By Richard Godmon, a tax partner at accountancy firm, Menzies LLP.

Share incentive plans that reward employees in a flexible way can prove a tax-efficient means of incentivising staff performance and retention, especially at a time when pay rises and cash bonuses are out of the question for many SME employers. But where should business owners start?

A recent fall in many business valuations, due to the impact of the Covid-19 pandemic, means that now could be the ideal time for business owners to rethink workplace rewards. Lower business valuations mean that shares will have a lower value too, which means that qualifying employees can expect to gain by selling them at a higher cash value further down the line.

There are a variety of ways that employers can reward staff through share ownership. For example, they can issue shares directly to key employees, who are required to pay income tax on their value at the point that they take ownership of them. Whilst this is a relatively simple solution, there are some important considerations to take into account, such as ensuring that existing shareholders understand that this approach could dilute the value of their own shares. For the employee, the need to pay tax when they take ownership of the shares may also not seem attractive immediately.

Most small businesses prefer to establish an approved, tax-advantaged share option scheme, such as an Enterprise Management Incentives (EMI) scheme. With this type of scheme, employees are not normally required to pay any tax when they exercise their share options, and are liable for capital gains tax (CGT), rather than income tax, when they sell them. In some instances, employees may also qualify for business asset disposal relief, previously known as Entrepreneurs’ Relief, which means they would be liable for a 10% rate of CGT when selling their shares.

Some employers may not qualify for one of the HMRC-approved schemes however, because the business has gross assets of more than £30 million or it is a subsidiary of a much larger business. In addition, some employees may not qualify for an approved scheme if they work insufficient hours, and businesses practising certain trades, such as property development or financial services, are also excluded. Businesses and employees affected in this way may opt for an unapproved share incentives plan instead. However, these plans don’t share the same tax advantages. This means that income tax is payable when shares are exercised, and any growth in the value of the shares, which is realised by the employee after this point, is liable for CGT.

When established and communicated in the right way, share incentive plans can be incredibly motivating for staff at all levels – from directors and senior managers, through to talented recruits. As well as being useful in helping to tie workers into the organisation, they can also align the interests of employees with those of the business, helping to drive performance and productivity. Before introducing a share incentive scheme, business owners should decide how much equity they are prepared to give away and have a clear idea of what they want to achieve.

Sometimes, employees can be sceptical about the value of a share incentive scheme and, given the choice, most would prefer to receive a pay rise or a cash bonus. To overcome this, employers should ensure workers have a sound understanding of the strategic growth plan of the business and if appropriate, its exit strategy. The value of the shares may need to be explained in detail. For example, if a key employee is being rewarded with a 1% shareholding, this may not sound much, but if the business 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.

Share incentive schemes are most effective when applied by entrepreneurial businesses that are well-funded and have a strategic growth plan, with clear financial targets. It is important to seek advice however, as implementing such schemes is a complex area and mistakes can be made. For example, it is not unusual for directors of small businesses to attempt to put in place an approved share incentive scheme, only to find out several years’ later that certain eligibility criteria were not met and employees are liable for income tax rather than CGT.

Employers should also be prepared to answer employees’ questions about the proposed share incentive scheme. For example, some 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.

In some situations, businesses that don’t qualify for an approved scheme, because they own significant property assets, for example, may choose to set up a ‘phantom share incentive scheme’. This type of scheme involves allocating a nominal shareholding to the employee, which is calculated based on the business valuation. Whilst the employee doesn’t own any actual shares, they have a legal agreement that gives them a right to claim a cash payment equivalent to the value of their phantom shares, after a specified time period.

With the economy rebounding rapidly, there is an opportunity for SME businesses to achieve strong growth in their target markets. Whilst they may not be able to match the salaries and rewards of some larger companies, a creative and well-communicated share incentive scheme could be key to their success.