For many companies, staff retention is a key issue. Giving employees a slice of the business can foster a sense of ownership and can be a key element in retaining and rewarding them.
One of the most widely used methods of achieving this is the use of Enterprise Management Incentive (“EMI”) Share Option Schemes. EMI Share Options are significantly more generous than ordinary share options from a tax perspective so can help you attract and incentivise key staff, in a very tax-effective manner. We asked John Leyden FCA, to explain how.
How do ordinary options work from a tax point of view and how are EMI options different?
Ordinary share options schemes work like this:
An employee is granted options and when they exercise their shares and sell the options, they pay tax. The taxes payable include employers’ NI, PAYE and employees’ NI – so a net profit of £100,000 results in £46,572 net cash after tax for a 45% taxpayer – an effective tax rate of 53.4%!
With EMI options they are taxed under capital gains tax and entrepreneurs’ relief applies so long as the option holder is still an employee when they sell, and has held the options for more than year. So, a profit of £100,000 leaves £91,170 net cash after the CGT personal allowance – almost twice as much as ordinary options.
In addition, the employer company can get a corporation tax deduction (currently 19%) for the profit made by the employee. So, it costs the employer £81,000 to get £91,170 into the employee’s hands – the anomaly of HMRC getting £8,830 from the employee and giving £19,000 to the employer seems odd – but what is not to like about it!
Can I grant options at a discount to market value?
The options should be granted at market value otherwise the profit below market value is taxed like ordinary options.
Market value should be agreed with HMRC before options are issued – typically HMRC will discount the “true” market value for two things:
1. Minority shareholding
The options will be a minority shareholding and minority discounts (typically 20-30%) would be agreed as the norm.
2. Restrictions on the shares
The options will have restrictions (generally the employee can lose the options if certain things happen for example, if they leave the company). These restrictions will probably reduce the “true” market value by about 15%.
Therefore, in practice it is possible to issue options at a discount to market value by about 35-40%.
You can only issue £250,000 worth of shares at full market value to any one employee in any three-year period and the whole scheme cannot exceed £3 million.
What is the process of granting EMI Options?
There are a few things to do to put in place an EMI Share Option Scheme:
- The rules of the scheme need to be written.
- The value of the shares and options need to be agreed with HMRC.
- The option agreements need to be issued to employees within 60 days of the HMRC agreement.
- The grant of options need to be reported to HMRC within 90 days of the issue of the options.
- The employer needs to complete an annual EMI return to HMRC.
How long does it take to set up an EMI share option scheme?
Typically it takes 2 to 3 months to get a scheme in place. I generally recommend that the rules are written before the valuation is requested as once the clock is ticking on the 60 days to issue it risks having to agree the valuation again. I have seen cases where management have taken months to agree rules because of other time critical pressures on their working week.
The valuation process takes between 15 and 45 days generally depending on the workload of HMRC – they work on a strict first come first served basis.
Having said that it is possible to put a scheme in place in 4 to 6 weeks if there is an urgent requirement and if management are committed to turning things around quickly.
How much does it cost to put an EMI scheme in place?
The cost of putting a scheme in place can vary dramatically. The factors affecting costs are:
- Are you getting your accountants to prepare the scheme or a law firm?
- How many employees are being granted options?
- How tailored do you want the EMI scheme to be?
Generally, I would recommend budgeting approximately £4,000 for an EMI scheme.
What do I need to consider?
There are a few things to think about before issuing EMI options:
Which employees should be included?
Consider which of your employees you want to grant share options to. Do you want to reserve it for a handful of key personnel, or would you prefer to broaden the number of staff that can benefit?
What is the total amount of the option pool?
Typically this is 10-15% of the company – but you might want to hold some back for future employees as you grow.
How will the employees earn their options?
Most companies vest the options over time, say 3 to 4 years (either monthly or annually) to retain and motivate employees, but vesting can be done on measurable targets, sales for example.
I prefer simplicity and generally go for a time-based approach – if someone is still with you in 3 or 4 years they must have been a worthwhile hire and be hitting targets otherwise you would have replaced them.
When can employees exercise their options?
This can be once they are vested or on a sale of the company. You need to think carefully about this issue as once they are shareholders they have certain shareholder rights (although you can issue options over non-voting shares to avoid this).
Should an employee lose their options if they leave?
Most US companies give options to all employees and let them keep them if they leave. The UK practice is generally to give options only to some key employees and take them back if they leave.
The rationale for this is that firstly, the options were given for retention which clearly did not work, and secondly, the company needs to hire a replacement who may need options, so they need to be recycled.
Can any company issue EMI share options?
Only companies with assets of less than £30 million are permitted to issue EMI share options.
Businesses that operate in certain industries are not allowed to offer EMIs. Excluded activities include:
- Property development
- Legal services
Only the parent company can grant EMI options – but it can still be a foreign parent company granting options to UK employees.
Anything else I should know?
Firstly, remember when you come to sell your company, the buyer will get the corporation tax deduction for the profit made by employees – that 19% HMRC gift we mentioned at the start.
It can be quite a large amount so you should always try to negotiate this tax saving as an addition to the purchase price – it costs the buyer nothing.
Secondly, when you do come to sell you will need to tell option holders at some point during the deal process – probably when it is close to signing.
Option holders often have trouble coming up with the funds to exercise so it is worth trying to negotiate a “cashless” exercise with the buyer – effectively employees get paid their net profit and don’t have to come up with funds for the exercise – but it does need the buyer’s agreement.
This guide has been written exclusively for ByteStart by John Leyden FCA, CEO of Carbon Accountancy Limited.
Last updated - 3rd May, 2018