Owner-managers contemplating selling their business to their employees could consider a sale of shares to a worker co-operative corporation in light of significant tax incentives proposed by the federal government in 2024.
Typically, when a business owner is ready to exit their business or retire, they must either sell, transfer, or discontinue the business. However, a sale to a worker co-operative can be a viable succession strategy as the business can continue with minimal disruption even if the owner leaves or retires.
In our article, Employee ownership trusts: A new tax incentive to consider for business succession planning, we discuss new tax incentives available on a sale to an employee ownership trust (EOT). The proposed capital gains exemption of up to $10 million and a longer capital gains reserve period are also proposed to be extended to worker co-operatives, which makes selling shares to this entity a comparable and attractive alternative for succession planning from a tax perspective.
While worker co-operatives have a long history in Canada, to be eligible for the proposed capital gains exemption, the co-op must be a newly established and meet a strict definition introduced with proposed legislation.
What is a worker co-operative?
To qualify as a worker co-operative, it must adhere to the precise definition provided in the Income Tax Act of Canada. This definition includes numerous conditions that must be met by the corporation at all relevant times, including the requirements that:
- the corporation be resident in Canada;
- it be incorporated or continued under a Canadian or provincial law that provides for the establishment of co-operative corporations;
- at least 75% of the individuals employed by the corporation and all qualifying co-operative businesses controlled by the corporation hold a membership share of the co-op;
- each initial membership share provided to an employee is issued for a nominal amount determined in the same manner for all members; and
- the bylaws of the corporation provide a procedure for allocating, crediting, or distributing any surplus earnings of the corporation such that no less than 50% of those earnings be paid on the basis of the remuneration earned by the qualifying co-operative workers from the corporation or the labour contributed by those members to the corporation.
Additional criteria apply with respect to the purpose of the corporation, future control of the corporation, directors of the corporation, and initial membership. These rules aim to ensure that the co-operative benefits employees while supporting the long-term success of the business.
What are the new tax incentives of selling a business to a worker co-operative?
The 2024 budget introduced an initiative aimed at facilitating the transfer of businesses to a newly created worker co-operative. This initiative includes incentives for both selling a business and forming a co-operative to acquire it. While draft legislation has been released, these incentives have not yet been enacted into law. If passed, the legislation would offer benefits to both the current business owners selling their corporation’s shares and the worker co-operatives purchasing them.
Selling to a co-op can offer several benefits to business owners looking to sell their shares. It increases the pool of potential buyers, provides for continuity of the business, provides for a $10 million capital gains exemption, and allows for a 10-year capital gains reserve. As well, to fund the purchase of the shares, the worker co-operative can borrow money from the underlying business and pay it back over an extended period of time. The incentive supports worker co-ops (purchasers) by enabling employees to collectively own and manage the business.
How does the $10 million capital gains exemption work and when can a business owner claim it?
To access the proposed $10 million capital gains exemption on a qualifying conversion to a worker-cooperative, it must be shared among individual owners who are selling their business. This exemption reduces taxable income and significantly lowers the taxes owed by the seller. Note that the capital gains eligible for this exemption are exempt from alternative minimum tax.
Where all of the following conditions are met, the rules permit an individual to claim the capital gains exemption on a qualifying co-operative conversion:
Transaction date:
No previous claims:
Throughout the 24-month period immediately prior to the sale:
- Ownership: The shares were not owned by anyone other than the seller, a related person, or a related partnership.
- Active business: More than 50% of the fair market value of the shares was derived from assets used principally in an active business.
Immediately before the sale:
- No professional corporations: The corporation being sold and any affiliated corporations that are owned directly or indirectly are not professional corporations. This means that they do not carry out the professional practice of an accountant, chiropractor, dentist, lawyer, medical doctor, or veterinarian.
- Not an established worker co-operative: The co-op must not already be established for the purpose of providing employment to its members who are its employees (excluding officers or directors) or the employees of another corporation controlled by it.
At the time of sale:
- Seller: The seller is an individual (not a trust) and is at least 18 years old.
- Involvement in business: Throughout any 24-month period ending before the sale, the seller, their spouse, or their common-law partner was actively engaged on a regular and continuous basis in the relevant business.
- Purchaser: The purchaser corporation is a worker co-operative.
- Residency requirement for workers: At least 75% of the co-operative’s qualifying workers must be resident in Canada.
- Residency requirement for members: At least 75% of the co-op’s individual employee members must be resident in Canada.
Joint election filed on time:
What is a qualifying co-operative conversion?
In addition to the previously mentioned conditions, the sale must meet all the criteria for a qualifying co-operative conversion, which include:
- Not related: The seller deals at arm’s length with the purchaser (the worker co-operative).
- Control: The purchaser acquires control of the corporation being purchased.
- Purchaser: The purchaser is a worker co-operative.
- Not related: The seller deals at arm’s length with the purchaser and the corporation that was sold.
- No influence: The seller does not retain any right or influence that, if exercised, would allow the seller (alone or together with any person or partnership related or affiliated with it) to control, directly or indirectly, the purchaser or the corporation that was sold.
What is the extended capital gains reserve and how does it work?
Both the current business owner and the purchasing worker co-operative benefit from a capital gains reserve of up to 10 years, compared to the usual maximum five-year reserve.
If the terms of the sale require payment over 10 years, the business owner can report the capital gains from the sale on their tax return over this period of time, thus allowing time for the purchaser to fund the purchase. A minimum of 10% of the gain must be reported as income annually, with the exact amount calculated each year based on the terms of the contract, actual amounts received, and the outstanding amount.
What is a disqualifying event?
A disqualifying event can occur after the sale that may retroactively deny the $10 million capital gains exemption. A disqualifying event occurs in the earlier of two situations:
- Worker co-operative status: When the co-op no longer meets the qualifying criteria.
- Assets used in an 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 attributed to assets used principally in an active business carried on by the worker co-operative.
If a disqualifying event occurs within 24 months of the sale, the capital gains exemption is considered to have never applied to the sale of the shares, which would negatively affect the seller. If the disqualifying event occurs after 24 months of the sale, the co-operative is required to report a deemed 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 can result in significant taxes owing to either the seller or the worker co-operative. Thorough planning is necessary to avoid these outcomes.
Is selling your business to a worker co-operative the right exit strategy for you?
The worker co-operative initiative lets business owners transition ownership to employees and, with proper planning, benefit from a $10 million capital gains exemption and a 10-year capital gains reserve. This offers significant tax advantages and allows for the continuity of the business.
How BDO can help
While the sale of a business to a co-op may be a good succession plan for a business owner, the ability to claim an exemption from tax on up to $10 million of capital gain is only available for sales that occur before 2027.
Complicating this short time frame is the fact that the relevant legislation to create a worker co-operative and for the capital gains exemption has not yet been passed into law, and at this point in time, it must be considered that the proposed legislation may not go forward with a new government. However, business owners and potential employee groups should be aware of this alternative to be ready to act when such legislation is passed.
As always with a sale of a business, careful planning is essential. BDO can assist both buyers and sellers navigate the extensive rules for this incentive and determine eligibility.
For more information or assistance with the worker co-operative or other incentives available, as well as structuring the business sale, please contact us.
The information in this publication is current as of Jan. 22 2025.
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.