[NOTE This article was originally published in the Autumn 2024 edition of Law Society Management Section Magazine – note that the tax incentives relating to EOTs have since changed and are reported in more detail on this website.]
Employee-ownership is a rapidly developing area of business ownership and one that is now being tentatively adopted by law firms.
Since tax incentives were introduced under the Finance Act 2014, to encourage the growth of employee-owned businesses, following the 2012 Nuttall Review of Employee Ownership[1], the UK has seen an escalating rise in the numbers of businesses owned by Employee Ownership Trusts (EOT), to the point where there are currently more than 1,650 employee-owned companies.
Serendipitously, the introduction of the tax incentivisation of employee-ownership emerged as the legal profession was just beginning to come to terms with the novel concept of non-solicitor ownership of legal practices, which had commenced in 2012. Though the development of the latter was not wholly without concern; the fears of a number of practitioners expressed at the time were that despite the potential opportunities Alternative Business Structures (ABS) offered, inevitably the persons most likely to benefit would be venture capitalists, supermarkets and stock markets as the traditional partner-centric model of ownership succumbed to the scions of the capitalist market.
But the fortuitous consequence of the introduction of the EOT legislation and the ABS structure was the potential for an employee-owned law firm. The EOT tax incentives created a benign tax pathway to employee-ownership; while the introduction of ABS, enabled law firms to be owned by EOTs.
The position today
There are now circa 20 to 30 UK employee-owned law firms. The exact numbers are not known. Against a backdrop of over 9,500 legal practices[2] that is a tiny fraction.
What is holding back law firms? Most likely it is the distraction of events that prevents partners on considering the future. Back in 2020, the issue of aging partners and concerns for succession were of critical concern[3]. Matters did not improve as the pandemic struck, followed by war in Europe, cost of living crises, disruptive mini-budgets, all of which set against the background turmoil of Brexit. Given these challenges, trying to address succession became exceedingly challenging, if not impossible.
Indeed, it is succession which leads most companies in the direction of the EOT, because the EOT provides the existing owners with an off-ramp to divest their stake and move the business into the hands of new owners and future leaders.
However, while the succession aspect is important, it is not the only reason for considering the option. EOTs can be highly beneficial in creating more employee-invested business and / or ethically motivated organisations.
The traditional succession routes
If partners have considered succession at all, they will be familiar with the traditional options:
- Introduction of new partners to buy out retiring partners
- Sale of the business or merger with another firm
- Closing down and liquidating
However, the environment appears to be challenging: of the 523 law firm closures in the 12 month period to March 2024, over 50% ceased trading, while only 22% merged[4]. The data does not detail the myriad number of damaging consequences which invariably arise when a business ceases to trade.
Likewise, finding new partners to buy-in and thereby pay-off an outgoing partner has become more challenging. A combination of rising house prices, substantial student loans and the roller-coaster ride of law firm fortunes does not encourage an appetite for more debt in the next generation.
Accordingly, there has never been a more important time to find new succession options for law firms.
The EOT option
The inception of the EOT brought forth a new alternative to succession. Rather than needing to find a buyer, the company owners would now be able to sell the business to a trust which would hold the benefit of the shares for the employees of the Company. The EOT would be created by the Company and would purchase the shares for a value at, or close to market value, with implementation being undertaken at a time of the owner’s choosing.
The absence of an incoming owner with visions of a radical new direction or potentially ‘synergies’ (for which, read dispensing with surplus employees) would allow the owners to fix in place values and culture which might otherwise be lost or crushed in a takeover. If those benefits alone were not enough, then it would be the tax incentives which would capture the attention; the sale of shares would be subject to zero capital gains tax (with no limit) and the ability to introduce a tax free profit share to all employees of up to £3600 per person.
EOT legislation[5]
In order to obtain the benefit of zero CGT the EOT must meet the provisions set out in sections 236H-U of the Taxation of Chargeable Gains Act 1992 (TCGA).
Simplified, the Act requires the following criteria to be met:
- The shares disposed of to the EOT must be made by a person (accordingly not a subsidiary of another company);
- The company (the subject of the share transfer) must meet the trading requirement (most companies comply with no issues but there are traps for the unwary);
- The EOT must meet the all-employee benefit requirement (all employees must be beneficiaries of the EOT and treated on equal terms);
- The EOT must meet the controlling interest requirement (hold a majority of shares and not be subject to any provision in an agreement which confers rights over the EOT in favour of the Sellers);
- The Limited Participation requirement is met[6];
Compliance with the rules is generally readily determined, though care must be taken in connection with the Limited Participation Test. Furthermore, the EOT Trust deed will either contain the necessary clauses or the EOT will fail the criteria and the sale will not take the benefit of zero CGT.[7]
Selling to an EOT
One of the most satisfying aspects for owners moving to an EOT is that the sale process is not combative, nor draining, by virtue of an absence of endless due diligence and other advisers choosing to negotiate tedious minutiae. Any lawyers reading this article who deal with commercial transactions will know that the M&A sector now regularly fields football-team sized phalanxes of lawyers on even the most modest of deals. All very well when you are earning fees that way, but far less appealing when you are the seller.
An EOT transaction has far less complication in terms of the process. It is not combative; in fact it is more a process of creating the most appropriate structure for the business going forward. While this may take time and much thought, it is not a design that is forced upon the sellers, rather it is one they craft.
Ultimately, the sellers, rather than the EOT, are the persons at risk – they only get paid if the EOT and the company it owns, thrives. Therefore, it is imperative that the sellers balance the terms of the sale with particular regard to the repayment of the sale price against the need to ensure that the business grows, reinvests and shares some profits with employees. There is much to be said in ensuring that the implementation of the EOT is seen to be beneficial for the current owners, the company itself and ultimately the employee-owners.
Valuation versus Consideration
While a valuation is certainly necessary to ensure that the price reflects the market value of the Company (and therefore relevant for capital gains), the acid test is checking that the proposed purchase price can be met through the likely post-tax profits of the company in the future years, because for most EOTs, the purchase price is paid through the future post-tax profits of the Company (the same pot from which dividends are declared). Failing to properly scrutinise the affordability of the repayment terms is probably the greatest risk for the business and the sellers.
EOT Bonus
Having implemented the EOT, the company owned by the EOT (or indeed all of the companies owned by the EOT) can then distribute a tax-incentivised bonus of upto £3600 per employee per year, under sections 312A-I Income Tax (Earnings and Pensions) Act 2003. To do so the Company must meet the following rules (again simplified):
- The bonus is not regular salary or wages;
- Is awarded under a scheme which meets the participation and equality requirements (all employees to benefit on equal terms);
- The company meets the trading requirement;
- The company meets the indirect employee-ownership requirement (the company is majority or fully owned by an EOT);
- The Office-holder rule is met (directors and other office-holders must not make up more than 40% of the total number of employees)
From an employee perspective, the profit share bonus may be the first tangible benefit of being employee-owned. How the bonus amount is determined and how it is shared with all employees will be an important development. Finding a methodology which matches the values of the business is important. A firm which has a strong sense of equality may choose an equal sum for all, whereas another firm which has a more commercial ethos might choose to share based on hours worked or percentage of salary (the latter being the classic John Lewis model).
Leadership
An EOT principally deals with ownership of the business, but don’t overlook the need for good leaders, who may take on the responsibility of leading the business in the future. It’s important to ensure that those individuals are properly motivated, retained or recruited; being an employee-owned business can create great resilience, but it does not insulate it from external market pressures.
Tools for incentivisation range from providing a direct shareholding for key individuals in the firm to share options (based on setting strategic goals) to simply providing a performance-based individual or leadership bonus.
One of the benefits of the EOT model is that it can remove the problems associated with equity ownership. Having paid for their capital stake, equity partners may (quite reasonably), expect to control the business decisions and its direction. However, not all partners are suited to business leadership (how many lawyers have MBA?!) and the intrinsic tie of ownership and leadership may well be damaging to some firms. Furthermore, this can also lead to the exclusion of those who may be better suited to leadership, but are unable or unwilling to pay the equity price tag.
Once the equity element is removed, individuals can be freed up to focus on developing and utilising their best abilities whether or not that is them ultimately taking up the responsibility of the role of managing partner/director or perhaps alternatively leading a growing team, opening a new office, or perhaps immersing themselves in a niche specialism.
The SRA
The SRA has now approved multiple firms becoming employee-owned. If the firm is not already a Licensed Body then an application will be required as the ownership by an EOT will mean that the firm is not owned exclusively by solicitors. The management of the firm is still keenly scrutinised by the SRA, but this is no different to the existing requirements for all firms. Ultimately there is no objection to employee-owned law firms from the legal regulator.
EOT Challenges
For any partner warming to the idea of an EOT as the potential future for the firm, there are practical issues to be considered:
Too many partners: choosing to sell to an EOT requires a high degree of alignment between the current shareholders. As any partner of a larger organisation will know, finding agreement on a major developments for the firm may be very tricky. Choosing to sell to an EOT may be a challenge on greater scale.
Aspiring partners: as mentioned above, ensuring leaders are incentivised is an important element of a successful EOT, but so is ensuring that the key individuals in the firm support the concept of becoming employee-owned and see that their future is not compromised by the EOT.
EOT exits: to date, there are few examples of EOT-owned businesses being sold out of the EOT. In principle, a successful business regardless of its ownership status may be subject to unsolicited offers. The EOT may determine that a sale is in the best interest of the employees. But note that the EOT will likely pay CGT on the whole of the sale price (not just the uplift against the original sale price) and any proceeds to employees will likely be subject to Income Tax.
Governance: In place of shareholders the directors are accountable to the trustees of the EOT (which is, of course, the shareholder). The EOT does not run the business but it should expect to have oversight of business plans and major decisions. It takes time to become accustomed to this development, but this can create stronger decision-making processes and more employee-conscious decisions.
Reflections from employee-owned law firm leaders
Robert Camp former managing partner at Stephens Scown LLP:
I believed it was essential to the success of the firm that everyone should feel truly invested in it. Regardless of their role, it was important to me that everyone saw it as their business, with a genuine stake in the rewards we were working towards. I knew that when people feel a sense of ownership, they are more motivated to provide the best service possible. Ultimately, it’s the people who work for the organisation who make the difference, and by sharing ownership, I wanted to ensure that every employee felt valued and empowered to contribute to our collective success.
David Owen at Oliver & Co solicitors (became employee-owned October 2022):
Becoming employee-owned has led to greater transparency, openness, and empowered decision-making among our employees, fostering a more engaged and innovative workforce.
It’s been an excellent exit strategy, helping us retain our culture and values while improving profitability, employee retention, and recruitment. Since the transition, we’ve enjoyed significant marketing advantages, distributed tax-free profit shares to eligible employees, and won two national awards. I wish we’d become employee-owned 10 years ago!
Conclusion
The employee-owned law firm may still feel like a radical concept in legal circles, but the model is already making waves. It provides a succession route for partners, where none may have existed, brings together employees as co-owners and distributes wealth to all those that contribute to the fortunes of the business.
In the words of the inestimable Lord Denning: “If we never do anything which has not been done before, we shall never get anywhere. The law will stand still whilst the rest of the world goes on; and that will be bad for both.”
[1] https://assets.publishing.service.gov.uk/media/5a79ab1b40f0b63d72fc7918/12-933-sharing-success-nuttall-review-employee-ownership.pdf
[2] https://www.sra.org.uk/sra/research-publications/regulated-community-statistics/data/solicitor_firms/
[3] https://www.lawgazette.co.uk/features/how-to-tackle-succession-planning/5102653.article
[4] https://www.sra.org.uk/sra/research-publications/regulated-community-statistics/data/firm_closure_breakdown/
[5] Note The 2024 and 2025 Budgets have since changed the tax rules – the current tax incentive is a 50% discount on the full rate of CGT meaning an effective rate of 12% as at 1st May 2026
[6] this is a convoluted test relating to the number of employed shareholders vs the number of employees not exceeding 40% – for any company going into EOT this needs to be thoroughly analysed!
[7] Warning! There are still templates made available on Government employee-ownership websites which are not compliant!
