Company Equity - Tax Implications

[phoenixdave]

Hi Everyone,

I'm looking for guidance on an equity proposal I have receivedfrom work and the tax implications. Last year my MD made a proposal that I would receive 5% equity in the company for achieving a sales target in 2020, which I did achieve. I can also now accrue a further 5% in 2021 for reaching the same target again.

Based on a recent company valuation the first 5% would be worth circa £80k. I spoke to my MD yesterday about the paperwork and he has been speaking to his legal contact regarding the equity/paperwork and he indicated the following options based on the feedback:

A) If I take the 5% equity now, it would essentially be a company benefit and would be immediately taxable so I would need to pay circa £40k in tax
B) Alternatively, I can be given the paperwork that entitles me to the 5% upon sale of the company and then I would need to pay the tax at that point when receiving the value of the equity (which will of course hopefully be worth more then too of course)

Both are reliant on my staying within the business until point of sale which I intend to do. With A), if I leave I would need to sell my shares back I guess.

I don't have any previous experience so could really do with advice on what the pros/cons of each approach are and if there are any other ways to structure this to minimise the tax I would need to pay.

Any and all advice would be very gratefully received.

p.s. I don't have £40k so would need to source this in order to go with option A.

If you need more information to assist, please ask.

Many thanks,

Dave

[Lambs]

P,

Although you cannot drive this as the employee, your MD/shareholder(s) should really/also be looking at the Enterprise Management Incentive Scheme ("EMI") or similar. This is an "approved" route to employee share ownership, and basically everyone benefits.

Much will depend on the long-term goal. Is it for you / your 'generation' to buy out the MD/current owners - so essentially a transfer of current ownership - or is the goal to lock in key staff with an equity stake, with a view to floating /selling to a 3rd party?

The 2 aims are not necessarily opposite one another. But the optimal route may differ.

With regards,

Lambs

[phoenixdave]

Hi Lambs,

Many thanks for responding.

The EMI Scheme looks interesting and will mention this to the owner.

The company is privately owned by Husband and Wife team. I am the only party being offered this as both a reward and an incentive to help increase the value.

I know they have an intention to sell in the next few years (circa 5 yrs or earlier if can get the value to the right level). I would love to be able to buy them out and I know they would be open to that but sadly I don't think I would be in a position to get the necessary capital.

Therefore, the more realistic likelihood is they will sell to a 3rd party and I should focus on helping increasing the turnover and attractiveness of the company so the value of my 5% also increases and at that point and I look to retain a key position under new ownership.

Regards,

Dave

[Lambs]

P,

If you are the right wo/man for the job, then there are ways to achieve the aim of buying them out. You can borrow, and/or they can take their sale proceeds out of the company's profits for some years to come, so you do not necessarily need to 'magic' large sums at a particular point in time.

But this is not something for a forum post. I recommend that you speak to a competent professional yourself. Much as it pains me to admit this as a tax specialist, tax efficiency is a subsidiary consideration. It should NOT be driven by tax, although there can be more and less tax-efficient ways to achieve whatever proves to be your goal.

With regards,

Lambs

[phoenixdave]

Hi Lambs,

Apologies for not responding sooner, we had a COVID emergency come up.

Many thanks for your guidance, I do appreciate it. Based on it, I took the decision to discuss the possibility of me potentially buying them out over time with them to see if this was a viability (before committing both emotional and time investment if they were contemplating a 3rd party purchase only), and they are in agreement this is a definite possibility so we will explore this further and I will speak to the appropriate professional as you recommended.

In the interim period, however, I did have one more question about the immediate equity element if you were able to help me.

At the moment, the 5% being given to me would incur an income tax charge. However, is it legitimate for me to pay the company a reduced sum for the shares so that I have purchased them rather than been gifted them? This would then mean that no income tax would be payable.

I looked into the EMI scheme you recommended and I appreciate that with this approach I would then have to pay the Capital Gains Tax on the difference between what I paid for the shares and the eventual value at point of sale but I just wanted to see if this was a legitimate approach.

Thanks again in advance.

Kind regards,

Dave

[Lambs]

P,

I am pleased that the path seems open to you.

With regard to the tax aspects, you are right that purchasing instead of gift will make a difference. However, I suspect it does not work quite how you might think or hope.

Essentially, the risk that you might be considered to be subject to Income Tax on the shares is by reference to your having 'earned' them by reason of your employment. The extent of the 'reward' falls if you also put some money towards them, but it does not change the underlying nature of the transaction. Instead, it merely reduces the amount that is exposed to Income Tax - simply, it becomes the difference between their 'worth' and what you paid for them, rather than the difference between their 'worth' and £nil when they were going to be a gift.

As your employer, it is largely (or perhaps at least initially) down to the director/shareholders to determine if they believe it is a reward for employment or something else, such as might arise out of long-term friendship. However, while technically arguable, the "family / social arrangements" line would be difficult to take if your ultimate aim were to buy out the current director/shareholders - that's a commercial deal, unlike where they might give all their shares to their children for £nil or similar.

It is further hampered by the fact that it is really the current director/shareholders who are driving these transactions, and should therefore be getting the advice.

These are complex issues, and difficult to convey in a forum format. But the short version is that your buying for anything less than their current value will leave you potentially exposed to an Income Tax charge - and possibly even NICs (although this is generally considered unusual in a small family company). Your director/shareholders really should look into EMI Schemes on the bases that: a Management Buyout is plausible; or you are a valuable employee that they want to lock in, in anticipation of a future sale. This would initially mean your getting options to buy, rather than actually getting the shares straight away. But the upsides to an HMRC-approved EMI regime are pretty good.

Proper professional advices is the way forward. Good luck, and if you do happen to become the proud owner of a company in the next 3-5 years, please feel free to update the thread!

With regards,

Lambs

[phoenixdave]

Thank you so much, it's great to know the implications and that makes sense re: relevance of difference between sum paid and value rather than sum paid and £0.

I think deferring the shares until point of sale is probably my best move (and possibly only given immediate income tax implications to the alternative) in conjunction with pushing them to look at an EMI scheme.

My only concern would be leaving employment before that time but that is just a risk I have to take. The alternative approach would present its own risk anyway of course if I paid income tax on shares and then company folded.

I really appreciate the advice and that has helped make things clearer in my mind.

Thanks again and best wishes.

Dave

[Lambs]

P,

Most welcome.

Your / their risks if you leave can be addressed by "good leaver" and "bad leaver" options. I go back to my original advice: get some, but not tax first. An accountant or lawyer with experience of doing deals such as this might well save you years of frustration. And maybe get some tax advice when you have an outline plan.

Regards,

Lambs

[phoenixdave]

Hi Lambs,

Sorry, I just thought of one more question. How would the HMRC work out the value of the shares in order to determine the income tax payable against it?

All I have to work with is the 5% equity offer and the MDs suggestion of the value but company value is obviously a perception until its actually sold.

Kind regards,

Dave

[Lambs]

P,

There are various methods, such as a (discounted) 5% stake in the company's Balance Sheet value, or in the value for similar businesses being offered on the open market today, or that have sold recently, or based on the income (dividends) that it has historically paid out. It's a specialist field and too complex to discuss in detail here. Again, it would primarily be for the current director/shareholders (employers) to determine, subject to (dis)agreement by HMRC.

With regards,

Lambs