Two entrepreneurs working on their bills in the retail store

A new option for business owners who wish to sell to their employees is now available, but a lack of clarity could limit adoption.

In 2022, Canada had about 1.2 million small businesses with fewer than 100 employees. About 23% of business owners said they’d like to exit their business by selling to their employees, according to a survey from the same year conducted by the Canadian Federation of Independent Business.

Newly introduced employee ownership trusts (EOTs) allow employees to buy a business over time, providing an alternative for entrepreneurs who have no suitable family to sell to or who fear that a third party may not preserve the firm’s legacy.

EOTs exempt the first $10 million of a seller’s capital gain from tax and allow the remaining capital gain to be spread over 10 years.

Business owners should weigh the benefits and drawbacks of an EOT compared to other exit methods and understand how EOTs are structured.

When an EOT is set up, the business owner sells the business to the trust, which will repay the seller over time, said Wesley Novotny, partner and corporate tax lawyer with Bennett Jones LLP in Calgary.

And unlike stock options, which usually pass ownership of a business to employees without giving them material governance rights, EOTs require the owner to give up control to a board of trustees that will act for the benefit of employees, said Michael Decicco, partner with Stikeman Elliott LLP in Toronto.

EOTs have already helped employee owners in the U.S. and the U.K. build wealth, keep jobs in the local community and create a more engaged workforce, said Christine Cooper, head of BMO Commercial Bank, Canada. “There’s a social benefit here as well as an economic benefit.”

In Canada, the government announced consultations for creating EOTs in the 2021 federal budget. EOTs were proposed as a dedicated type of trust under the Income Tax Act in the federal budget the following year and new incentives were added in 2023.

Enabling legislation for EOTs is included in Bill C-59, which at press time is under consideration by a House of Commons committee. EOTs are effective as of Jan. 1, 2024.

When to use an EOT

EOTs could be an appealing option for sellers who want to leave a legacy and do not need an immediate payout.

Selling a business to a competitor or a private equity firm might yield a larger and quicker payout than would a sale to employees using an EOT, but there are also potential downsides, Decicco said.

Competitors might rebrand the business while private equity firms could roll it into one of their portfolio companies.

Business owners must comply with an EOT’s rules to take advantage of the tax breaks. For example, EOTs must treat the capital and income interests of all employee beneficiaries the same way, with exceptions for reasonable criteria like salary caps and tenure.

If a business owner wants more flexibility, they could use a holding company instead, Novotny said.

“There certainly will be instances where the holding company will still be the preferred method.”

The setup costs for an EOT compared to a holding company won’t be meaningfully different, Novotny said. Both require a governance framework, and EOTs will become just as replicable as holding companies as uptake increases.

EOTs can have income and capital accounts for employee beneficiaries. As the company earns a profit, the trust can distribute some earnings to income accounts, similar to how stocks pay dividends, Decicco said. The capital account can be used to allocate shares in the company, which employees can sell back to the trust or another employee when they retire or change jobs.

Although the $10-million capital gains exemption is attractive, Novotny said he hasn’t seen an EOT transaction yet as the final legislation hasn’t been released. Bill C-59 does not address whether the $10-million exemption will be indexed in future or whether the exemption can only be used once in the seller’s lifetime.

“I think that’s what’s holding it back, because [the exemption is] a very big incentive,” he said. “But until we know the details, it’s really hard to tell people what to do.”

Commercial banks will probably find structuring EOT loans to be an attractive business opportunity, Cooper said: “For most lenders, it should be something that there would be good appetite to do.”

But the pending legislation means the bank hasn’t processed any EOT-related transactions yet. When the legislation is finalized, she said the bank will do further due diligence.

“We’ve had lots of conversations, and certainly have clients waiting to see if it pans out the way they expect and who are interested in taking this option as a succession plan,” she said.