Handing shares to a key employee feels like a commercial decision. In tax terms it is a reporting event, and one with a deadline attached.
If anyone who works in your business has acquired shares or options — and that includes you, on incorporation — you have almost certainly created an employment related security. The rules are not difficult. They are simply unforgiving, and they are among the most commonly missed obligations we see in owner-managed businesses.
What counts as an employment related security?
Securities acquired by reason of employment, taxed under Part 7 of the Income Tax (Earnings and Pensions) Act 2003. The deeming provision in section 421B is drawn very widely: where the opportunity to acquire securities comes from an employer, or from someone connected with an employer, the acquisition is treated as employment related. Your intention is not the test.
In practice it catches:
- shares issued to a new hire, whether or not they pay for them;
- shares transferred personally by a founder to a key employee;
- share options, growth shares, and nil-paid or partly paid shares;
- securities acquired by an employee’s spouse or other connected person;
- founder shares subscribed for on incorporation, in a good number of cases.
That last one is the one that surprises people. It is also why a business can reach its third or fourth year with unreported acquisitions sitting on the cap table and nobody aware of it.
What is the deadline, and what are the penalties?
The arrangement must first be registered on HMRC’s ERS online service. Registration is not instantaneous, so leaving it to the end of June is a poor plan.
The annual return is then due by 6 July following the end of the tax year. A nil return is required every year until the scheme is formally ceased — the obligation does not lapse because nothing happened.
Penalties are automatic:
- £100 the day after the deadline;
- a further £300 at three months;
- another £300 at six months;
- £10 per day thereafter.
Inaccurate returns carry separate penalties of up to £5,000.
Will there be a tax charge as well?
Usually, yes. Income tax is charged on the market value of the securities less anything the employee pays for them. Issuing at nominal value does not avoid the charge; it determines its size. A defensible valuation is the foundation of the whole exercise.
Where the shares are readily convertible assets — broadly, where there is a market or a sale in prospect — the charge runs through the payroll under PAYE, with employer’s National Insurance on top at 15%. If the employee does not reimburse the PAYE you have accounted for within 90 days of the end of the tax year, a further income tax charge arises on the amount you funded on their behalf.
What is a section 431 election, and do I need one?
Most private company articles impose restrictions on shares — pre-emption rights, compulsory transfer provisions, leaver clauses. Those restrictions reduce the value on acquisition, which sounds helpful, but the trade-off is that future growth is then taxed partly as income rather than capital.
A joint section 431 election, made within 14 days of acquisition, brings the charge onto the full unrestricted market value immediately, so that all subsequent growth falls within capital gains tax. On cheap shares in an early-stage company this is usually the right call: a small tax charge now in exchange for capital treatment on exit.
Fourteen days is absolute, and the election cannot be undone. It is the single most valuable fourteen-day window in employee share planning.
What about EMI options?
Enterprise Management Incentive options remain the strongest route for most owner-managed businesses: no charge on grant, no income tax on exercise where the option was granted at market value, and growth taxed as capital.
But the reliefs depend on notifying the grant to HMRC by 6 July following the tax year in which it was made. A late notification leaves an unapproved option and the loss of the entire tax advantage — a difficult conversation to have with a senior hire who thought they had something valuable.
What tends to go wrong?
The pattern repeats. A business does something commercially sensible three years ago, takes advice on the commercial terms but not the tax mechanics, and now has an unreported acquisition, a missed section 431 election, and growth that will be taxed at income rates on exit.
Add the likelihood that the employee will not meet the 5% holding and two-year conditions for Business Asset Disposal Relief — now charged at 18% — and the outcome at sale is materially worse than the founder ever intended.
By the time it surfaces, which is usually in due diligence, the options are limited and expensive.
What should I do now?
If anyone in your business holds shares or options, confirm three things: that the arrangement is registered, that a return has been filed for every year since, and that the section 431 position was considered at the time.
If any of those answers is uncertain, establish the position now rather than in the last week of June.
Frequently asked questions
Who has to file an ERS return?
Any employer where securities or options have been acquired by reason of employment. There is no minimum size, no exemption for small companies, and no exemption for owner-managed businesses. Once an arrangement is registered, a return is due every year — including a nil return — until it is formally ceased.
What is the penalty for a late ERS return?
£100 immediately after the 6 July deadline, a further £300 at three months, another £300 at six months, and £10 per day after nine months. Separate penalties of up to £5,000 apply to careless or deliberate inaccuracies.
Do founder shares count as employment related securities?
Frequently, yes. The section 421B deeming provision is wide enough to catch shares subscribed for by directors on incorporation. Many companies assume founder shares fall outside the rules and discover otherwise during due diligence.
What happens if I miss the 14-day section 431 deadline?
The election cannot be made late. The shares remain restricted securities, and a proportion of any future growth in value will be taxed as employment income rather than as a capital gain — potentially at 45% plus National Insurance instead of capital gains tax rates.
Is EMI better than giving shares directly?
For most owner-managed businesses, yes. EMI options avoid a charge on grant and, where granted at market value, on exercise — leaving growth to be taxed as capital. They also give you control over when and whether the employee ever becomes a shareholder. Both routes need an up-front valuation and correct documentation.
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LMJ Group provides accountancy, tax and advisory services. We do not provide regulated financial, investment or insurance advice; where required, we refer clients to appropriately authorised advisors.