are ready to be awarded to employees. EBTs can also help to deal with concerns about dilution as they create a way of ring-fencing a pool of shares for use in employee share schemes that are effectively kept separate from other shares in the company.
Frustratingly, the tax and trust law legislation establishing and running EBTs is designed for family trusts. However, we have lots of experience and can help you set us arrangements with minimum fuss.
This briefing looks at one particular aspect which arises for companies controlled by a small group of shareholders where inheritance tax (IHT) is a concern. A typical example might be a family owned business where the Company pays into the EBT, a shareholder then sells or transfers his shareholdings into the EBT and then shares are held for the employees (e.g. through an EMI scheme.)
IHT and EBTs
IHT does not just apply on death (when the charge is 40%[1]), but also on certain transfers of property during a person’s lifetime (when the charge is 20%). This usually includes gifts or transfers at less than market value (broadly, if the donor’s estate is reduced by the transfer). That includes gifts or sales of property or assets to trusts.
IHT and family owned businesses
Special IHT rules apply to “close companies”. A close company, broadly, is one controlled by 5 or fewer people, or controlled by any number of participators who are directors[2] – so that will include many small family businesses.
The close company rules are trying to ensure that a small group of closely connected people (known as the “participators”) don’t use a company to transfer assets without paying IHT. As a result, there can be an IHT tax charge on the value of the transfer appointed to key shareholders[3]. (No charge arises for shareholders/participators holding less than 5% of the share capital.)
IHT exemptions for EBTs
There is a particular IHT exemption for EBTs[4]. A gift in to an EBT by a close company[5] (e.g. a payment to allow the EBT to buy shares) will be exempt from IHT if the EBT meets certain requirements which, in summary, are as follows:
- Must be used to benefit most of the employees and directors (and their dependents) in the company (or in a group of companies);
- Must not be used to benefit any of the participators or persons connected with them (unless they hold less than 5% of the share capital).
This kind of trust is generally known as a “section 86 trust”. A section 86 trust, therefore, provides an exemption for family owned businesses wanting to transfer shares into an EBT, but only if the owners (and people connected with them) are not able to benefit under the trust (unless they hold less than 5% of the shares), or if when they acquire the shares they pay Income Tax on the full value[6].
A difficult IHT scenario?
You therefore need to be particularly careful if you have:
- A close company;
- With high value;
- Wishing to fund an EBT;
- When the EBT will be granting an option (rather than giving free shares) to a director; or
- When the EBT will be granting an option (rather than giving free shares) over more than 5% of the shares to any employee (or to an employee already holding more than 5% of the shares).
Getting around it
The key thing to remember is, firstly, this set of conditions is relatively rare. For example, there will only be a problem with directors if they also control the company; and it is not always the case that individual employees will benefit under an EBT to the tune of more than 5% of the share capital.
However, should the position arise, bear in mind the following:
- You can include directors and 5% shareholders without a tax liability if they are going to pay income tax on the full value of the shares they receive – so not normally an EMI.
- Most EBTs in private companies do not acquire shares at the start but only when options are exercised or when someone leaves. That means there are only small amounts of funds going into the trust and thus a small exposure to IHT.
- In fact, the actual liability can be very small, particularly in a smaller private company. For example, each shareholder has a proportionate part of the value allocated to them; this can be reduced by the annual IHT exemption (£3,000) – including a one year carry forward if unused; furthermore business property relief may apply.
- For close companies with higher values, or for shareholders with larger holdings, the nil rate band (currently £325,000) can be used to prevent an immediate liability.
There are alternative approaches – including company buyback and cancellation of shares, or using treasury shares, although these have other drawbacks.
Finally, it is of course always possible to calculate the potential tax liability, and insure against it.
Conclusion
An EBT is such a useful tool for companies looking to extend ownership to employees, directly or indirectly, and particularly for privately held businesses that although there are some technical difficulties (and these are not limited to the points covered in this briefing), these can usually be overcome with good planning.
For further guidance on using EBTs, contact a member of our team on 020 8949 5522, or via enquiries@rm2.co.uk.
[1] Subject to the nil rate band, currently £325,000
[2] Corporation Tax Act 2010 Section 439
[5] Similar rules apply to an individual transferring property to an EBT, except that the exemption from IHT will only apply if within a year of the transfer the EBT holds a majority of the ordinary shares in the company, and has a majority of the voting power (Section 28 IHTA 1984).
[6] Section 12(1) IHTA 1984
