Are EOTs the answer to business owners' succession woes?

Family office leader sees benefits, challenges for new planning structure

Are EOTs the answer to business owners' succession woes?

The federal budget in March has been a cause of some concern among financial planners, particularly those whose clients stand to be affected by changes to rules around alternative minimum tax and permissible share sales. But it’s also opened one important new planning tool for Canadian business owners.

Starting in 2024, Canadian business owners will be able to use Employee Ownership Trusts, structures that allow for leveraged buyouts by employees. EOTs can be an important tool for Canadian business owners as they look to sell their enterprises.

“There's been various studies for the past few years about the number of Canadian business owners that are looking to exit their businesses,” says Jason Kinnear, manager, Family Office Services at CWB Wealth.

Clock’s ticking

Research from the Canadian Federation of Independent Business has found over three quarters (76%) of small business owners in Canada will be exiting in the next decade, which Kinnear estimates tracks fairly well with CWB Wealth’s client base of business owners.

By CFIB’s estimates, over $2 trillion is set to be in play over the next 10 years. It’s no surprise that the stakes are so high, Kinnear says, as the family business – the accumulation in the value of an entrepreneur’s work – overwhelmingly tends to be their single largest financial asset.

“Not only does it pay for their salaries and, potentially, their family members’. It's also going to fund their retirements and any legacies, inheritances that they leave for the next generation,” he says. “Having a properly drawn up succession plan so that they can maximize the value of their businesses is very important for our clients.”

Having followed various government announcements over the past year or so, CWB Wealth anticipated EOTs would be included in this year’s budget. With changes to the Income Tax Act opening the door for EOTs in Canada, Kinnear says Canadian entrepreneurs are now on more even footing with counterparts in other developed countries where the structure has been used effectively.

“It's a successful strategy that's been used for several years in the United States and the United Kingdom, so it's going to be a good planning opportunity for our clients and for Canadian business owners in general across the country,” he says. “I think it's a good first step.”

A slow-burn path to EOT adoption

As with all first drafts, there’s still room to improve on Canada’s EOT legislation. While U.K. rules allow business owners to transfer their business to an EOT on a tax-exempt basis, the current tax laws in Canada don’t allow that as yet. In other words, deploying an EOT strategy would result in a taxable event for Canadian entrepreneurs, which could hinder its adoption.

“There’s possibly some tax planning that would have to go along with implementing this,” Kinnear says. “For our business owner clients, we work collaboratively with their corporate accountants. … It’s all about minimizing the amount of tax the business owner is eventually going to have to pay on it.”

Another potential snag, according to commentators, relates to the timing of the sale proceeds. Business owners have traditionally been able to receive all or substantially most of the proceeds in fairly short order after selling to a third party, after which they can invest the money how they like. With the EOT, Kinnear says, business owners will face a runway of multiple years, and potentially up to a decade.

“For a lot of business owners, that could raise some cashflow considerations and concerns. That’s another area we have to strategize and map out,” Kinnear says. “What will an extended payment period look like for business owners to use this? And how does it impact any big purchases they have planned?”

With those and other challenges, it will likely take time for most business owners, their advisors and their accountants to come to grips with EOTs. But once early adopters work out the kinks and proclaim their success, the strategy may very well take the natural next step of attracting attention in the media and at industry conferences. For now, only time will tell whether they can truly catch on – and hopefully, catch fire.

According to CFIB’s research, the most common obstacle to succession planning is finding a suitable buyer, shared by over half of small business owners (54%). A strong 90% majority say the most important planning consideration is ensuring their current employees are protected, while another 84% are concerned about selecting a buyer who’s able to conduct their businesses the same way they have.

“EOTs address those two major concerns,” Kinnear says. “In certain circumstances, I think these trusts may be a great fit in addressing some of these succession challenges.”