It can be difficult for business owners to know where to start regarding share incentive plans. Plans that reward employees in a flexible way can be a tax-efficient means of motivating staff performance and retention, especially when cash bonuses and pay rises are unattainable for many SME employers.
Due to the impact of Covid-19, there has been a decrease in many business valuations; this means that now is the ideal time for business owners to rethink their workplace rewards. A lower business valuation is reflected in the price of shares, meaning their value will also decrease. Therefore, qualifying employees can potentially sell them at a higher cash value in the future.
There are many ways that employers can use share ownership to reward staff. For example, they can directly issue shares to key employees, who in turn will be required to pay income tax on their value when they take ownership of them. Although this is a relatively simple solution, some important considerations need to be taken into account, such as ensuring that existing shareholders understand that this approach has the potential to dilute the value of their own shares. The need to pay tax immediately when they gain ownership of shares may not be immediately attractive to the employee.
Why you should establish an approved scheme?
Establishing an approved, tax-advantaged share option scheme tends to be the preference for most small businesses. Schemes such as an Enterprise Management Incentive (EMI) mean employees are not usually required to pay tax until they exercise their share options on a sale. At that point, rather than paying income tax when they sell them, they are liable for capital gains tax (CGT). Additionally, employees may qualify for business assets disposal relief (Entrepreneurs’ Relief), meaning they would be liable for a 10% rate of CGT when selling their shares.
There are some factors that mean employers may not qualify for one of the HMRC-approved schemes. For example, if a business has gross assets that exceed £30 million or it is a subsidiary of a much larger business. Additionally, some employees may not qualify for an approved scheme if they work insufficient hours, and businesses practising certain trades, such financial services or property development, are also excluded. Employees and businesses affected in this way may opt for an unapproved share incentive plan instead. However, these plans don’t share the same tax advantages. This means that when options are exercised, income tax is payable, and any growth in the value of the shares, which is realised by the employee after this point, is liable for CGT.
Benefits to staff
Share incentive plans can be especially motivating for all levels of staff, it even applies to recruits, helping to tie workers into the organisation. Although, this motivation only works if the plan is established and communicated in the right way. An additional benefit of these plans is the ability to align the interest of employees with those of the business they work for, helping to increase productivity and performance. In order to have a clear idea of future business achievements, business owners need to decide how much equity there are prepared to give away.
Sometimes, employees can be sceptical about the value of a share incentive scheme and most would prefer to receive cash bonuses or a pay rise. To overcome this, employers need to ensure workers have a sound understanding of the strategic growth plan of the business and if necessary, its exit strategy. Share values may need to be explained in detail. For example, if a key employee is being rewarded with a 1% shareholding, this may seem small, but if the business has plans to sell in five or ten years’ time for an estimated £50 million, or float on the stock exchange, it could amount to a sizeable cash windfall.
When share incentive plans are applied by entrepreneurial businesses that have clear financial targets and a strategic growth plan, they seem to be the most effective. Although when implementing these schemes, they can be complex, and mistakes can be made. For example, directors of small businesses often attempt to implement approved share incentive schemes, only to discover that the correct criteria were not met and employees are therefore liable for income tax rather than CGT. It is therefore important to seek professional advice to avoid unwanted complications. Employers should also be prepared to answer employees’ questions about the proposed share incentive scheme. For example, employees may want to know what will happen to their shares if they retire or otherwise choose to leave the company before they can be exercised. To address these concerns, the employer may wish to create an internal market or Employee Benefit Trust, so the exiting employees can sell their shares back to the other Trustees in exchange for a cash payment.
Some businesses don’t qualify for an approved scheme due to the ownership of significant property assets or other factors. On this occasion some businesses may decide to set up a ‘phantom share incentive scheme’. This involves calculating a nominal share holding to an employee, based on the valuation of the business. Although the employee does not own any actual shares, a legal agreement allows them the right to claim a cash payment equivalent to the phantom shares value, after a set time period.
With the economy quickly bouncing back, there is an opportunity for SME businesses to achieve strong growth in their target markets. Whilst they may not be able to match the rewards and salaries of some larger companies, a creative and well-communicated share incentive scheme could be key to their success.