This blog article was written by Gemini and edited by Jonathan Carter, CPA, CMA, CPB.  As you read this article, you’ll realize that this is a very technical undertaking. 

If you are considering an Employee Ownership Trust, it is vital that you consult with a tax specialist and that it be set up correctly. This is not a DIY project.  

KATA would engage with a third-party tax specialist if this was a consideration for succession planning.

Employee Ownership Trust (EOT)

For many Canadian business owners, the question of succession planning looms large. What happens to the company you’ve poured your heart and soul into? How do you ensure its continued success, preserve its culture, and secure a fair return on your life’s work?

Traditionally, options included selling to a competitor, a private equity firm, or a family member. However, a new and increasingly attractive alternative has emerged: the Employee Ownership Trust (EOT).

Since January 1, 2024, Canada has formally introduced detailed rules for EOTs, creating a powerful incentive for owners to transition their businesses to the very people who helped build them – their employees. 

This isn’t just about feel-good optics; EOTs offer significant financial and non-financial benefits, particularly thanks to some compelling tax breaks.

What Exactly is an Employee Ownership Trust (EOT)?

At its core, an EOT is a specialized trust that acquires and holds shares of a qualifying business for the collective benefit of its employees. Think of it as a mechanism that allows a company to become employee-owned without requiring individual employees to directly purchase shares or put up their own capital. Instead, the trust acts as the owner, and employees become beneficiaries of that trust.

Here’s how it generally works:

• The Sale: The current business owner sells a controlling interest (at least 51%) of their company to the EOT. The sale price is typically at fair market value.

• Funding the Purchase: A key innovation of the EOT model is how the purchase is financed. Unlike traditional buyouts where employees need significant upfront capital, the EOT usually borrows money from the underlying business itself to fund the acquisition. This loan is then repaid over time from the company’s future profits.

• Employee Beneficiaries: All eligible current (and, if the trust permits, former) employees become beneficiaries of the EOT. This means they indirectly benefit from the company’s success, often through profit-sharing, dividends, or a share in equity growth.

The specific formula for distributing these benefits (e.g., based on wages, hours worked, or tenure) is defined in the trust deed.

• Governance: The EOT is managed by a board of trustees, at least one-third of whom must be employee beneficiaries. This ensures that the employees have a voice in the company’s direction and that decisions are made in their collective best interest.

• Irrevocable Nature: An EOT is typically an irrevocable trust, meaning it’s set up for the long term and cannot be easily dismantled. This provides stability and a clear path for sustained employee ownership.

Why Are EOTs Gaining Traction in Canada?

Beyond the altruistic notion of empowering employees, EOTs offer several compelling advantages:

1. Succession Planning Alternative: For many owners nearing retirement, finding a suitable buyer can be challenging. EOTs provide a viable exit strategy, allowing owners to transition their business to a familiar and dedicated workforce, preserving their legacy, and often their company’s culture and values.
2. Business Continuity: Selling to an EOT often means less disruption to operations. The existing management team and employees remain, ensuring a smoother transition and continuity of business relationships.
3. Enhanced Employee Engagement and Productivity: When employees have a vested interest in the company’s success, they are often more engaged, motivated, and productive. Research has shown that employee-owned companies can exhibit greater resilience, innovation, and profitability.
4. Local Job Preservation: EOTs help keep businesses and jobs within their local communities, preventing potential relocation or significant changes that can occur with external acquisitions.

The Game-Changing Tax Breaks in Canada

The Canadian government has introduced significant tax incentives to encourage the adoption of EOTs. These incentives primarily benefit the selling business owner and are a major driver of interest in this model.

1. The $10 Million Capital Gains Exemption (Temporary):

This is the headline-grabbing incentive. For qualifying business transfers to an EOT occurring in the 2024, 2025, and 2026 tax years, an individual selling their shares can claim a capital gains exemption of up to $10 million.

• What this means: For eligible sales, the first $10 million of capital gains realized by the seller on the disposition of shares to an EOT will be tax-free. This can result in substantial tax savings (potentially up to $2.5 million, depending on the seller’s marginal tax rate).

• Stackable with LCGE: Importantly, this $10 million exemption is in addition to the existing Lifetime Capital Gains Exemption (LCGE), which is indexed to inflation (approximately $1.25 million in 2024). This means a single seller could potentially realize over $11 million in tax-free capital gains.

• Conditions: To qualify for this exemption, certain conditions must be met, including:

• The seller must be an individual (or a personal trust with an individual beneficiary) over 18 years of age.
• The business must be a Canadian-controlled private corporation (CCPC) and meet certain active business requirements.
• The seller must have been actively engaged in the business for at least 24 months.
• The EOT must acquire a controlling interest (more than 50%) in the business.
• A joint election must be filed with the CRA by the EOT, any purchaser corporation, and the eligible vendors.
• The seller must deal at arm’s length with the EOT and the corporation after the transfer and not retain control.

2. Extended Capital Gains Reserve:

For sales to an EOT where the proceeds are received over time (which is common as the EOT repays its loan from future profits), the capital gains reserve period is extended from the usual five years to ten years. 

This allows the seller to defer the taxation of their capital gains over a longer period, providing more flexibility in financial planning.

3. Exception to Shareholder Loan Rules:

Normally, loans from a corporation to a shareholder (or a trust benefiting a shareholder) can have adverse tax implications, such as being deemed a taxable benefit if not repaid within a certain timeframe. 

For EOTs, the rules are more lenient: the qualifying business can lend funds to the EOT to purchase shares, and these loans can have a repayment period of up to 15 years without triggering immediate taxable benefits.

4. Exemption from the 21-Year Deemed Disposition Rule:

Most trusts in Canada are subject to a “21-year deemed disposition rule,” which generally triggers a capital gain for tax purposes every 21 years on their capital property.

EOTs are specifically exempt from this rule, allowing them to hold the business indefinitely without triggering a deemed disposition and associated tax implications. This provides long-term stability for the employee-owned business.

Considerations and Challenges

While EOTs offer exciting opportunities, it’s crucial to be aware of potential considerations and complexities:

• Financial Viability: The business needs to have stable cash flows to service the debt taken on by the EOT for the purchase. Companies with weak profit margins or volatile revenues may find this structure challenging.
• Costs and Complexity: Setting up an EOT involves legal, accounting, and valuation complexities. Engaging experienced professional advisors is essential to ensure compliance and a smooth transition.
• Loss of Direct Control: For the selling owner, transferring control to an EOT means relinquishing direct management oversight. While they can often remain involved in a non-controlling capacity (e.g., as a board member), ultimate decision-making rests with the EOT trustees.
• Valuation Challenges: The sale price to an EOT must be at fair market value, determined by a certified business valuator. This independent valuation may sometimes be lower than what could be achieved in a competitive third-party sale.
• Employee Management and Engagement: While EOTs can boost morale, ensuring effective employee engagement in governance and decision-making requires careful planning and communication.

Is an EOT Right for You?

The EOT model is a compelling option for many Canadian business owners, particularly those who:

• Are seeking a succession plan that preserves their legacy and business culture.
• Want to reward their employees and ensure their continued involvement in the company’s success.
• Operate a profitable business with stable cash flows.
• Are keen to take advantage of the significant capital gains exemption available until the end of 2026.

Given the intricacies of the legislation and the substantial tax implications, it is paramount for any business owner considering an EOT to consult with experienced legal, tax, and financial advisors. They can help you navigate the eligibility requirements, structure the transaction effectively, and ensure that an EOT aligns with your specific succession goals and financial objectives.

The introduction of the Employee Ownership Trust in Canada represents a progressive shift in business succession planning, offering a unique blend of financial advantage and legacy preservation. For the right business, it’s a powerful tool to secure a bright future for your company and its invaluable employees.

Ready to explore if an Employee Ownership Trust is the right succession strategy for your business? Contact us today! Let’s discuss your unique situation and unlock your legacy.