When an entrepreneur decides to sell their business and excludes selling to family members or current business partners, they may consider selling to their employees as a group.
In 2023, the government introduced employee ownership trusts (EOTs) as a way to sell a qualifying business to employees as a group. By the time it was first possible to create these trusts, on Jan. 1, 2024, the government had also introduced a capital gains exemption (available for a limited period of time) of up to $10 million of capital gains realized on a sale to an EOT.
This article explores EOTs and their benefits as an option to business owners.
What is an employee ownership trust in Canada?
An employee ownership trust provides an alternative for business owners to transfer their business to their employees in a tax-efficient manner. An EOT is a trust that holds shares of a corporation for the benefit of its employees. The employees do not own the shares; instead, they are beneficiaries of an irrevocable trust that holds the share(s) of the qualifying corporation(s).
For the purchase, the rules permit an EOT to borrow from the underlying business to fund all or part of the purchase of shares and allow the loan, properly structured, to be outstanding for a maximum of 15 years from the date of purchase. It is not usually possible for a shareholder (the EOT) to borrow from the corporation of which it is a shareholder without tax consequences, so this is a relieving condition of the general shareholder benefit rules and can also address financing concerns that employees may have. Note that with an EOT, it is the trust that acquires the corporation, as the employees do not pay directly to acquire the shares.
For business owners, an EOT offers an option for succession planning. It ensures business continuity while providing a capital gains exemption of up to $10 million and permitting a maximum 10-year capital gains reserve compared to the usual maximum five-year capital gains reserve that can be claimed when the proceeds of sale are due over time. Note that capital gains eligible for the $10 million capital gains exemption on a qualifying business transfer to an EOT are exempt from alternative minimum tax.
When is an individual eligible for the capital gains exemption of $10 million?
The most significant tax incentive available to business owners who sell to an EOT is that the first $10 million in capital gains realized on the sale of shares to an EOT in 2024, 2025, or 2026 is exempt from income tax. The rules permit an individual to claim a capital gains exemption on a qualifying business transfer where the following conditions are met:
- Previous claims: No capital gains exemption for a sale of shares to EOTs has previously been claimed in respect of the same business by any individual.
- Ownership and active business: Throughout the 24 months prior to the sale, only the individual (or a related person or related partnership) owned the shares, and more than 50% of the fair market value of the shares of the qualifying business was derived from assets which were used principally in an active business.
- Immediately before the sale:
- Not a professional corporation: The corporation and any affiliated corporations are not professional corporations (a corporation that carries on the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian, or chiropractor).
- No control: The EOT does not control the corporation.
- At the time of the sale:
- Vendor: The business owner is an individual (not a trust) and is at least 18 years old.
- Involvement in business: The individual (or their spouse or common-law partner) was actively engaged on a regular and continuous basis in the business throughout any 24-month period ending before the disposition time.
- Beneficiaries: At least 75% of the employees who are beneficiaries of the EOT are resident in Canada.
- Joint election: The $10 million capital gains exemption must be shared among individual owners who are selling their shares of the corporation. The EOT, any corporation owned by the EOT, and the vendors, must jointly file an election with the Canada Revenue Agency (CRA), indicating the amount eligible for the capital gains exemption of up to $10 million. If there is more than one vendor eligible for the exemption, they must indicate the percentage that is allocated to each. This must be filed with the CRA on or before the filing due date of the EOT’s tax return that includes the sale.
How does the extended capital gains reserve work?
If the terms of the sale require payment over a number of years, both the current business owner and the purchasing EOT can benefit from a capital gains reserve of up to 10 years. This allows more time for the EOT to fund the purchase, and it spreads out the capital gains from the sale on the vendor’s tax return over a longer period of time. A minimum of 10% of the gain must be reported each year as income.
What is a qualifying business transfer to an employee ownership trust?
In addition to the above conditions, the sale must satisfy the requirements of a qualifying business transfer, which include:
The vendor must sell the shares of capital stock of a corporation.
The purchaser must be an EOT or a Canadian-controlled private corporation (CCPC) that is wholly owned by an EOT.
Immediately before the sale, all or substantially all (generally 90% or more) of the fair market value of the assets of the corporation is attributable to assets used principally in an active business carried on by the corporation or a corporation wholly owned by it.
At the time of the sale, the vendor deals at arm’s length with the purchaser, the EOT acquires control of the corporation, and the EOT’s beneficiaries are employees of the business.
At all times after the sale, the vendor remains at arm’s length with both the purchaser and the corporation that was sold and the vendor does not retain any right or influence that would allow the vendor (or someone related or affiliated with them) to control directly or indirectly the corporation or the purchaser.
What are the requirements of an employee ownership trust?
To qualify as an EOT, the trust must meet specific criteria designed to ensure it benefits the employees and supports the business's long-term success. Key conditions include:
What disqualifying events impact employee ownership trusts?
It is important to note that a disqualifying event can occur after a sale that can retroactively deny the $10 million capital gains exemption.
A disqualifying event occurs in the earlier of two situations:
- EOT status: When the EOT no longer meets the criteria to be an EOT (noted under the What are the requirements of an employee ownership trust? section).
- Active business: If at the beginning of two consecutive taxation years following the sale, less than 50% of the fair market value of the shares is attributable to assets used principally in an active business.
If a disqualifying event occurs within 24 months of the sale, the capital gains exemption is deemed never to have been applied to the sale of the shares. If the disqualifying event happens after 24 months, the EOT is deemed to have a capital gain in the year the disqualifying event occurs. The deemed capital gain is equal to the capital gains exemption that was claimed on the sale. These consequences would result in significant taxes owing. Planning is required to prevent such occurrences.
Is an employee ownership trust right for your exit strategy?
Employee ownership trusts allow business owners to transition ownership to their employees while providing a significant tax benefit to the business owner if they can claim the $10 million exemption. While this structure will not work for management buy-outs or a buy-out by only a few key employees, it can be a viable option for business owners who wish to reward their employees by giving them a tangible stake in the business. By meeting the eligibility criteria and understanding how EOTs work, entrepreneurs can use this incentive to ensure a smooth succession plan.
How BDO can help
As currently legislated, the $10 million capital gains exemption on qualifying business transfers to an EOT is available for sales occurring before 2027. Careful planning is needed to ensure the extensive criteria are met by both buyers and vendors. For assistance in determining your eligibility for this incentive, please contact us.
The information in this publication is current as of Dec. 18, 2024.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.