Employee ownership trusts (EOTs) are often celebrated for turning employees into long-term custodians of a business. But there is one little known rule that can quietly unravel the whole structure, known as the limited participation requirement. Even if an employer qualifies at the time of transition to an EOT, it is easy to fail the limited participation test after the transition.
An individual who holds 5% or more of the shares in an organisation is known as a participator. To keep an EOT’s tax advantages, the participators must not exceed 40% of the workforce. This is called the participator fraction. The purpose of the participation requirement is to guard against relief being given to individuals who hold a substantial shareholding in circumstances where they, along with others, make up a significant proportion of the workforce before and after the creation of the EOT.
A participator is anyone who is beneficially entitled to, or has rights to acquire, 5% or more of share capital, or any class of share capital, or is entitled to 5% or more of its assets on a winding-up. The participator fraction must not exceed two-fifths during the 12 months after disposal and from disposal to the end of the tax year. Failing to monitor this accurately can invalidate capital gains tax relief.
A breach can trigger a disqualifying event, allowing HM Revenue and Customs to claw back reliefs. Breaches where the participator fraction exceeds two-fifths can be disregarded if they last no more than six months and the excess was caused by factors outside the trustees’ reasonable control.
A breach of the two-fifths limit can be disregarded only if it lasts no more than six months and is due to events outside the trustees’ reasonable control. Misinterpreting what counts as outside control, such as trustee decisions or trust set up delays, can lead to non-compliance.
In small organisations with narrow share classes, a single enterprise management incentive (EMI) or unapproved grant can give rights over greater than or equal to 5% of that class, instantly making the holder a participator. Share splits, buy-backs or creating a growth class can shrink the denominator and push existing holders over 5%. If a participator’s spouse or adult child joins the payroll, this can lead to the breach of the test.
Design fixes that work include a hard cap at 4.99% per class, asking senior employees annually to disclose any family or household connections with 5% holders, and when creating growth or non-voting shares, design the class wide enough that realistic awards, such as options or grants, stay below 5% of that class.
If the ratio edges up, trustees have a grace period of six months to fix any breaches if the cause was outside their control. Where equity headroom is thin, consider using net asset value-linked or profit-bank bonuses instead of more option. These reward performance without creating new participators.
For disposals made on or after 30 October 2024, the settlement must meet the trustee independence requirement. This requirement is met if fewer than 50% of the trustees are persons who are excluded participators, and excluded participators do not have control of the settlement.
The requirement is that the EOT is not controlled by excluded participators. If there are trustees who are excluded participators, they must be a minority of the trustees. This requirement is a governance rule, as opposed to the limited participation test, which is about the workforce.
The 40% rule was built to prevent control resting with a narrow group, yet in practice it is often the first casualty of an enthusiastic equity incentive plan. A little modelling up front such as having clear class limits and trustee visibility can help keep the EOT structure safe.
Elena Visser-Adams is a senior associate at Burges Salmon
