I was introduced to a new client the other day, and found myself envying him!He had a brilliant idea for a new business venture, and he had recruited a very bright young lady fresh out of Business School to run it for him. He looked set to make a great deal of money.He had a problem, however. The business idea couldn’t be patented or otherwise protected, and he was worried that his bright young lady would hang around long enough to pick up how the business model worked, and then walk out and set up something similar for herself.
It was a very real risk – in fact, I have to admit I had briefly considered doing much the same thing myself as he was explaining his ideas to me!
He wanted to offer her a slice of the business, in the form of shares in the company he was setting up. To keep her loyal, she would have to sign an agreement that if she left the company, she would sell these shares back for what she paid for them. If she ran the business well, she would get more shares.
Letting key employees have a slice of the cake is not a new idea, but it is often a good one. The problem is that, largely because such schemes have been used to avoid tax in the past, there is a fearsome array of tax traps that can catch both the employee and the company.Two of the biggest problems are:
The Market Value Rule
If an employee gets the shares for nothing, or pays less than the market value for them, he will have to pay income tax on the difference, and he and the company will have to pay national insurance contributions.Valuing shares in private companies is notoriously difficult, and the taxman will only tell you if he agrees with your valuation once it is too late – in a “post transaction ruling” after the shares have been issued.
Nearly all shares in private companies given to employees have some sort of restrictions placed on them – most typically as with my client, the employee has to sell them back to the company if he leaves.
There can be further tax (and NIC) charges on “restricted” shares – in the worst case, most of the gain on a sale of the shares could be charged to income tax and NIC, instead of being treated as a capital gain. If the restrictions on the shares are changed (for example, if you stay with the company for five years, the shares become yours absolutely) there can be a similar charge on the increase in value of the shares because the restrictions have been removed.
The Enterprise Management Incentive Scheme (“EMI”)
This is a scheme approved by HMRC, which allows companies to let their employees acquire shares without all the associated tax charges. Provided the rules are followed, the only tax the employee will pay is capital gains tax when the shares are eventually sold, and this will probably be at a rate of 10% or even less – often, there is no tax to pay at all.
The basic points about the scheme are:
1 Employees are granted “EMI Options” – these allow them to buy a certain number of shares at a certain price at a specified time in the future, which can be anything from immediately to up to ten years later
2 Provided the price to be paid for the shares is not less than their market value on the day the Option is granted, there will be no tax or NIC when the shares are bought, and this value can be agreed in advance with HMRC. Assuming the company grows in value during the period between granting the Option and buying the shares, the employee may well be able to pay less for the shares than they are worth on the day she buys them, and will not be taxed on the difference
3 Unlike most HMRC-approved share schemes, the EMI does not have to be offered to all employees – many schemes are set up just for one key person
4 Up to £100,000 worth of shares (or 30% of the value of the whole company if less) can be offered under the EMI
5 The shares offered can have as many restrictions as the employer likes, without creating the tax charges that usually go with them.
The EMI was ideal for my client. It would encourage his star employee to stay with the business, by offering her a chance at a virtually tax-free gain if the company was sold, and the chance of tax-efficient dividends from her shares in the meantime.
Any company that wants one or more of its employees to have a slice of the cake should consider two points:
1 The EMI scheme is the most versatile of the tax-approved share schemes
2 Letting employees have shares without using a tax-approved scheme will nearly always lead to serious tax problems for both employer and employee!