Selling to an Employee Ownership Trust: The Federal Tax Exemption

You may be thinking about selling your Ontario business to the people who helped build it. One route to consider is a sale to an employee ownership trust (EOT). The federal Income Tax Act has a specific capital gains exemption for qualifying sales to an EOT.

This article explains in plain language how that exemption is built, who can claim it, what conditions apply and what can go wrong afterward. It is general information only. EOT sales involve tax, corporate and trust law together, so the details of your own sale need to be reviewed by a lawyer and an accountant.

What the EOT exemption is

The exemption is found in section 110.61 of the Income Tax Act. It is a deduction available to an individual who sells shares in a qualifying business transfer to an EOT. It is separate from the better-known lifetime capital gains exemption for qualified small business corporation shares, which has its own tests and its own limit of $1,250,000 for dispositions after June 24, 2024, indexed to $1,275,000 for dispositions in 2026.

The mechanics work through an election. The vendors, the EOT and the subject corporation make a joint election, and the elected amount cannot exceed $10,000,000. Each individual seller is assigned a percentage of that elected amount, and the percentages assigned to individuals cannot total more than 100%.

The deduction itself is the lesser of two amounts. The first is the elected amount multiplied by your assigned percentage and by the taxable fraction of the gain, less anything you claimed before. The second is a limit that nets the gain against allowable business investment losses, investment expenses and net capital losses. In plain words, other losses and investment history in your tax file can make the deduction smaller than you expect.

Who qualifies and what conditions apply

Several conditions apply to the seller and to the business. The list below summarizes the main ones in section 110.61(1).

• Holding period: for the 24 months before the sale, the shares must have been owned only by you or a person or partnership related to you.
• Active business: more than 50% of the fair market value of the shares must come from assets used principally in an active business.
• No professional corporations: the business and its affiliates cannot be professional corporations.
• Age: you must be at least 18.
• Active engagement: you or your spouse or common-law partner must have been actively engaged in the business for a 24-month period ending before the sale.

The Department of Finance has published explanatory notes describing amendments to section 110.61, including wording on the holding period and the active business test. Those notes say the amendment is deemed in force from January 1, 2024. Because the wording has been changing, it is worth confirming which version of the rule applies to your sale date.

Whether your particular corporation, ownership history and assets meet these tests depends on the facts. A business that has held a lot of passive assets, or whose shares were recently issued, may need a closer look.

Elections, deadlines and denial rules

The election is filed by the trust's filing-due date for the year of disposition. That is different from the deadline in some other family-transfer rules, which run off the seller's filing date, so do not assume the dates line up.

The Act also contains anti-avoidance and denial rules. The deduction is denied if one purpose of a transaction is to enable a deduction that would not otherwise be available. It is also denied if the claimant knowingly, or through gross negligence, fails to file on time or to report the gain.

The clawback if things change after the sale

The exemption is not necessarily final on the day of closing. Section 110.61 sets out disqualifying events. One is the trust ceasing to be an EOT. Another is the start of a year in which less than 50% of the business's fair market value comes from active-business assets.

• If a disqualifying event happens within 24 months of the sale, the deduction is treated as never having applied.
• If it happens in the following eight years, the trust is deemed to realize a capital gain equal to the elected amount.

This matters for planning. After the sale, the business needs to keep meeting the active-business test and the trust needs to keep its status. Before you agree to a deal, ask who is responsible for monitoring those conditions and what the sale agreement says if a problem arises.

Spreading the tax with a reserve

EOT sales are often paid for over time out of the business's future profits. A capital gains reserve can let you report the gain over several years rather than all at once. The general reserve requires the gain to be brought into income over at least 5 years. For shares disposed of under a qualifying business transfer to an EOT, section 40(1.3) extends the reserve to 10 years.

How a reserve interacts with the EOT deduction in a particular year is a technical question that depends on your numbers, so have your accountant model it before closing.

What to do next

If you are weighing an EOT sale, a little preparation makes the first meeting with your advisers far more useful. Timing is worth confirming early, since the rules have been amended and the availability of the exemption for sales in particular years should be checked against current law.

• Gather your share register, articles and any past share issuances so ownership over the last 24 months can be traced.
• List the corporation's assets and separate active-business assets from cash and investments.
• Confirm whether the corporation or any affiliate is a professional corporation.
• Identify who has been actively engaged in the business, and for how long.
• Ask your accountant to estimate the deduction, including the effect of any business investment losses, investment expenses or net capital losses.
• Ask a lawyer and accountant who will file the joint election, by what date, and how the clawback risk is handled in the sale agreement.
• Compare the EOT route with other options, such as a sale using the lifetime capital gains exemption, before you commit.

Frequently asked questions