How employee ownership trusts limit estate planning

Many Canadians own shares of their own businesses, and these private corporation shares form much of their personal wealth for estate planning purposes. Traditionally, one spouse would often bequeath their shares to the other spouse or to adult children, in hopes they could continue the business (assuming shares weren’t transitioned prior to death). However, business succession increasingly involves employees and other third parties, rather than family.

While Budget 2023 introduced new rules for employee ownership trusts (EOTs), a structure used commonly in the United States and United Kingdom as an incentive for small business owners to pass ownership to their employees, the proposed rules are limiting.

Consider the hypothetical client situation of two friends in their 40s, Jean-Luc and Will, who created a successful business (Opco) with the following common fact pattern:

• Jean-Luc and Will each own 50% of the common shares, and they each acquired their shares for nominal consideration.
• The fair market value of Opco is $1 million.
• Jean-Luc and Will are both Canadian for purposes of the Income Tax Act.
• Opco is an active Canadian-controlled private corporation operating exclusively in Canada with five employees other than Jean-Luc and Will.
• Jean-Luc and Will hope to have many years to plan the eventual sale of the business to employees or a third party and access their capital gains deduction.
• While the friends have different personal and business viewpoints, each acknowledges that their employees and Opco deserve a smooth succession to the next generation.
• They agree that their spouses and children must not take over the business.

For a trust to qualify as an EOT, it must reside in Canada and have two purposes:

• hold shares of qualifying businesses (such as Opco) for the benefit of qualifying employee beneficiaries, and
• make distributions to those beneficiaries.

For Jean-Luc and Will to use an EOT, they would need to sell at least half of their shares at fair market value, meaning they would be taxed on this disposition and presumably give up control to the EOT. As both Jean-Luc and Will are in their 40s, they may not wish to cede control of their business to the EOT until they are ready to retire.

While shareholders will be permitted to defer part of the capital gain for up to 10 years (five years for most transactions), a minimum of 10% of the gain would be required to be brought into income each year for 10 years.

Unlike most trusts, EOTs contain significant limitations on who may act as trustees, as these rules require a separation between the old owners and the new EOT. Specifically, the trustees of the EOT must be Canadian residents or registered trust companies, and the major shareholders who sell to the EOT cannot make up more than 40% of the trustees, the directors of a corporate trustee, or the directors of the qualifying business.

The trustees are also re-elected by the beneficiaries every five years. This means Jean-Luc and Will could lose their trustee roles when their own employees elect trustees.

In any event, Jean-Luc and Will would need to find at least three additional directors of Opco and trustees of the EOT, potentially at a significant annual cost. Substantial upkeep costs may have been contemplated by the federal government, as there is an ability for the qualifying business to loan funds to the EOT with a repayment period of up to 15 years without triggering an income inclusion under Section 15 of the Income Tax Act pertaining to shareholder loans.

EOT beneficiaries may only be “qualifying employees,” meaning people who are employed by the business beyond a reasonable probation period (no more than one year). However, this definition excludes employees with significant economic interest in the corporation. In our example, Jean-Luc and Will would be excluded from participation in the EOT.

The proposed EOT legislation requires that the beneficiaries be treated in a “similar” manner, with only length of service, remuneration and hours worked to be considered when making EOT distributions. In our example, if there was an exemplary employee to whom Jean-Luc and Will wished to provide additional benefits, they would need to do so outside of the EOT (and they may need the trustees to agree).

Similar to most personal trusts, distributions from an EOT are taxable in the beneficiary’s hands, and undistributed trust income is taxed at the highest personal marginal rate. However, one benefit of an EOT is that it is not subject to a 21-year deemed disposition event, as it is intended that an EOT should be able to exist for as long as the corporation does.

Importantly, in an EOT, individual employees do not receive shares directly. Rather, the trustee holds the shares for the benefit of all present and future qualifying employees as a single evolving class of beneficiary, without the ability to issue any of the shares to the beneficiaries. This means that a departing employee would no longer be a qualifying employee or beneficiary, and a repurchase or redemption of shares would not be needed. This also means that if an Opco employee wished to purchase shares directly, they may need independent financing, as well as a willing vendor.

Ultimately, in exchange for a few small tax benefits and an ability to benefit employees in a manner akin to being shareholders without issuing shares in their names, EOTs will likely require significant upkeep and compliance, a taxable disposition by the selling shareholders, significant inflexibility, and a loss of control during transition that may be contrary to the entrepreneurial spirit of many owner-managers.

Short of additional legislative incentives, other conventional pre-existing strategies may yield more favourable results for owner-managers like Jean-Luc and Will. These strategies may include use of:

• estate freezes to allow new employees to purchase shares at a nominal value and participate in growth while existing common shares have their value “frozen” in fixed value preferred shares through corporate reorganizations;
• unanimous shareholder agreements to structure the affairs of a corporation, including to facilitate share transactions, facilitate post-mortem planning, and confirm buyout terms for shareholders;
• employee stock option plans to allow employees to purchase shares of a corporation in the future at a predetermined fixed price; and
• robust wills, powers of attorney, and other estate planning documentation to ensure personally held shares can be administered properly upon death (or in advance of death) and are distributed in a reasonable manner for tax purposes without adversely affecting corporate planning and business continuity.

Matt Trotta is vice-president, Tax, Retirement and Estate Planning with CI Global Asset Management.