Selling a business to an employee ownership trust: the tax memo can be right and the deal can still fail

Koby Smutylo is a business lawyer and mediator at Smutylo Law+ in Ottawa.

THE $10-million capital gains exemption for selling a business to an employee ownership trust (EOT) became permanent on June 18, when Bill C-30 received Royal Assent and the words "and before 2027" came out of subsection 110.61(1) of the Income Tax Act. Stéphanie Pépin covered the change here in July. Until then, every one of these succession files turned on whether the client could close by December 31, 2026, and a hard date settles an argument about valuation faster than any adviser can. That pressure is gone. What sits underneath it fails for reasons a tax opinion never reaches. 

Your client signs the share purchase agreement, shakes hands with people he has employed for twenty years, and drives home. He no longer runs the company. For the next two years he still owns the tax bill if the people now running it get something wrong. He is not permitted to pick those people, and unless the employees elect them, most of them must by statute be independent of him. 

Nobody forgot to close that. Parliament built it that way on purpose.

The founder does not get to pick the board

The definition of "employee ownership trust" in subsection 248(1) requires that at least one-third of the trustees be beneficiaries of the trust. Employees, in other words. Commentary keeps reporting this as a requirement that trustees be elected by the employees, which is a different rule doing a different job: where any trustee is appointed rather than elected by the beneficiaries within the preceding five years, at least 60 per cent of all trustees must deal at arm's length with everyone who sold shares to the trust. 

Put those together and the founder cannot assemble a friendly board. A third of the people who will run the company are employees who have never sat in a governance seat. Most of the rest are either elected by the staff or required to be strangers to him. All of them owe fiduciary duties to a class that includes every employee, which is to say they owe those duties to each other and not to him. 

For someone who has run the place on instinct for thirty years, this is a larger adjustment than the tax analysis suggests. It is what he or she telephones you about in year two. 

Start that conversation a year before closing rather than at it. Find the employee trustees early and get them real governance training while it can still change anything. Consider a professional trustee for the arm's-length majority, because "independent of the vendor" and "able to run a company" are not the same test and the statute imposes only the first. And settle his post-closing information rights while he still has the leverage to ask for them, which is before the shares move.

The company lends the money to its own buyer

Almost every one of these purchases is paid for out of the company's future earnings. Subsection 15(2.51) makes that possible by switching off the shareholder loan rule where the qualifying business lends to the trust that controls it, provided there are bona fide arrangements to repay within 15 years. Subsection 40(1.3) stretches the capital gains reserve to ten years, bringing in at least ten per cent of the gain a year, against the usual five years at 20 per cent. 

Both are generous. Both assume the business earns enough, for long enough, to buy itself. 

When it does not, picture the meeting. Three of the people at the table used to report to the person sitting across from them. Two more were brought in precisely because they owe him nothing. They have to decide whether to enforce this year's payment against the person who built the company and sold it to them on terms he set, or to let it slide and answer to every other employee for that. They are a creditor of a business run by people he or she cannot instruct, holding paper whose value depends on managers they chose and handed the keys to. There is nobody else in the room to be angry at. 

So model the vendor note against a bad year rather than the plan, and write covenants that start a conversation long before they start a default. Decide at the outset who has authority to renegotiate on each side and put it in the document. Be explicit about security and subordination rather than leaving it to be sorted out later, because later means during the first bad quarter, between a founder and a board of his former staff.

The clawback sits on the seller

Under paragraph 110.61(4)(a), a disqualifying event within 24 months of the disposition means the deduction "is deemed to have never applied." The reassessment goes to the vendor. The trust and any purchaser corporation are jointly and severally liable with him, which is some comfort until you remember what the trust owns: the company, and a note it has not finished paying. Only afterwards, under paragraph (b), does an event in the following eight years put a deemed gain on the trust instead. 

That is 24 months, not the 36 that Budget 2024 described. The provision wins over the budget papers, and I have seen the 36-month figure repeated in more than one planning memo written well after Royal Assent. 

A disqualifying event under subsection 110.61(3) includes the trust ceasing to qualify as an EOT, and the start of a taxation year at which, for the second year-end running, less than half of the share value comes from active business assets. The statute carves out a business that is shut down and sold off to pay its creditors. It does not carve out a business that shrinks into its real estate and investments; Finance's own example is a company that leases out the premises it used to operate from. So for two years your client carries the tax consequences of a company he no longer controls, run by trustees he was legally prevented from packing with allies, and the exposure is the whole exemption. 

Manageable — but only if it is priced and papered at the front end. Put covenants in the trust deed that protect the qualifying conditions specifically and not the business generally. Give him real information rights for at least the 24-month window, so the first he hears of a problem is not the reassessment. And have one honest conversation about a soft year one while everyone still likes each other.

What I would tell the founder

None of this is an argument against employee ownership trusts. Where a business has a real management team, no obvious outside buyer, and an owner who cares what happens to the people who built it, nothing else in Canadian business succession planning does the same job. 

It is an argument about sequence. Availability of the exemption is a tax question with a settled answer. Whether he is glad in year three is a governance question, and it does not get easier because the tax question came back clean. 

The deadline going was good news. It was also the only thing making anyone hurry. The exemption is permanent now; the founder's control over the thing it applies to ends the afternoon they shake hands. 

Koby Smutylo is a business lawyer and mediator at Smutylo Law+ in Ottawa. Called to the Bar of Ontario in 2001, he works with owner-operated companies on shareholder agreements, business sales and succession, including sales to employee ownership trusts. Author photo courtesy Koby Smutylo. The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.