EMPLOYEE OWNERSHIP TRUSTS: Business Succession Planning

Experienced legal representation for tax planning, tax structuring and business transactions.

ROLLOVER  -  ESTATE FREEZE  -  REORG  -  HOLDCO  -  CCPC  -  SUCCESSION  -  TAX PRODUCTS

Contact Neufeld Legal PC at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

Employee Ownership Trusts (EOTs) are a new and attractive option for business succession planning available to Canadian business owners, with certain tax advantages being available until December 31, 2026 (namely, a $10 million capital gains exemption from taxation for business owners who sell a qualifying business to an EOT). EOTs may be used to facilitate the purchase of a business by its employees, without requiring the employees to pay directly to acquire the shares. For business owners, an EOT provides an additional option for business succession planning, which can be particularly advantageous for small and medium business corporations that can optimize the significant tax benefits that are presently available.

Key Features of Canadian Employee Ownership Trusts

• New Legislation: The Canadian government introduced specific legislation for EOTs in its 2023 budget, with the rules becoming effective on January 1, 2024. This legislation provides the structure and tax incentives necessary for this business model.

• Tax-Free Capital Gains: The most significant incentive is a $10 million capital gains exemption for business owners who sell a qualifying business to an EOT. This exemption applies to sales that occur between January 1, 2024, and December 31, 2026. This tax-saving opportunity can be a powerful motivator for a business owner looking to retire or exit their business.

• Extended Capital Gains Reserve: For sales to an EOT, the standard five-year capital gains reserve is extended to 10 years. This allows the seller to spread out the tax on the sale of shares over a longer period, improving cash flow.

• Financing Flexibility: A key feature of the Canadian EOT is the relaxation of shareholder loan rules. This allows the business itself to lend money to the EOT to finance the purchase of shares from the owner. The EOT then repays the loan from the company's future profits, and the loan can be outstanding for up to 15 years without adverse tax consequences. This makes it possible for employees to acquire the business without having to use their personal funds.

• Perpetual Ownership: The 21-year deemed disposition rule for trusts does not apply to EOTs. This means an EOT can hold the business in perpetuity without triggering a taxable event every 21 years, promoting long-term stability and business continuity.

Requirements for a Canadian Employee Ownership Trust

To qualify for the tax benefits and operate as a legal EOT in Canada, a trust must meet several strict conditions:

• Canadian Resident: The EOT must be a trust resident in Canada.

• Irrevocable: The trust must be irrevocable, meaning it cannot be undone.

• Control Requirement: The EOT must acquire and hold a controlling interest (more than 50%) of the company's shares.

• Beneficiaries: The beneficiaries of the trust must be all current employees of the business (with some exceptions for new employees on probation or those who were significant shareholders). The EOT can also be set up to include former employees.

• Governance: The board of trustees must have at least one-third of its members as employee beneficiaries. Furthermore, the trustees cannot act in the interest of one beneficiary to the detriment of another.

• Arm's Length Transaction: The seller must deal at arm's length with the trust and any purchasing entity. The seller cannot retain a controlling interest in either the company or the trust after the sale.

• Fair Market Value: The sale of shares to the EOT must be at fair market value.

Requirements for a Qualifying Business Transfer

A qualifying business transfer to EOT necessitates a disposition by the business owner (seller) of shares of the subject corporation to either (i) a trust or (ii) a CCPC that is controlled and wholly-owned by a trust, if:

• immediately before the disposition, all or substantially all (generally 90% or more) the FMV of the assets of the subject corporation are attributable to assets (other than an interest in a partnership) that are used principally (generally more than 50%) in an active business carried on by the subject corporation or a corporation that is controlled and wholly-owned by the subject corporation;

• at the time of the disposition:

  • the seller deals at arm’s length with the trust and any purchaser corporation,

  • the trust acquires control of the subject corporation, and

  • the trust is an EOT, the beneficiaries of which are employed in the business;

• at all times after the disposition:

  • the seller deals at arm’s length with the subject corporation, the trust and any purchaser corporation, and

  • the seller does not retain any right or influence that, if exercised, would allow the seller (whether alone or together with any person or partnership that is related to or affiliated with the seller) to control, directly or indirectly in any manner whatever, the subject corporation, the trust, or any purchaser corporation.

Employee Ownership Trusts vs. Employee Stock Option Plans and Employee Share Purchase Plans

It is important to differentiate Employee Stock Option Plans (ESOPs) and Employee Share Purchase Plans (ESPPs) from the newly introduced EOT structure.

• EOTs are a specific legal and tax-defined structure designed for succession planning. The trust holds all the shares on behalf of all employees, who are the beneficiaries. The primary benefit for employees is a share of company profits, not direct ownership of individual shares.

• ESOPs are legal arrangements whereby the corporation grants its employees the right (an "option") to purchase a specified number of shares at a predetermined price (the "exercise price") for a set period of time. The key tax benefit was a 50% deduction on the stock option benefit (the benefit being the difference between the fair market value of the shares at the time of exercise and the exercise price, such that this deduction effectively meant the income from the options was taxed at a rate similar to capital gains, rather than the higher personal income tax rate). As of July 1, 2022, non-CCPCs were subjected to a $200,000 annual vesting limit to take advantage of the stock option benefit (with no limit being imposed on CCPCs).

• ESPPs are legal arrangements whereby the corporation allows employees to directly purchase shares, often at a discount. Many ESPPS allow employees to contribute a portion of their wages/salary through payroll deductions to buy shares, with many corporations also providing an employer matching contribution or discounted share price to encourage participation.

For business succession planning, including Employee Ownership Trusts, contact our law firm to schedule a confidential initial consultation with a knowledgeable tax planning lawyer at Chris@NeufeldLegal.com or 403-400-4092 / 905-616-8864.

 

What is a Section 85 Rollover: A section 85 rollover enables a taxpayer (the transferor) to dispose of “eligible property” to a taxable Canadian corporation (the transferee), so that most, if not all, of the tax consequences which usually arise on such a disposition are shifted to the transferee corporation from the transferor. The transferor is permitted to dispose of the property to the transferee corporation for an “agreed amount” which may be other than the fair market value of either such property or the consideration received for it. Read more . . .

 

What is a Butterfly Transaction: A Butterfly Transaction, technically known as a Divisive Reorganization, is a tax-free method of dividing up assets in a corporation into separate corporate allocations, which is commonly implemented when the shareholders are seeking to go their separate ways and thus divide out the corporation’s assets. A Butterfly Transaction can also be carried out when the corporation consists of two different businesses with a view to separating the divisions so that they are each in a separate corporation; or alternatively, to “purify” a corporation of its non-active business assets . . . Read more . . .

  

What are Capital Dividends (Tax-Free Dividends): Capital dividends are private corporation dividends that are paid tax-free to their Canadian-resident shareholders, such that no part of the dividend is included in computing the recipient shareholder’s taxable income. Read more . . .

  

Importance of Maintaining a Capital Dividend Account [for Tax-Free Dividends): A private corporation’s Capital Dividend Account is the means by which the corporation pays its resident-Canadian shareholders tax-free capital dividends. The Capital Dividend Account (CDA) does not appear on a balance sheet, although it might appear in the notes of a financial statement, where the accountants are sufficiently apprised as to the inner workings and transactions of the corporation. Read more . . .

 

What is an Eligible Dividend (Enhanced Dividend Gross Up / Tax Credit): An eligible dividend is a taxable dividend that receives an enhanced dividend gross up and an enhanced dividend tax credit and is available on dividends from either a public corporation (not entitled to the small business deduction) or a private corporation with high earnings (net income over the $500,000 small business deduction). Read more . . .

 

What is a Non-Eligible Dividend (Ordinary Dividend): A non-eligible dividend (also known as an ordinary dividend) is a taxable dividend that does not receive the benefit of the enhanced dividend gross-up and the enhanced dividend tax credit that is provided to eligible dividends. Read more . . .

 

What is a Stock Dividend: A stock dividend is a dividend paid by the issuance of shares of the capital stock of the payer corporation. The term "stock dividend" is defined as including any dividend paid by a corporation to the extent that it is paid by the issuance of shares of any class of the capital stock of the payer corporation, . . . Read more . . .

 

Click here for our law firm's News & Insights specific to our areas of legal practice.