The new exit plan

In the 1970s, a brother and sister founded a small business in a rural Western Canadian town. For years, the entrepreneurs struggled to make ends meet. Through blood, sweat and tears, they eventually grew the business into a multi-million-dollar operation that now employs most of the town. As the siblings prepare to retire, a private investor from the big city offers to buy the company, putting its future as the lifeblood of the town in doubt.

One fateful day, a new plan emerges: they can sell the business to their employees, ensuring the company they worked so hard to build will stay in the community and that their hard-won legacy will live on.

This may sound like the plot to a feel-good television special, but a scenario like this could soon play out in real life for a multitude of Canadian businesses, thanks to a new exit strategy: the Employee Ownership Trust (EOT).

An EOT is a trust that holds shares of a corporation for the benefit of its employees. EOTs allow employees to purchase a business without paying directly to acquire the shares. This helps employees, who might not have access to financing, buy the business and reap the rewards of ownership. For business owners, it presents a new opportunity to consider in their succession planning.

When draft legislation to create EOTs was initially announced in the 2023 federal budget, it didn’t make a lot of noise since it contained minimal tax incentives. Then in November 2023, the Department of Finance proposed to exempt from taxation the first $10 million in capital gains realized on the sale of a business to an EOT, subject to certain conditions.

In other words, a business owner’s first $10 million of value could be essentially tax free, which for many would be a significant part of the purchase price.

So, the small initial bit of noise grew closer to a roar, but there were still question marks until the 2024 federal budget provided more details. It said the $10 million exemption would be available on the sale of shares to an EOT between 2024 and 2026 if certain conditions are met. A few of these conditions include that:

• The individual, a personal trust of which the individual is a beneficiary, or a partnership in which the individual is a member, disposes of a corporation that carries on a “qualifying business” 
• At any time prior to the qualifying business transfer, the individual (or their spouse or common-law partner) has been actively engaged in the qualifying business on a regular and continuous basis for a minimum period of 24 months
• Immediately after the qualifying business transfer, at least 90 per cent of the beneficiaries of the EOT must be resident in Canada.

[Related: 2024 Canadian federal budget: How new measures announced in this year’s budget may impact Canadians and businesses]

When passing the business down to the next generation isn’t an option, or finding the right buyer is like finding a needle in a haystack, an EOT appears like a shining beacon of hope in the complex world of succession.

The KPMG Private Enterprise^™ Business survey found that nearly eight in 10 (79 per cent) of Canadian family business leaders are speeding up their succession plans due to growing pressures both outside and inside the family. With a demographic shift now underway, 73 per cent expect to transition to new leadership within three to five years.

All in all, EOTs will likely be an attractive option for many retiring business owners, especially those located outside major markets. Like the brother and sister example we started with, these owners tend to have close relationships with the employees who helped in the company’s success. They are admirably sentimental about keeping their employees happy and ensuring the business stays rooted in the community.

(One fear is that a larger corporate buyer would move the head office to a big city centre and effectively devastate the local job market. Another is that a third-party or foreign buyer would replace the workplace culture with their own.)

With advantages to both parties, an EOT offers the opportunity to bring employee ownership to fruition.

However, not to be overlooked are the potential downsides of the EOT. Owners who opt for one generally agree to take deferred payments from the business’s profits over time rather than getting a cheque cut tomorrow like they would with a third-party buyer—though that is just an option. Besides, not everyone is concerned about an immediate payout. Family-owned businesses tend to be patient capital and they may be more willing to accept this trade-off, with the notion that their business “will be in good hands.”

They should be aware, though, that cash coming over time will be heavily tied to the performance of the business, which carries some risk in terms of capital. Another downside is owners may still feel a vested interest in the business versus a clean-cut break, so it may not provide the freedom they hoped for—but this may be offset by the business continuing to be the lifeblood of the town and the owners continuing to accrue goodwill on that basis.

The concept of governance is important in an EOT transition, as there are trustees who act for the interests of all the employees who are now owners together. While governance is more associated with larger public companies, it’s increasingly common in private companies, including those that are family-owned. 

Establishing governance now—from intentional communication to formalized decision-making—will create the foundation for the employee group to be successful as future owners. Private and family businesses are embracing governance, recognizing it can be fit for purpose and not over-formalize or slow down nimble entrepreneurs. 

To determine if an EOT is right for you, think about these questions:

• Are your employees like a family? Are you invested in their long-term success?
• If you’ve built a great workplace culture, will it survive after a sale to a private investor or competitor?
• Do you want your business to stay rooted in the community?
• Are you willing to give up control?
• Are you willing to be patient for your capital?
• How much involvement do you still want to have in the business?

There are many other questions—along with more fine print to consider. While there are many plot twists in the stories of family businesses, it’s possible to create that picture-perfect ending before you move on to your next chapter.

Staying up to date on your current tax situation, the taxation of future generations and the latest tax laws and opportunities can be overwhelming. Our trusted tax professionals at KPMG Family Office can help manage, enhance and preserve your wealth. Learn more here.