How to Successfully Leverage Employee Ownership Trusts (EOTs) for Business Succession Planning

Introduction: EOTs Are A New Method For Business Owners To Pass Ownership To Employees

Employee ownership trusts (EOTs) are an important tax planning tool for Canadian business owners who plan to exit their business. EOTs present a unique succession planning opportunity that involves tax advantages and have been introduced as an option for business owners as of January 1, 2024.

An EOT aims to facilitate employee purchase of a business via a trust arrangement, eliminating the need for employees to provide upfront funding. Instead, the business itself supplies the necessary funds to the EOT, which then acquires a controlling stake in the business. To accommodate the use of the business’s earnings for the purchase, the standard 5-year capital gains reserve period is extended to 10 years, allowing only 10% of the gain on deferred proceeds to be recognized as income each year by the business owner vendor. Additionally, the government has introduced a temporary capital gains exemption for the first $10 million of gains realized from selling a business to an EOT. This exemption is subject to conditions, and is effective for the 2024, 2025, and 2026 taxation years if applicable.

A major advantage to Employee ownership trusts is that is allows the business owner to be paid out through the company rather than requiring the employees to acquire financing through  the more difficult route of bank or personal savings. Banks can still be used to provide some financing for the purchase price, but they do not need to be relied upon entirely. EOTs provide an incentive for Canadian resident employees to purchase their employers, thus precluding foreign entities from acquiring the businesses, ensuring more local ownership.

Requirements to Qualify As An Employee Ownership Trust

To qualify as an EOT, the trust must satisfy several key requirements related to its residence, assets, beneficiaries, and governance.

Trust Residence

To be recognized as an EOT, the trust must be a Canadian resident for tax purposes, following the normal requirements for a Canadian resident trust.

Trust Assets

The EOT must hold a controlling interest in qualifying businesses controlled by the EOT, with the shares of these businesses constituting at least 90% of the trust property value. Furthermore, any major decisions regarding the trust’s assets, such as giving up control of a qualifying business, require approval from more than 50% of the current employee beneficiaries.

Beneficiaries

The Employee ownership trust must benefit all active employees of the qualifying business and may also include former employees if desired. However, certain employees are excluded:

• Significant Owners: Employees who directly or indirectly hold 10% or more of the fair market value (FMV) of any class of shares of the qualifying businesses.
• Major Shareholders: Employees who, alone or with related or affiliated persons or partnerships, own 50% or more of the FMV of any class of shares.
• Vendor Group Members: Employees who, before the EOT acquired the business, owned 50% or more of the FMV of all shares or debts of the qualifying business.
• Probationary Employees: Employees who have not completed a reasonable probationary period, not exceeding 12 months, may be excluded but are not required to be.

The allocation of capital and income interests among beneficiaries must be done in a fair manner, based on a combination of their length of service, remuneration), and hours worked. The EOT can apply different formulas for current and former employees or for income versus capital distributions, but must ensure all beneficiaries are treated equitably.

Distribution Limits

Distributions from the Employee ownership trust must follow a formula that considers length of service, remuneration, and hours worked. While there is flexibility in applying different formulas for different contexts, trustees must ensure that no beneficiary is given preferential treatment over another.

Employee Ownership Trust Trustees

Trustees of an EOT must be either Canadian licensed trust companies or individuals. They can be elected by the active employee beneficiaries at least every five years, with at least one-third being active employees. Note that election is not a requirement. If not elected by the beneficiaries, at least 60% of the trustees must deal at arm’s length with previous owners. Each trustee has an equal vote.

Special Approvals by Employee Beneficiaries

More than 50% of active employee beneficiaries must approve:

• Any transaction or series of transactions leading to the loss of employment for at least 25% of the active employee beneficiaries (excluding terminations for cause).
• Any winding up, amalgamation, or merger of the qualifying business (excluding mergers with affiliates).

Business Control

The EOT must maintain a controlling interest in one or more qualifying businesses. Additionally, at least 60% of the business’s directors must be independent of previous controlling shareholders and their affiliates, and must act at arm’s length from them.

Pro Tax Tip: Employee Ownership Trusts Have Both Upsides and Downsides

Employee ownership trusts have some enticing upsides such as the $10 million capital gains exemption. They also have other benefits, including the exemption from the 21 year deemed disposition rule which states that trust assets are taxed as capital dispositions pursuant to a deemed disposition every 21 years.

EOTs can be a great way for business owners to create an opportunity for their business to be continued through their employees rather than sold to a third-party buyer. However, this succession strategy is not without its downsides. EOTs have strict requirements to qualify as an EOT. Failing to comply with these requirements will result in the EOT becoming disqualified, so a holding company can provide more flexibility. Additionally, the proceeds from the sale will be paid out the seller over a period of many years rather than an upfront payment. This places a level of risk on the seller, who is entrusting the buyer employees to run the business in a manner that allows them to generate the funds to finance the purchase price.

Compliance with the Employee ownership trust rules can be complex and not suitable for all businesses. If you are considering an Employee ownership trust, contact one of our expert Canadian tax lawyers to assess whether an EOT is the right choice for you.

FAQ

Can I use an Employee Ownership Trust to sell a minority stake?

EOTs are a tool for succession planning, and require selling a controlling stake in the company. As such, they are not effective for selling minority stakes. Other options such as stock option plans and share purchase programs can be an effective way to sell a minority stake. An expert Canadian tax lawyer can help advise you on which options are most suitable for your circumstances.

How are decisions made within an Employee Ownership Trust?

Decisions within an EOT are made by the trustees, who can be elected by the active employee beneficiaries, though election of trustees is not a requirement. Trustees have equal voting rights, and decisions must adhere to the principles of fairness and the trust’s governing documents, as well as trustee’s fiduciary obligations. Major decisions, such as changes to the trust property or business structure, often require approval from a majority of the active employee beneficiaries. In practice, while trustees will govern the trust, they may delegate decision making to a Board of Directors of the company, which is how it usually works in the US and often in the United Kingdom.

What happens if the business controlled by an Employee Ownership Trust faces financial difficulties?

If a business controlled by an EOT faces financial difficulties, the EOT and its trustees are responsible for managing the situation, including exploring restructuring options or potential sales. The primary goal is to safeguard the interests of the employee beneficiaries and ensure the long-term viability of the business.

DISCLAIMER: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.