Employee buy outs: an alternative succession solution for professional partnerships
It's common for UK professional partnerships to adopt a "naked in/naked out" approach to membership. In broad terms, new members of the partnership are not required to contribute a substantial sum on joining the partnership (naked in), but equally they don't get more than that initial contribution (possibly plus interest) when they leave the partnership (naked out).
In such circumstances it is relatively easy for partners to move in and out of the ranks. The "naked out" part of this means that a retiring partner does not realise a capital return for goodwill built up over time. What the partner gets is a share of profits over the time he or she was a partner. This business model can stand the test of time. There are no distracting discussions on what "my equity" is worth and "how will I get paid that increase in value"? But it is not the only way to maintain the independence and longevity of a business.
Some partnerships don’t adopt the naked in/naked out approach. Their partners expect a capital return on retirement. Delivering that return or switching to the naked in/naked out approach can be problematic.
An alternative route is now available for professional partnerships: employee ownership. This is a simple model and gives employees a collective ownership of the company (a preliminary step of course being the conversion of the partnership to a company). This is particularly relevant now because of the availability of two new tax exemptions:
(a) from April 2014 there is an exemption from capital gains tax (CGT) on gains on certain disposals of shares in a trading company (or in a holding company of a trading group) that provides an employee ownership trust (EOT) with a controlling interest in that company; and
(b) from October 2014 there is an exemption from income tax (but not national insurance contributions) of £3,600 per employee per tax year for certain bonus payments made to all employees of a company or group where an EOT has a controlling interest.
The CGT exemption has attracted attention to employee buy outs as a succession solution. Instead of a sale of shares being taxed typically, for owner managers, at an effective rate of 10% after entrepreneurs’ relief, there is an unlimited exemption from CGT.
The income tax exemption means there can also be a tax benefit for all staff in this business model. In most cases dividends otherwise payable to the EOT as a majority shareholder are waived by its trustee and are paid out instead as bonuses to all staff – tax free up to £3,600 per employee per tax year. This is a key concept – instead of external shareholders receiving dividends and staff bonuses being paid simply at the discretion of a board of directors, the EOT model provides staff with an economic stake.
Tax should not be the sole driver of employee ownership. Other ingredients need to be thrown into the mix, including a willingness on the part of the current owners and the employees to make employee ownership work, but the tax incentives available are significant and should be taken into account when considering what legal form a business should take and succession planning options.
If you would like to know more about succession planning for professional partnerships or converting a business to employee ownership please contact Graeme Nuttall OBE (author of the Nuttall Review and champion of employee ownership) or Guy Burman.