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Small businesses and tax benefits of incentivising a key employee

This information has been prepared by Sykes Anderson Perry Limited as a general guide only and does not constitute advice on any specific matter. We strongly recommend that you seek professional advice before taking action. No liability can be accepted by us for any action taken or not taken as a result of any information or advice given or omitted. The information herein does not constitute investment advice. Always consult an IFA if before taking any investment decision.

Business owners running a small family company find it hard to share control of the company with outsiders. This becomes important when you need to reward a talented employee to ensure they remain with the company. This short article looks at how you can keep control of your company, incentivise key employees and receive a tax benefit at the same time.

The easiest way to ensure a valuable employee / director is devoted to the business is to give or sell them shares in the company. This will mean, however, that the employee will have a say at general meetings and your control over the company will be diluted. A more suitable alternative is to take advantage of the Enterprise Management Incentives (“EMI”) Scheme. This has tax advantages for both the employee and the business owner. This is how the scheme could work.

Example

Mr and Mrs A own a shoe making business (Shoe Ltd). They would like to make sure their executive director, Miss B, who has been with the company for 7 years and helped the company grow, does not leave but they do not want Miss B to have a stake in the company. Instead of selling shares to Miss B outright, Shoe Ltd decides to grant her an EMI option to purchase a 5% shareholding (say 5000 shares). The option is exercisable on the sale of Shoe Ltd for the market value of the shares at the time of the grant. The market value of the shares at the time of the grant (1 May 2014) is £4.

The business has grown significantly and in 2020 Mr and Mrs A who would like to retire now are approached by a large clothing retailer with an offer to purchase Shoe Ltd for £10 million. Mr and Mrs A agree and the sale takes place on 1 October 2020.

Miss B exercises her EMI option and purchases 5,000 shares for £20,000 (their market value at the time of the grant of the option) and instantaneously sells them to the clothing retailer for £500,000. The retailer pays £100 per share for all the shares regardless of whether these are purchased from Mr and Mrs A or Miss B. Miss B realises a gain of £480,000. She will pay capital gains tax at 10% only as long as the EMI option has been held for 12 months which is the case here. Assuming tax-free allowance for 2016/17 is £11,000, her tax bill will be £46,900.

This is good for Miss B because she can take advantage of the Capital Gains Tax Entrepreneurs’ Relief at 10% which in other circumstances would not be available as shares normally need to be held for at least 12 months before they are sold.

What are the advantages for Mr and Mrs A? Firstly and most importantly, they have incentivised Miss B who has remained in the company and helped it grow, without diluting their shareholdings whilst they are in business. When they come to sell, they do of course receive less than had the option not been granted, but at the same time the company receives corporation tax relief of £480,000. The relief is equal to the difference between the market value of the shares at the time the option is exercised and the amount paid by Miss B for the shares when exercising her option (essentially, equal to Miss B’s gain).

Importantly, because this is an additional bonus for the buyer who purchases the company with a significant corporation tax deduction, Mr and Mrs A can negotiate a better sale price for themselves. This corporation tax deduction is often overlooked by entrepreneurs and their accountants.

Please note that there are certain criteria which need to be satisfied in order for tax reliefs to be available. We can analyse your position and advise on the availability of reliefs and advantages of using the EMI scheme in your circumstances. Please contact Sykes Anderson Perry if you would like to explore your options.

February 2015

David Anderson Solicitor Advocate, Chartered Tax Adviser and barrister (unregistered)
Sykes Anderson Perry Limited