Employee Ownership Trusts
A New Option for Business Succession in Canada
If you are a business owner in Canada, you may be wondering how to plan for the future of your company and your employees. You may have considered selling your business to a third party, transferring it to a family member, or winding it up. But have you ever thought about selling your business to your employees?
Employee ownership trusts (EOTs) are a new option for business succession in Canada that was introduced in the 2023 federal budget. EOTs are designed to facilitate the purchase of a business by employees and employee ownership of Canadian businesses. EOTs offer tax benefits for both sellers and buyers, as well as potential advantages for business performance and employee engagement.
In this blog post, we will explain what EOTs are, how they work, and what benefits they can offer. We will also highlight some of the key requirements and limitations of EOTs that you should be aware of before considering this option.
What is an EOT?
An EOT is a trust that is established for the sole purpose of holding shares of a qualifying business for the benefit of its employees. A qualifying business is a Canadian-controlled private corporation (CCPC) that carries on an active business in Canada and has at least three employees who are not related to each other or to the seller.
An EOT can purchase shares of a qualifying business from an existing owner using funds borrowed from the business itself or from a third-party lender. The seller can defer the recognition of capital gains on the sale by spreading them over 10 years, instead of five years as under the general rules. The EOT can repay the loan over 15 years without adverse tax consequences, as opposed to the general two-year repayment requirement for individuals and certain other trusts.
The EOT must distribute its income from the qualifying business to its employee-beneficiaries based on their length of service, remuneration, and hours worked. The employee-beneficiaries must include all employees who have worked for the qualifying business for at least one year and who are residents of Canada. The EOT cannot distribute any capital gains or losses from the disposition of shares of the qualifying business.
What are the benefits of an EOT?
An EOT can offer several benefits for both sellers and buyers of a qualifying business, as well as for the business itself and its employees. Some of these benefits are:
Tax deferral: The seller can defer up to 90% of the capital gains tax on the sale by spreading it over 10 years. The buyer can deduct interest payments on the loan used to purchase the shares from the business income.
Business continuity: The seller can ensure that the business will continue to operate under the same management and culture, without disruption or loss of goodwill. The buyer can benefit from the existing customer base, supplier relationships, and market reputation of the business.
Employee engagement: The employees can become owners of the business and share in its profits and growth. This can increase their motivation, loyalty, productivity, and innovation.
Social impact: The EOT can promote local economic development, community involvement, and environmental sustainability by keeping the ownership and control of the business within Canada.
What are the requirements and limitations of an EOT?
An EOT is not a simple or straightforward option for business succession. It involves complex legal, tax, and financial considerations that require careful planning and professional advice. Some of the key requirements and limitations of an EOT are:
Eligibility: The EOT must meet strict criteria to qualify for tax relief, such as being resident in Canada, having only two purposes (holding shares and distributing income), having at least three unrelated employee-beneficiaries, and holding at least 51% of the voting shares and 90% of the value of all shares of the qualifying business.
Governance: The EOT must have a trustee who is responsible for managing the trust assets and making decisions on behalf of the employee-beneficiaries. The trustee can be an individual or a corporation but cannot be related to or controlled by the seller or any employee-beneficiary. The trustee must act in the best interest of all employee-beneficiaries and follow certain rules regarding conflicts of interest, disclosure, voting, and reporting.
Valuation: The seller must sell the shares of the qualifying business at fair market value to avoid any tax implications or penalties. The fair market value must be determined by an independent and qualified appraiser who is not related to or controlled by the seller or any employee-beneficiary. The valuation must take into account the financial performance, growth potential, and risk factors of the business, as well as the market conditions and comparable transactions.
Financing: The EOT must have sufficient funds to purchase the shares of the qualifying business and repay the loan over 15 years. The funds can come from the qualifying business itself or from a third-party lender, such as a bank, a credit union, or a government agency. The loan must be secured by the shares of the qualifying business and bear interest at a reasonable rate. The EOT must also have enough cash flow to cover its operating expenses and distributions to employee beneficiaries.
The introduction of EOTs may present an interesting opportunity for business owners to consider transitioning ownership of their companies to their employees in a tax-efficient way. Compliance with the rules will require careful planning and drafting of the related trust documents to ensure compliance with provincial legislation regarding trusts as well as federal and provincial tax rules.
Don’t miss this opportunity to explore the benefits of EOTs for your business. Whether you want to reward your employees, secure your legacy, or optimize your tax situation, EOTs can offer you a flexible and efficient solution. Contact us today and get a free consultation with our tax specialists. They will guide you through every step of the process, from assessing your eligibility to setting up and maintaining your EOT. Let us help you turn your vision into reality. Act now and contact us today!