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If you’re looking to give employees shares in your company, beware the tax implications!
I encounter many entrepreneurs who wish to recognise the efforts of their early-stage employees in creating a successful venture by considering giving them a share of their business.
Those entrepreneurs who are comfortable giving their employees shares in the company are not always aware of the tax implications.
More often than not, if they have thought about it at all, they assume that this is not a taxable event and that if there are any tax consequences at all they arise only on the employees when they receive dividends from the company, or on the proceeds of sale should they come to sell their shares in future. This is not the case!
In fact, shares are given to an employee are treated as Employment Related Securities (“ERS”) and the market value of the shares is deemed to be employment income in the hands of the employee and therefore liable to income tax.
Moreover, if the shares are “readily convertible assets”, they will also be liable to National Insurance Contributions and the liabilities for both income tax and National Insurance Contributions will need to be collected by the employer under PAYE.
Broadly, shares are readily convertible assets if they are convertible for cash, e.g. if the company is listed on an exchange or there are arrangements in place for the sale of the shares at the time they are given to the employee.
What is the result? The employee is given shares along with a tax liability, and, if readily convertible assets, a National Insurance Contributions liability.
The employee will be obliged to report the receipt of the shares on his or her Tax Return and pay the income tax arising under Self-Assessment or, if the shares are readily convertible assets, the employer will be obliged to operate PAYE and collect the income tax and National Insurance Contributions and pay them over to HMRC.
Such an employee may not be in a position to pay the tax, whether under Self Assessment or PAYE and what should be a reward for their contribution to the business, and an incentive for the future, becomes an unwelcome problem.
Additionally, there might be penalties arising from the employer’s lack of awareness of the rules around Employment Related Securities and, if relevant, the failure to collect tax and National Insurance Contributions under PAYE.
Fortunately, there are alternatives that sidestep these problems.
The government is keen to promote employee share ownership and recognises some tax-advantaged share scheme arrangements which, when operated correctly, remove these potential problems.
This article is written to provide an overview of the practicalities of issuing shares to employees and how these employee share schemes work.
An employee share scheme can take various forms.
Essentially, it is method of rewarding employees by granting them shares or offering them the opportunity to buy the shares a set price. The shares may be given directly or indirectly, immediately or in the future.
The most common form of employee share scheme operates by giving the employee a right to purchase shares in the company in the future.
Generally, a right to purchase future shares is given via the grant of an option. The option gives the employee the future right to purchase shares for a price determined at the date of grant of the option. Often this will be the market value of the shares at the date of grant of the option, but the option may provide the employee with the opportunity to purchase the shares at a discount. The option may be drafted in such a way that the employee is required to satisfy certain conditions in order to exercise the option and acquire the shares.
Share schemes can be structured flexibly, some being offered company-wide to all employees, others to specific key staff. Looking at share schemes from a commercial perspective, they may be used for an array of objectives. For example, the may be used to facilitate reward and recognition in employment packages, incentivise and motivate employees or as a measure to retain key staff.
Employee share schemes may also be used as a potential vehicle for an owner to exit from that business and can play a key role in succession planning, offering the current owners a means to encourage and develop a motivated, committed management team that could acquire the company in future.
Employee share schemes can be divided into tax advantaged schemes and non-tax advantaged schemes.
The former must be registered with HMRC and meet prescribed conditions to benefit from the associated tax advantages. The latter is anything which falls outside of a tax advantaged employee share scheme and are not required to be registered.
Non-tax advantaged share schemes do not carry any tax benefits and the receipt of shares under such a scheme will broadly be treated as employment income for the employee. Depending on the type of share and any arrangements in place, the non-tax advantage shares may be subject to PAYE and NICs, as discussed above.
Whether tax-advantaged or non-tax advantaged, there are three general methods of providing shares to employees:
If employees acquire shares directly, generally they will subscribe for new shares rather than an existing shareholder passing over their own shares.
A point which needs to be considered is that the current shareholder’s rights might be diluted by the issue of new shares, though this can be managed by creating separate share classes etc. which carry specific rights. One may place restrictions on the rights attaching to the shares given to employees for various reasons. Such restrictions often include:
Shares issued to or given to employees will generally be treated as an Employment Related Securities subject to income tax and potentially National Insurance Contributions (“NIC”) where they are ‘readily convertible assets’.
Rather than issuing shares directly to employees, a company may establish a trust for the purpose of holding shares on behalf of current or prospective employees known as an Employee Benefit Trust (“EBT”).
The trust acts as a “warehouse” for the shares, enabling employees the option to withdraw the shares from the trust at a later date whilst allowing benefits, such as dividends, to accrue within the trust. Depending on the terms of the scheme, an employee might be given the choice to acquire further shares at a discount.
Again, certain restrictions may be imposed in relation to the employee’s ability to withdraw the shares and the rights of existing shareholders and/or trustees to repurchase the shares should the employee ‘default’. A ‘default’ in relation to a share scheme might include reference to ‘bad leavers’. For example, if an employment contract is terminated after a short period of employment. Conversely, good leaver provisions might be included enabling employees to keep their options/shares. This might be the case where an employment is terminated due to redundancy or ill health.
Regardless of these restrictions, the control of the shares remains with the trustee of the Employee Benefit Trust, which will often be the owner of the company or the company itself.
The withdrawal of shares may be subject to income tax and potentially subject to NICs depending on whether the shares are readily convertible.
The primary benefit of using such a trust is that it allows the shares to be created in pursuance with share scheme arrangements. For example, it allows a founder create a given number of shares, with any attaching rights and/or restrictions, which he or she is willing to allot to employees.
Generally, where an employer gives shares to an employee, the value of the shares will be subject to income tax and potentially National Insurance Contributions if they are readily convertible assets.
If the employee subsequently sells the shares they will be subject to capital gains tax on the capital gain (assuming they are sold at a gain!)
However, a company may instead choose to grant options to its key staff rather than provide them with shares, whether directly or through a trust.
An option to acquire shares is a right to purchase shares at some point in the future for a set price, usually the market value of the shares at the date of grant of the option. Granting an option is not a taxable event and the employee will suffer no income tax or National Insurance Contributions at that point.
As an example, a share option granted to an employee might be the right to acquire 1,000 shares at £20 each on the third anniversary of the grant of the option. On the third anniversary, the employee might decide to exercise his/her option in full and would therefore pay £20,000 for 1,000 shares as per the terms of the share option.
On the third anniversary, the shares may have increased in value since the date of the grant to say £30 per share. Having acquired the shares for £20 each, the employee may wish to immediately sell the shares for a profit of £10,000. Alternatively, he/she may wish to continue to hold the shares.
Depending on whether the share option is under a tax advantaged scheme or is non-tax advantaged, the exercise may give rise to tax on the £10,000 benefit (regardless of whether the shares are subsequently sold) as employment income.
Commonly an employee will only exercise their options in the event of a sale of the company to a third party. In this instance, the employee would exercise his/her options, acquire the shares, then immediately dispose of them to the purchase of the company, using the proceeds of sale of their shares to the third party to settle the cost of acquiring them under the terms of the option.
Share schemes are a potentially attractive way for entrepreneurs and business owners to provide rewards to their key staff, while still retaining control over the company.
Nevertheless, it is important to recognise the potential tax implications, and consider carefully whether share ownership, or share options, can be appropriately structured to get the desired result for both employer and employee without any unpleasant tax surprises.