If you’re reading this you probably know about the advantages of incentivising your team with share options, i.e. rewarding them for their work by giving them the right to buy shares in your company in the future (the “option”) at a certain pre-agreed price (the “exercise price”). When a team member exercises their option at some time in the future, they’ll be able to buy the shares at the exercise price and, hopefully, sell them later at the market price, benefitting from the price difference.
Broadly, there are two types of option schemes that are relevant to most UK startups:
- an EMI Scheme
- an Unapproved Scheme
There are also a bunch of other option schemes available (CSOP and others) but they’re generally not useful to UK startups, offering neither the simplicity of Unapproved Schemes nor the tax benefits of EMI Schemes, so generally, you can safely ignore the others and just focus on these two.
BTW, if you hear the term ESOP that’s just a mostly American term meaning any Employee Share Option Plan, so when you’re told you should set up an ESOP, for a UK company that generally means creating an EMI share option scheme. Easy.
With two types of schemes relevant to startups, which is right for your company and your team members?
What is an EMI (Enterprise Management Incentive) Option Scheme?
First, we have the extremely popular EMI Option Scheme, designed to incentivise and reward employees by offering them a right to get shares in the company if they work for you long enough (time-based vesting) or if they help you achieve certain business goals (milestone vesting). This scheme is special because it offers potentially quite significant tax advantages to both the company and the option holder.
These tax advantages come with quite a few eligibility criteria and ongoing compliance requirements, all enforced by HMRC. These requirements are almost like a triple-lock or triple layer of controls which attach to respectively:
- the shares subject to the options,
- the company issuing them, and
- the employee who will be the recipient of the options (the option holder).
- the option shares must be Ordinary (or Ordinary non-voting) shares,
- the company can only have a limited number of issued EMI options at any given time, and
- the employee must dedicate at least 75% off their working time to that company.
Crucially, to reap the benefits of an EMI Option Scheme the option holder must be an employee of the company or the holding company of the group. Consultants, advisers and non-executive directors are all excluded. And, since an EMI scheme offers a benefit against UK taxes, it can only benefit those employees who are UK taxpayers.
With EMI Option Schemes normally reserved for UK-resident employees, everyone else who cannot get the tax benefits of an EMI scheme – including advisers, non-executives or companies – normally gets their share options separately. Read on to learn how Unapproved Schemes can help.
While you could, technically, offer an EMI Option to an employee based in Sri Lanka or Spain, that is not the best use of your EMI options. There’s a limit to the amount of EMI options available to each company, so you’d want to allocate them to UK employees rather than on non-UK employees who’ll count towards that limit, but who won’t get any benefit.
What is an Unapproved Option Scheme?
Second, there’s the Unapproved Option Scheme. It is called “unapproved” because tax authorities do not endorse, approve it or otherwise get involved when you set the scheme up and issue individual options. That doesn’t mean it’s illegal – merely that, unlike an EMI scheme, it doesn’t come with any tax advantages.
In all other respects, unapproved option schemes work in much the same way as EMI schemes, and they let you reward and incentivise those team members who do not qualify for EMI options.
This is why many companies set up both an EMI and an Unapproved Option Scheme, which enables them to offer options to team members depending on each individual’s circumstances.
Both schemes are compatible with two popular tax elections that you can also create on SeedLegals. These elections are really important and often misunderstood – but wait, keep reading, you’ll want to know this!
S431 and NIC Tax elections: What are they?
In the UK, when you give someone share options, they don’t normally incur any tax liability at that time. It’s only when they exercise the option, which may be years later, that tax liability would first arise, typically on the difference between the price they paid to exercise the options and the market price of the shares at the time.
For anyone who is an employee of the company at the time, or who HMRC may deem to be an employee or getting an employee benefit, that could result in tax liability for the company. If your company was one day saddled with potentially hundreds or thousands of pounds in tax liabilities for options your team members have exercised, that would be a huge problem. To avoid that companies will usually ask option holders to sign a tax election.
There are two standard tax elections available that are relevant here:
- s431 election
- NIC election
These are joint elections, meaning that they need to be made by both the option holder and the company, and this is done by signing an HMRC-prescribed form.
Being tax elections, the s431 and the NIC election can be very useful when there is a taxable event – i.e. when income tax (and national insurance contributions, which often go with it) becomes payable. As we know, this happens normally when the option holder exercises the option and gets their option shares, but taxation does not necessarily end there.
Other events, such as certain amendments to the company’s Articles and the sale of option shares, may trigger income tax liability as well.
- EMI Option Schemes are special in that the option holder does not have to pay income tax on exercise of the option if the price per share that they pay then is no less than the market value that those shares had back when the option was granted.
- Income tax may still be payable in relation to EMI option shares, for example, if the employee got shares at a discount (relative to their market value on grant, or if the option is exercised more than 90 days after a “disqualifying event”).
Events triggering income tax liability are called taxable events.
There may be taxable events, spread over time, concerning option shares acquired under both Unapproved and EMI Option Schemes. The idea is that the value of a share can increase as time goes by, so any future taxable event would attract a tax charge on the higher amount. So, what does each tax election do?
The s431 election is there to make sure that the income tax is only paid once. This is achieved by the company and option holder agreeing that the option holder’s income tax will be paid straight away on exercise of the option, and that the calculation of this tax will be based on the so-called “unrestricted” value of the option shares, which can be higher than the actual (current) value. Capital gains tax, normally charged if the employee sells the shares, will still be payable.
The NIC election is there to transfer the liability for the payment of employer’s share of national insurance contributions (NIC) to the option holder. In the context of share options the law allows the employer to shift this responsibility to the employee. So, whenever there is this election and NIC become payable, the option holder is responsible for making the full payment – although this is usually still done through the employer who just gets paid (reimbursed) by the option holder.
One final thing to note is that the two elections are only available to those participants of the option scheme who are employees (you are not usually supposed to pay NIC for your advisers and consultants anyway) and whose employment is within the scope of UK taxation. This is usually the case for employees resident in the UK, but some non-resident employees may still be caught if they are considered to “perform duties in the UK” – it’s always better to check the position with your accountant in every individual case.
What’s the best way to set up your EMI or Unapproved option scheme?
On SeedLegals we’ve automated all this. Simply sign up and create your company. We’ll help you choose the right option scheme for your team, show you the best option vesting and exercise terms for your company and team, and walk you through every step of the process. And, the SeedLegals platform will create all the documents, including the scheme rules, option grants, option certificates for team members, tax elections, and more.
Talk to the experts
If you’re still unsure, our team are on hand to answer any questions, so book an option scheme design call.
Disclaimer: This is not tax advice. Please check with a tax adviser before relying on any of the above statements.