Employee ownership trusts could be an attractive option for business owners struggling to find a third-party buyer or reluctant to sell to private equity firms.andreswd/iStockPhoto / Getty Images
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Employee ownership trusts (EOTs) are so new to the Canadian business landscape that even experts find themselves at a loss to grasp their implications fully. Yet, those experts say financial advisors should have a basic understanding of this new structure for business-owner clients considering a sale of their enterprise.
Included in legislation to implement measures from the 2023 and 2024 federal budgets, EOTs offer another succession option for Canadian entrepreneurs, which is good news, says Kendra Thompson, consulting partner and national wealth and investment management leader at Deloitte Canada.
She says an EOT “isn’t necessarily a slam dunk for clients who might be suitable, but the ability to discuss it with those clients is an opportunity to add value to a multi-decade relationship for advisors.”
An EOT is a trust that holds shares of a corporation for the benefit of employees. This structure can make it easier for employees to purchase a business by allowing them to borrow from the business to finance a buyout over an extended repayment period. The trusts promote employee ownership and provide another option for business succession.
Legislation to implement EOTs could be amended before it passes, and there could also be further guidance from the Canada Revenue Agency (CRA) around the rules. Yet, lack of regulatory clarity aside, advisors can still endeavour to understand what EOTs may mean for business-owner clients who have yet to devise a plan to make the transition out of their business, she says.
“The best advisors help navigate ambiguity all the time, and so this is just another example of that ambiguity.”
What’s certain, though, is many entrepreneurs are looking for succession solutions.
A 2022 survey by the Canadian Federation of Independent Businesses found 76 per cent of business owners plan to exit their business in the next decade.
In turn, more than $2-trillion in business assets could change hands. However, the survey found only 9 per cent had a formal business succession plan in place.
Although most advisors are not experts in succession planning, they’re likely to play a critical role at some juncture in that process for entrepreneur clients, says Vivek Bansal, director of tax and estate planning at Mackenzie Investments in Toronto.
“The proceeds of any business transaction – be it selling to a third party or an employee-owned trust – would need to be invested,” he says.
EOTs were first proposed in the 2022 federal budget, with more details added in 2023. This year’s budget clarified the conditions under which sellers to an EOT would be eligible for a $10-million capital gains exemption for this year, 2025 and 2026.
That exemption is likely to catch the attention of advisors and business-owner clients, says Evelyn Jacks, president of Knowledge Bureau Inc. in Winnipeg. “It can be a trigger for that very important conversation.”
That’s especially true, she says, in light of the budget announcement to increase the capital gains inclusion rate. As of June 25, that rate will increase to 66.7 per cent from 50 per cent on capital gains of more than $250,000 in a given year for an individual and on all capital gains for companies and trusts. That will likely have a significant impact on decisions for selling business owners, Ms. Jacks notes.
While the feds also increased the lifetime capital gains exemption to $1.25-million from $1-million as of June 25, the sheltering potential of an EOT is more worthy of consideration than ever, says Nicole Ewing, director of tax and estate planning at TD Wealth in Ottawa, although more information is needed to compare EOTs to other options.
Based on the limited information provided, and EOTs’ history in the U.S. and U.K., these vehicles for business transition could be attractive to business owners struggling to find a third-party buyer or reluctant to sell to private equity firms.
“For owners with a significant place in their communities … it might be more attractive,” Ms. Ewing says, because EOTs allow employees to purchase the business through the trust structure by borrowing funds from the business to be paid back in 15 years.
But the model is not without financial risks. “You need faith in your employees because you’re funding the sale out of future cash flow,” Ms. Ewing notes. “If the employees and management aren’t able to ensure that cash flow will continue, there is a risk that you don’t get paid.”
Typically, selling to a third party yields the highest payout among the available choices for business owners, says Troy Wright, managing director of STS Capital Partners, a sell-side advisory firm for entrepreneurs.
EOTs will provide another option for owners who have considered selling to employees but found financing to be a challenge.
“In the past, these types of sales were more of a management buyout, which is a highly leveraged transaction,” Mr. Wright says.
An EOT is likely to result in a lesser payday for owners because it’s funded through the business itself, and employees likely don’t have access to funding to purchase the enterprise otherwise. If it involves third-party lending at some stage, which occurs with EOTs in the U.K. and U.S., these lenders are likely to use lower valuations than for third-party buyers, Mr. Wright adds.
But EOTs have a modestly successful track record in those jurisdictions. In the U.K., for example, the number of EOTs has increased significantly every year since they became available in 2014, according to Go EO, a firm that helps companies become employee-owned. Specifically, there were 1,300 employee-owned businesses in the U.K. as of December 2022, and there were 576 EOTs as of June 2021.
“Ultimately, what the government is trying to do – and it’s the right thing – is keep small businesses strong and give them the opportunity for employees to be part of that $2-trillion transition,” Mr. Wright says.
Whether EOTs will appeal to business owners, particularly as more details emerge, remains to be seen.
Regardless, advisors should have a basic understanding to bring up the subject with business-owner clients pondering an eventual exit, especially in light of other tax changes that may feel “ominous,” Ms. Jacks says.
“The more proactive advisors are in talking into the fear and letting the numbers tell the story with supporting experts on how the business will be sold … and then how the money is going to flow, the better.”
After all, Ms. Jacks adds, “it leads to a much broader discussion about the proceeds that will now come under management – hopefully with the advisor.”
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