How do I sell my business to an Employee Ownership Trust (EOT)?
Employee ownership trusts are now available in Canada, modelled after similar frameworks in the U.S. and the U.K. EOTs offer an attractive succession planning tool for business owners approaching retirement or looking to exit the company. They can provide a smooth ownership transition, improve employee engagement and maintain continuity in business operations.
This guide discusses the 7 Steps to Selling Your Business to an EOT, from drafting the trust deed to securing financing. If you’re considering stepping away from your company but aren’t sure of the right exit strategy, keep reading to learn how to transition your business to an employee ownership trust successfully.
Want to learn more about the pros and cons of EOTs and whether they are an appropriate exit strategy for your company? Check out our article – Is an EOT Right For Your Business?
Step 1: Employee Communication and Engagement
When you transition ownership of your company to an EOT, your employees become the new owners. It is, therefore, essential to obtain their input from the start by opening a clear, two-way communication channel. Beginning the conversation as early as possible will help you gauge employee interest, capability, and motivation. You should clearly convey the following information:
- Inform employees about the transition, explaining what an EOT is and how it will impact them
- Highlight the benefits they will receive as beneficiaries of the trust
- Provide opportunities for employees to ask questions and express concerns
- Educate employees on their roles and responsibilities within the new structure
Consistent engagement helps build trust and ensures a smoother transition to the new ownership model. Be sure to maintain communication with your employees throughout the process, providing timely updates wherever possible.
Step 2: Setting up an Employee Ownership Trust
Once you’ve decided to sell your business to an EOT, the next step is establishing the trust itself. This requires drafting a trust deed that complies with Canadian regulations and appointing appropriate trustees.
Drafting the Trust Deed – Work with legal advisors to draft a comprehensive trust deed. This foundational document outlines the;
- Trust’s purpose
- Rules for distributing profits
- Roles and responsibilities of the trustees
- Rights of the beneficiaries
- Governance structure
To qualify as an EOT, you must set up an irrevocable trust resident in Canada. The trust deed should clearly state that the trust is established exclusively for the employees’ benefit and comply with all legal requirements for EOTs in Canada.
Appointing Trustees – Select trustees who meet the residency and independence requirements. They should understand their fiduciary duties and be committed to acting in the best interests of the employee beneficiaries. All trustees must be Canadian residents, and they cannot be significant shareholders or related to the previous owners of the business. Trustees are elected by the active employee beneficiaries at least every five years, and at least one-third of the trustees must be employees. This structure ensures that the trust is managed in the employees’ best interests.
Step 3: Prepare for the Sale
With the legal components in place, you can prepare to sell shares to the newly established EOT. This involves conducting an independent valuation of your business, negotiating the terms of the sale and drafting the share purchase agreement. The goal of this step is to ensure that the transaction is fair, transparent, and beneficial for all parties involved.
Business Valuation – Obtain an objective assessment of your business’s worth by hiring a Chartered Business Valuator (CBV) who will use various methods to determine your company’s fair market value. Several factors can influence the valuation, including the company’s revenue, profitability, growth potential, competitive advantages, and market conditions.
Negotiating Terms of Sale – The trustees will negotiate the terms of the share purchase, including the price, payment schedule, and any conditions attached to the sale. This negotiation should balance the selling owner’s interests with the EOT’s financial capabilities. Business owners may opt to receive payment over several years to take advantage of tax deferrals, such as the extended capital gains reserve period of up to 10 years for qualifying business transfers.
Drafting the Share Purchase Agreement – Once terms are agreed upon, a legally binding share purchase agreement is drafted with the assistance of legal professionals. This document details all terms and conditions of the sale, including:
- Purchase price
- Payment terms
- Deferred payment arrangements
- Representations and warranties
- Conditions precedent
- Indemnities
- Responsibilities of both parties
- Post-sale obligations
Step 4: Financing an Employee Ownership Trust
EOTs offer a unique succession strategy, as the purchaser does not have to pay out of pocket to buy the business. However, as the employees are not providing any upfront capital, alternative funding methods must be utilized. When transitioning your business to an employee ownership trust, there are three main financing options:
Debt Financing – One of the most common EOT financing methods is debt financing. This involves the EOT borrowing funds from lenders to purchase the business’s shares. The debt is typically repaid over time using the company’s profits. It is crucial to work with financial institutions that understand the EOT structure and can offer favourable terms.
Vendor Financing – In some cases, the current owner may finance the sale. This can be structured as a loan from the seller to the trust, where the seller agrees to receive payment for the business over a period of time. Vendor financing can be attractive because it offers a high degree of flexibility and provides a smoother financial transition.
Internal Financing – Under the new EOT framework, the shareholder loan repayment period is extended from one year to 15 years. This allows businesses to lend funds to an EOT to finance the purchase of shares and repay that loan over 15 years without triggering tax consequences. Internal financing leverages the company’s existing resources to facilitate the transition and requires careful cash flow planning to ensure the business can meet its obligations without jeopardizing operations.
Step 5: EOT Tax Planning
Employee ownership trusts come with several tax benefits as well as some specific rules that business owners must understand for optimal tax planning. Here are some key considerations to ensure a smooth and tax-efficient transition:
Capital Gains Exemption – One significant tax benefit of selling to an EOT is the potential capital gains exemption. For qualifying business transfers (QBTs), the Canadian government offers a temporary tax exemption on up to $10 million in capital gains realized on the sale to an EOT. This exemption is available for the 2024 to 2026 tax years and can significantly reduce the seller’s tax burden.
Capital Gains Reserve – The capital gains reserve allows sellers to defer a portion of the capital gains tax for up to 10 years. This can be particularly beneficial when the sale is structured with installment payments, providing cash flow flexibility and reducing immediate tax liabilities.
Shareholder Loan Rules – When structuring the sale, it’s essential to consider the shareholder loan rules. These rules have been adjusted to accommodate EOTs, allowing for more favourable loan terms and conditions between the trust and the business.
21-Year Deemed Disposition Rule – EOTs benefit from an exemption to the 21-year deemed disposition rule, which typically requires trusts to realize capital gains every 21 years. This exemption helps maintain the tax efficiency of the trust over the long term.
Income Distribution – Income generated by the business is held within the EOT before being distributed to the employee beneficiaries. These distributions are taxed at the individual level, not at the trust level, which can result in a lower overall tax rate. Benefits must be allocated among the employee beneficiaries in a fair and equitable manner, considering factors such as their length of service, remuneration, and hours worked. This helps maintain the trust’s structure and ensures that ownership remains collective rather than individual.
Restricted Distributions – EOTs are prohibited from distributing shares of the qualifying businesses to individual beneficiaries. Instead, any distributions the trust makes to the beneficiaries must be in cash or other property.
By carefully planning for these tax implications, business owners can optimize the financial outcomes of selling to an EOT, ensuring a successful and tax-efficient transition.
Step 6: Transferring Ownership to an EOT
Once everything is in place and you’ve secured financing, you can complete the legal transfer of shares to the EOT. This step involves executing the necessary legal documents to transfer ownership from the current owners to the trust, including the share purchase agreement and any loan agreements. The trust deed and any other documents required to establish the EOT must also be finalized at this point.
Step 7: EOT Management and Compliance
After the ownership transition is complete, a plan should be created for the ongoing management and operation of the business under the EOT structure. Training and support should be provided to employees and trustees as needed. Considerations include:
Trust Governance – The trustees should hold regular meetings, maintain accurate records, and ensure that all decisions are made in the best interests of the employee beneficiaries. Transparent reporting to the beneficiaries fosters trust and accountability.
Regulatory Compliance – The trust must comply with all legal and tax obligations, including filing annual trust returns and adhering to CRA reporting requirements. Regular reviews can help ensure ongoing compliance with EOT qualification criteria.
Financial Management – It is critical that the trust’s finances are actively managed on an ongoing basis. This involves monitoring cash flow, managing debt repayments, and ensuring that profit distributions to beneficiaries are made fairly and in accordance with the trust deed.
Professional Advice
Navigating the complexities of establishing an EOT requires expert guidance. Engaging professional advisors early in the process can save time, reduce risks, and ensure a smooth transition.
Legal Advisors – Legal professionals experienced in trust law can help draft the necessary documents, such as the trust deed, and ensure that the trust complies with all legal requirements.
Tax Professionals – Tax advisors can help you maximize the tax benefits associated with selling to an EOT, including potential capital gains exemptions and deferrals. They can also assist with tax planning for both the selling owners and the trust itself.
Financial Advisors – Financial experts can help with valuing your business accurately, structuring the sale, and arranging financing if necessary.
Final Thoughts
Employee Ownership Trusts represent a promising option for business owners planning their succession while preserving their company’s legacy and rewarding their employees. By providing tax benefits, fostering employee engagement, and ensuring a smooth transition, EOTs can offer a win-win solution for all parties involved.
However, setting up an EOT involves careful planning, adherence to legal and tax requirements, and a commitment to ongoing management and compliance. It’s essential to seek professional advice to navigate the complexities and ensure that an EOT is the right fit for your business.
This article was written by the NVS Professional Corporation team, your knowledgeable Barrie and Markham accountants. The content is intended as a general guide for informational purposes only. For specialist advice tailored to your specific situation, please reach out to our expert team.
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