EO Explained: EO Bonus vs Trust Distribution

Continuing our series of articles explaining Employee Ownership (EO) we explain the difference between the EO Bonus (Profit Share) and Trust Distributions.

It is often assumed that the EO Bonus that benefits from tax free payment up to (currently) £3,600 to all employees is a trust distribution. In practice, this is a share of the profit from the company to employees as a result of being employee owned. It is not a distribution of the trust limited to beneficiaries.

Here we explain a few of the underlying principles.

Principles of EO Distributions to Employees

One of the recognised benefits of being an EO company is that profit share distributions can be made with a tax free element – currently £3,600 can be paid to employees free of any tax payment by the individual and the company (NI still has to be paid).

However, this profit distribution is not the same as a distribution by the EOT to Beneficiaries of the trust. Too frequently the payment of each are confused.

Profit Distribution

As long as a company profit has been made, this is available for distribution to employees whether or not any deferred consideration (or other payments due under the EO transaction) have been paid in full. Hence, an EO can pay out profits to employees alongside the repayment of the deferred consideration (which is also paid out of profits).

The profit distribution to employees is often referred to as a profit share, rather than an EO bonus. This ensures that it is not confused with any other bonus schemes in place in the company (such as sales bonuses or performance bonuses). The term profit share also then clearly aligns receipt by employees with their contribution to the profit of their business.

Calculation of the amount of profit to be shared with the employees should be balanced with other financial commitments of the company (current, future and potential), such as tax, investment, strategic spend, etc. The company should not be put in financial jeopardy to pay employees a cash amount.

Company Dividends

There is no profit distribution, or dividend, payable to the Trust Company as shareholder. Under the terms of the EO transaction it will have waived its rights to a dividend.

If there is a minority shareholder, a dividend may be paid to them based on their quantum of shares held. The amount may be similar to the amount payable as a EO bonus, but is not an equivalent payment and the EO bonus should not be confused with, or termed as, a company dividend,

Trust Distribution

The only distribution to Beneficiaries of the trust is on the sale of any assets held by the trust company, ie on sale of all or some of the shares.

It should be noted that on the sale, any residual Capital Gains Tax (CGT) will need to be paid, either by the original vendors or the trust, depending on time of the transaction and period since the original sale. Tax is also payable on any Tax Distribution by the Company and the individuals in receipt of funds.

Recipients

In order to meet the equality principles of EO legislation all employees must participate in an EO bonus scheme. Exclusions can only be made for:

• New employees up to 12 months;
• Those under a disciplinary hearing, until the outcome is known and, if the claim is dismissed, their EO bonus is then payable;
• Those employees who have resigned and are working their notice
• Directors of the company.

Any exclusions must be incorporated into the written scheme terms.

Trust distributions are limited to trust beneficiaries as defined in the Trust Deed, and may include employees who have recently left the business. Beneficiaries will exclude those related to the original vendors or with direct shareholdings over 5%.

Frequency

EO bonus payments are made during each employment tax year (April onwards) aligned to profit from the previous financial year of the company.  

Multiple payments may be made during the year either as and when profit is realised, or to stagger the impact on the balance sheet. However, care should be taken to not put the business at financial risk as a result of one off large bonus payments or as a result of staggered in-year payments.

Trust distributions are made only on the sale of shares, with no staggered distribution to beneficiaries.

Requirements

The terms of an EO bonus scheme must be documented, although it can be flexible enough to be adjusted year-on-year.

There is no requirement for a long detailed bonus policy, but written evidence of its existence must be available if payments are ever challenged for example by HMRC.

Any trust distribution, which by its nature is likely to be significantly more than an EO bonus distribution, should be:

• Backed by professional external advice;
• decided by the trustees, not the Company, and
• Clearly documented to evidence alignment to EO legislation, principles of equality distribution and trustee discussion.

Further Thoughts

An EO Company may have additional bonus or incentive schemes sitting alongside the EO Profit Share, however, they should be clearly defined as separate schemes.

The terms of an EO distribution, whether it is an EO Profit Share or a Beneficiary Distribution, should follow the legislative guidelines in terms of equality.

This means that distributions should be made to all eligible recipients on an equal basis.

The calculation can only be made based on the same amount given to all, or a combination of one or more of the following calculated on a points basis:

• Length of service
• Hours worked
• Salary.

Care should be given to ensure that certain teams or groups of individuals do not unfairly benefit from the distribution methodology to the detriment of others. The equality principle is a core principle of EO that should be front and centre in all calculations.

Conclusion

Too often employees associate the only benefit of EO as being the profit share. It isn’t and future EO Explained will delve into this topic further. But as a tangible, cash in hand benefit, it is very visible. As such, care should be taken to apply the legislation correctly.

Communicating EO bonus distributions as a share of the profit made by all employee contribution, can reinforce the benefit that all individuals get through their own, and their colleagues, hard work. It can form the basis of greater employee engagement and participation when calculated and communicated well.

All IDTs members have access to the IDT Toolkit which includes bonus distribution calculation tools available through them to our EO clients. If you would like to discuss this topic further, do get in touch with one of our trustees or contact us at info@directorsandtrustees.co.uk