Employee ownership trusts introduced, but with no incentives

Small business owners hoping to sell to their employees will soon have a new tool to do so, but some advocates worry that uptake will be insufficient in the absence of incentives.

Following promises made in previous budgets, the 2023 federal budget provided details on employee ownership trusts (EOTs), a structure that will allow groups of employees to purchase a business over time.

“Companies with higher levels of employee ownership are better all-around businesses,” said David O’Leary, founder and principal of Kind Wealth, a fee-only planning firm, in Toronto, citing research from Harvard Business Review and others. “The benefits make this one of the few remaining truly non-partisan issues. Who doesn’t want to see more profitable companies with happier and more financially secure employees?”

A 2022 survey from the Canadian Federation of Independent Business (CFIB) found that 53% of small business owners would be more likely to sell to their employees if the option was available.

“Oftentimes it’s difficult just to find a buyer, period,” O’Leary said, adding that many owners don’t want to sell to buyers who will “lay off staff or strip the company down and sell it for parts.”

He said he has a client in his 70s who wants to retire but can’t because “the vast majority of his wealth is on paper in his business. The trouble is, it’s proving very difficult to find a buyer for his niche business.”

O’Leary said an EOT could solve his client’s problem.

Indeed, the budget suggested EOTs would provide an attractive succession opportunity for the 76% of small business owners who plan to retire over the next decade, according to the CFIB.

To make EOTs viable, the government proposed exempting them from several existing tax rules, understanding that EOTs will probably last longer than many other types of trusts.

However, the legislation did not include incentives for employers or employees to participate in EOTs, which both the Canadian Employee Ownership Coalition (CEOC) and the CFIB had recommended.

Jon Shell, managing director and partner with Social Capital Partners in Toronto and a member of the CEOC steering committee, said employee ownership is one of the most powerful tools to build middle-class wealth. However, he said we shouldn’t expect the budget to drive significant uptake.

“Without the types of incentives we’ve seen be so successful in the U.S. and the U.K., this new trust will be marginal in Canada. And with so many baby boomers retiring over the next 10 years this would be a massive missed opportunity,” said Shell, whose comments reflect his own views rather than the coalition’s.

Owners “are making a major sacrifice” selling to an EOT, he said: they get paid out over time, as opposed to in a lump sum, and may forgo the opportunity to evaluate multiple bids.

Shell said the U.K. previously had a similar structure to the EOT proposed in Tuesday’s budget, but few took advantage. In 2014, the U.K. government waived capital gains taxes for selling a controlling interest in a company to an EOT, and more than 30,000 workers became owners in 2021 alone.

Other carrots could include incentives for lenders, which have existed in the U.S., as well as preferential tax treatment for the employee-owned business, which would allow employees to repay the seller faster, Shell said.

Even without incentives, Michelle Connolly, senior vice-president and Advance Wealth Planning leader with Wellington-Altus Private Wealth in Toronto, said EOTs can be a “very viable option” when a business owner has no obvious single successor and family members are uninterested. Furthermore, the transaction must occur at fair market value, which limits the downside for business owners.

“It’s keeping businesses in the community,” she said. “For employees gaining wealth, they’re vested. That business is better off.”

EOTs are proposed to take effect as of Jan. 1, 2024, and the government said it “welcomes stakeholder feedback on how best to enhance employee rights and participation in the governance” of EOTs.

Shell said he looks forward to providing that feedback.

“We’re glad that there’s legislation, and it’s a step in the right direction. We want to be supportive of business owners who want to choose this path,” Shell said. “It’s really important that it’s not punitive for them to do so, and at this point that’s not the case.”

Tax rules for EOTs

An EOT must reside in Canada and have only two purposes: to hold shares of qualifying businesses for the benefit of employee beneficiaries, and to make distributions to those beneficiaries.

Only “qualifying employees” can be EOT beneficiaries — defined as people employed by the business but without significant economic interest in it. An exception exists for employees who haven’t yet passed a reasonable probation period.

The proposed legislation allows for an employee’s length of service, remuneration and hours worked to be considered when making EOT distributions, but employees must otherwise be treated “in a similar manner.”

Like with other personal trusts, distributions are taxable in the beneficiary’s hands and undistributed trust income is taxed at the highest personal marginal rate.

The EOT must hold a controlling interest in the qualifying business, with shares in the business constituting “all or substantially all” of the EOT’s assets. When transferring a qualifying business to an EOT, the shares must be disposed of for no more than fair market value. The shares must also go immediately to an EOT or a corporation wholly owned by the EOT.

Trustees of the EOT must be Canadian residents aged 18 and older and must be elected at least once every five years. Previous owners of the business could not be more than 40% of the EOT’s trustees or directors.

The budget also proposed exempting EOTs from several existing tax rules:

• The five-year capital gains reserve: capital gains resulting from a qualifying business transfer to an EOT could be brought into income over 10 years instead of five, meaning at least 10% of the gain would need to be declared as income each year.
• The shareholder loan rules: the repayment period would be extended to 15 from one year for amounts loaned to an EOT from a qualifying business to purchase shares.
• The 21-year rule: EOTs would be exempt from the 21-year rule.

The government expects EOTs to cost $20 million over five years, and said it may add restrictions in future “to protect the integrity of the tax system.”

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.