A Comprehensive Guide to Employee Share Schemes

mariam-abu-hussein
Mariam Abu HusseinLegal Assessment Specialist @ Lawhive
Updated on 20th September 2024

One of the toughest challenges of running a business is funding. Many business owners get stuck and ultimately give up when they have no means of funding to keep supporting the business. Getting investors is usually tricky, and personal funds are sometimes insufficient. This is where the idea of sharing ownership in exchange for funding comes in. It’s even better when the sharing is within your team. 

Equity is a popular way of securing funding for businesses, and it’s usually perfect for small-to-medium scale enterprises. Basically, it’s like securing investment through less stringent means. Partners, friends, and even employees get a stake in owning the business in exchange for funding. For employees, getting equity is an alternative to compensation, and it even drives productivity. This is what is known as an employee share scheme.

So, if you’re concerned about funding and employee dedication in your business, an employee share scheme might “cure the headache”. In this article, you’ll learn:

  • The different types of employee share schemes and how they work

  • The benefits of share schemes for both employers and employees

  • Tax advantages that come with approved share schemes

  • Key legal and regulatory considerations to ensure compliance

  • Potential challenges

What Are Employee Share Schemes?

Employee share schemes are popular with start-ups and businesses due to their win-win benefits for employers and employees. An employee share scheme is an arrangement where employees are given a stake in the company’s ownership. By design, it helps a company secure much-needed funding, and also to attain and retain high-end talents in the company. With an employee share scheme, companies can easily win over top-notch talents, and also drive employee dedication to the company’s cause.

Sometimes, an employee share scheme features a slightly lower salary in exchange for a stake in the company. The funds that might have gone strictly into employee compensation are ultimately slashed, with a portion reinvested into the company while the affected employee gets a stake in the company. Besides saving costs on hiring new talents, some employee share schemes also allow companies to secure funding directly from within themselves. 

With an employee share scheme, the employee’s interest is aligned with the company’s success since they now have a stake in ownership. This way, employees are less likely to seek alternative employment and would be motivated to stay productive at the company. Why? The company's success means an increase in share profit for the employee. Hence, neither the employer nor the employee would want to sabotage the other through unproductivity or harsh policies. 

Types of Employee Share Schemes

There are different types of employee share schemes. While they’re fundamentally alike, they operate differently. Some provide better tax benefits, some help with smooth management buyouts, and others are better suited for small companies. Here are some employee share schemes you should know:

Share Incentive Plans (SIPs): 

Share Incentive Plans (SIPs) are basically tax-saving protections that are mostly for employees, but the employer isn’t left out. By law, employees don’t have to pay Income Tax (IT) on shares held for over five years. Should they sell their shares afterwards under a SIP, they still won’t be charged any capital gain tax (CGT). As such, SIPs give employees greater control over their earnings with less taxes. For the employer, SIPs help with internal funding, which also comes with tax relief. This also has the additional benefit of retaining employees.

There are four types of SIPs:

  • Free Shares: They’re basically non-taxable shares that are open to all employees of a company on equal terms. Each employee can legally receive free shares worth up to £3,600 per tax year. 

By design, free shares must be allocated equally to employees or based on fair criteria such as salary structure, length of service, or performance. Hence, employees can only enjoy higher share allocation if they’re extra-dedicated to the company’s goals. 

There’s also an incentive to hold the free shares for at least five years. By law, free shares can be forfeited if an employee resigns or gets fired within three years of purchasing the company shares. Also, the tax relief on free shares is minimal if the shares are withdrawn within five years of purchase. 

  • Partnership Shares: These are usually purchased via pre-tax salary deduction and National Insurance Contributions (NIC). With this arrangement, employers can deduct up to £1,800 or 10% of the employee's salary per tax year. The deductions will cover the employer’s NIC while allocating shares to the employee per month. There is also room for employees to accumulate deductions to buy shares at the current market value subsequently.

With partnership shares, both employer and employees can actively save costs on NIC and tax. Employees can choose to buy shares consistently or accumulate and buy at a later profitable date.

  • Matching Shares: When employees buy partnership shares, employers can match their effort by giving them at most two free shares per partnership share bought. This way, the Return on Investment (ROI) and tax reliefs are greater. 

  • Dividend Shares: Every shareholder is entitled to being paid dividends on shares bought. Once an employee receives the dividends on bought shares, the employer can allow the employee to use the same dividends to buy more shares on an SIP. These newly bought shares are known as dividend shares. Employees can buy up to £1,500 of dividend shares per tax year.

Although employees will not have to pay Income Tax on the shares bought, they may have to pay Dividends Tax (DT). DT is only deducted if the dividends are not used to buy more shares. The tax cut varies between 0% to 38.1%.

Note that shares must be held for at least five years for all SIPs to qualify for tax relief and avoid NIC.

Enterprise Management Incentives (EMIs)

EMIs are great for small companies due to their tax relief options. For context, small companies are those with less than 250 employees and less than £30 million in assets. Unlike SIPs, which offer shares to purchase per year, EMIs can offer shares up to £250,000 for a 3-year period. This way, the tax relief can be enjoyed for a longer period.

Some EMI tax reliefs include:

  • No income tax or NICs on shares purchase

  • No income tax or NICs on sale of shares within 10 years of purchase

  • Capital gains tax is usually 10% or less on the sale of shares two years after purchase.

Unlike SIPs, EMI share prices don’t fluctuate based on the market. Rather, EMI share prices remain fixed, and employees can buy shares at the same starting price of the scheme. Only when there’s a discount in the share's market value, an employee may have to pay income tax or NIC on the discounted difference. Hence, if there’s a 10% discount on the purchase price, the employee would need to pay income tax or NIC on the 10% profit value. 

Company Share Option Plans (CSOPs): 

Just like EMIs, CSOPs allow employees to buy shares of up to £30,000 at a fixed price from the start of the scheme. There’s no income tax or NICs on buying or selling shares bought and held for at least three years. The employer also enjoys corporate tax reliefs equal to the gains earned by employees after selling off bought shares.

Under CSOPs, employees and employers are only entitled to tax relief if the shares are held for at least three years and sold within ten years of purchase. There is also a capital gains tax allowance for shares sold within ten years of purchase. This means that roughly £12,300 of initial profit from the sale of shares is tax-free. Afterwards, profits are taxed between 10% and 20%, depending on the employee’s income.   

Employee Share Option Schemes (ESOSs): 

ESOSs allow employees to buy the company at a fixed price in the future. They are like a combination of CSOPs and EOTs. Employees do not have to earn a stake of ownership in the company by using their own funds and can simply hold off buying shares until a later convenient date.

Some of the benefits of ESOSs include:

  • Employees are incentivised to remain and grow with the company. 

  • Employee performance is improved due to stronger motivation thanks to ESOSs.

  • The ownership of a company can be conveniently changed in-house through management buy-outs without seeking external mergers or acquisitions. 

  • Exemption from capital gains tax.

Employee Ownership Trusts (EOTs): 

EOTs are usually adopted by traditional companies and limited liability partnerships to build an employee ownership system. With this kind of trust, the transition of ownership is easier and smoother since it is done in-house rather than dealing with the challenges of the average merger or acquisition arrangement.

Some of the benefits of EOTs include:

  • Annual tax-free cash bonus of up to £3,600 per employee for each tax year.

  • Shares are awarded as an incentive to attain and retain talents and improve employee performance.

  • Lower cost of ownership transition in terms of finance and corporate politics.

  • Employees can own the company through shares without risking their own direct funds.

  • Exemption from capital gains tax.

Unapproved Share Schemes: 

Unlike other share schemes, an unapproved share scheme is not heavily regulated. With it, employees can buy shares later for a fixed price. While the fixed cost is usually based on the market value as of the date of executing the scheme, the price is sometimes flexible. The set price for unapproved share schemes usually fluctuates between zero and a nominal amount. And it usually comes with performance-based conditions for the employee. Hence, an employee is only qualified for the scheme and a percentage of shares based on meeting the company’s performance metrics.

Unlike other share schemes, the unapproved share scheme is subject to income tax and NIC. 

Benefits of Employee Share Schemes

Employee share schemes are profitable for both the employer and the employee. The benefits include tax relief, management costs, and overall company success.

For the employer, share schemes offer the following benefits:

  • Corporate tax reliefs

  • Internal funding opportunities

  • Incentivising employees for optimal performance

  • Attracting and retaining talents in the company

  • Reduction in management and transition of ownership costs. Basically, the company can be sold gradually while enjoying tax relief. 

  • Reduction in cost of recruitment since high-performing employees are retained and are more likely to recommend new talents.

For the employee, share schemes offer the following benefits:

  • Income tax and NIC reliefs. 

  • Tax protection and favourable conditions for capital gain tax

  • Potential for owning the company in future

  • Owning a stake in the company positions the employee as a key stakeholder who may need to be consulted concerning the company’s future. The number of shares held by the employee depends on this.

Generally, the tax advantages of an employee share scheme include:

  • Protection from tax deductions and NICs when shares are held for at least three years and sold within ten years after the grant.

  • Zero or minimal capital gains tax for schemes like SIPs, EMIs, CSOPs, and ESOSs.

HM Revenue and Customs regulates all employee share schemes except the Unapproved Share Scheme. This means that employers must ensure that their share scheme arrangements comply with HMRC regulations to qualify for tax benefits. 

Most of the HMRC requirements are unique to each share scheme. However, there are some generic requirements for all share schemes. They are: 

  • Registration: Share schemes must be registered with the HMRC for additional guarantee. This registration comes with a clearance certificate that may strengthen employee trust in such schemes.

  • Documentation: Share schemes must be documented with no hidden terms and conditions.

  • Agreement: To avoid legal disputes, both the employer and employees must agree to the scheme’s terms and other company policies. Employees are advised to consult lawyers to interpret terms clearly and represent them during negotiations.

  • Employee protection: While share schemes favour both parties, an employer can sabotage them. As such, employees should seek legal protection and have their lawyer negotiate favourable terms. 

Challenges and Risks

While employee share schemes are great, a few risks may threaten the benefits offered. These challenges and risks include:

  • Employees have to live off a lesser salary in return for receiving shares.

  • The market value of shares is determined by market fluctuations. Hence, there’s a risk of the share values dropping, especially if the company encounters difficulties.

  • Employers may place unnecessary financial burdens on employees to secure funding via these schemes.

  • There may be harsh performance expectations placed on employees in exchange for shares.

  • Share schemes typically dilute the company's ownership, making control difficult. Decision-making is stalled because shareholders need to be consulted beforehand.

  • The tax reliefs of share schemes are time-bound. As such, employees who withdraw from the scheme before the stipulated period of at least three years will have to repay NICs and income tax reliefs. 

FAQs

How do employee share schemes work?

Share schemes allow companies to access funding internally and enjoy tax reliefs by allocating shares to employees. The value of the allocated shares is deducted from the employee's salary, granting the employee an ownership stake and tax relief.

What are the tax benefits of employee share schemes?

Under the employee share schemes, employees don’t have to pay income tax or National Insurance Contributions (NICs). Capital gains tax is also heavily subsidised.

Which share scheme is best for my company?

Choosing a share scheme depends on the company's size and business. While SIPs are great for start-ups and high-risk companies, EOTs and CSOPs are great for larger and more traditional companies.

Can share schemes be offered to all employees?

Yes, share schemes can be offered to all employees or executive directors. 

  • What happens to employee shares if the company is sold?

Employees will have to share their shares when the company is being sold. Either the shares are converted to cash or swapped for shares in the acquiring company.

Conclusion

Employee share schemes are grand for both employers and employees. Besides allowing employees to earn a stake in owning the company, the employing company also gets easy access to funding from the employees. Since share schemes are regulated by law, there’s less risk of sabotage, and the tax benefits make it a juicy deal for both parties. 

With employees earning a stake in the company, their interests are ultimately aligned with the company's. This means there’s a greater chance of improved employee performance and retaining top talents. 

Employee share schemes are complex. Expert advice is needed to choose a suitable share scheme for a company. What’s more, employees need to consult finance and investment lawyers to weigh their options before agreeing to a share scheme. The solicitors at Lawhive can help explain grey areas and represent you as an employee during a share scheme arrangement.

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