Employee Ownership Trust: Business Succession Planning

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

From the perspective of tax minimization, business owners presently looking at implementing a business succession plan should seriously consider the viability of an Employee Ownership Trust (EOT), which has only recently been made available by the Canadian federal government and initially has been assigned considerable tax advantages, which may well expire after its initial phase-in on December 31, 2026. Employee Ownership Trusts have become a new and attractive option for succession planning available to Canadian business owners. Employee Ownership Trusts offer a unique way to transition a business to employees while preserving its legacy and offering significant tax benefits.

Key Features of Employee Ownership Trusts

New Legislation: The Canadian federal government introduced specific legislation for Employee Ownership Trusts 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 Employee Ownership Trust. 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 Employee Ownership Trust, 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 Employee Ownership Trust is the relaxation of shareholder loan rules. This allows the business itself to lend money to the Employee Ownership Trust to finance the purchase of shares from the owner. The Employee Ownership Trust 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 Employee Ownership Trusts. This means an Employee Ownership Trust can hold the business in perpetuity without triggering a taxable event every 21 years, promoting long-term stability and business continuity.

Requirements for an Employee Ownership Trust

To qualify for the tax benefits and operate as a legal Employee Ownership Trust, a trust must meet several strict conditions:

Canadian Resident: The Employee Ownership Trust must be a trust resident in Canada (excluding deemed resident trusts).
Irrevocable: The trust must be irrevocable, meaning it cannot be undone.
Control Requirement: The Employee Ownership Trust 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 Employee Ownership Trust can also be set up to include former employees [more about Permissible Beneficiaries of an EOT].
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 [more about Permissible Trustees of an EOT].
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 [more about a Qualifying Business Transfer].
Fair Market Value: The sale of shares to the Employee Ownership Trust must be at fair market value, with has all or substantially all (generally 90% or more) of the FMV of the property of the trust attributable to shares of one or more Qualified Businesses that the trust controls [more about Qualified Businesses].

Employee Ownership Trusts vs. Employee Share Ownership Plans

It is important to differentiate Employee Share Ownership Plans (ESOPs) from the newly introduced Employee Ownership Trust structure.

Employee Ownership Trusts 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 in Canada can take many forms, from simple stock option plans to formal share purchase programs. They are not as strictly regulated as Employee Ownership Trusts and don't come with the same specific tax advantages. An ESOP typically involves employees directly acquiring individual shares, often over time.

For knowledgeable and experienced legal representation for succession planning and trusts, including employee ownership trusts, contact tax lawyer Christopher R. Neufeld at Chris@NeufeldLegal.com or call 403-400-4092 (Calgary, Alberta) / 905-616-8864 (Toronto, Ontario).

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