Employee Ownership Trusts Revisited with Jon Shell | E120

welcome to the financial planning for Canadian business owners podcast you will hear about industry insights with award-winning financial planner and entrepreneur Jason Pereira through the interviews with different experts with their stories and advice you will learn how you can navigate the challenges of

being an entrepreneur plan for success and make the most of your business and life and now your host Jason Pereira hello and welcome T the show of John shell brought him back to discuss employee ownership trusts again because now we have some definitive legislation around these and that have addressed many of the issues or concerns we had in

the first episode so hopefully you will enjoy this update hell John how's it going it's good Jason how are you good John thanks for coming back appreciate it thanks for having me back I will go so far to say as in a in a budget that was full of things I despised this was one thing I loved let's talk about employee ownership trust which you've been a big player in and actually before

we start let's talk about a little bit about who you are and remind people of who you are and what your involvement with this topic is sure John shell I'm chair of Social Capital Partners we are a nonprofit based here in uh Toronto uh our objective is to find ways for people who don't have ACC access to asset

ownership to be able to get asset ownership uh all of us here generally have a private sector background I was a consultant for a while I bought Veterinary practices for a while and been doing this work for about seven years our approach to asset ownership has has centered around employee

ownership over the last four or five years and I think that's what we're going to talk about today we are all right for those who didn't listen to the previous episode they really should go should go back let's talk about what is an employee ownership trust an employee ownership trust is a new structure that has just been added to the income tax

act its purpose is to facilitate the transition the succession of a privately held business to its employees and when I say its employees all of its employees the trust is a vehicle that owns shares indirectly on behalf of all of a company's employees and in that way it

has facilitated a lot of transitions to employees in the US and the UK where that model exists I know we're going to get into detail about how the model works but in the US and the UK I should just quickly say there are a lot of of majority employee owned companies and most of those the vast majority of them use a trust model like the employee

ownership trust that we now have in Canada in the UK there's over 300 companies a year are sold to employee ownership trust that's um about 5 to 10% of all transactions in the UK they now about 2,000 of them um in the US there are about 7,000 companies owned through their version of

the employee ownership trust here in Canada we have very few there's less than 100 we think maybe 50 or 60 majority employee owners companies but we haven't had this model yet and we think that's about to change okay all right let's talk about the benefits of this model first and foremost let's from the pick that back we're get at this okay so let's start

off by talking about the from the employer standpoint why would they want to sell their business to an employee ownership Trust and of course this is very new in Canada so let's talk about specifically Through The Eyes of what the Canadian legislation says so if you're a business owner in Canada of a privately of a private company and we can talk about the types of companies

for whom this applies when you look to sell and I have been a business owner looking to sell this is a this is an issue that I understand a little bit there aren't a ton of options for you right there depending on the size of your company you could sell to private Equity depending on your industry you might be able to sell to a competitor

but there are a lot of business owners who don't want to go either of those routes right for reasons that they're worried about their company culture they built their company over decades they care deeply about their employees they're often in a community that where there aren't private Equity companies or competitors so they worry about their head office being moved a lot of

considerations for owners who are looking to sell and there aren't often people who are from that Community from that industry with the means to buy their company so the employee ownership trust acts as another option for succession it allows an owner to sell

their shares to this trust the trust then owns the shares on behalf of all employees there there's a trustee appointed to govern that trust and the company continues to be managed the way it always has been it's not like now it's a co-op and it's one person one vat and everything goes if they built a culture and a structure and a a business

that has stood the test of time and they think we'll continue to to stand the test of time and they have a decent management transition in place they can sell their shares to this trust and then all of the benefits in the future flow to their employees now question is obviously how do I get paid if I'm an owner who does this thing and the way it

works is the owner so the simplest way to describe it is the business owner lends the money to the company to buy the company from themselves and so then the the company will pay back the owner out of cash flow over time and once that debt has been repaid then the company's owned free and clear by the employees in

the us there is a lot of Bank involvement in their version of this we hope that will be true in Canada too where a bank will will um also provide a loan to the trust to buy the shares of the company and so the owner will be able to get some cash up front in that scenario yeah so it's what's known as a

vendor takeback which is not unusual and very common if we can Finance through debt then absolutely it's definitely a benefit but let's talk about okay some owners may say that and say hold on a sec I'm not I'm technically the lender here like where why I'm basically having the company pay me with the company's money but I own the company already so

the question becomes why would they do this and then there's some very good incentives around taxation baked into this legislation and you take yeah first off I'll I'll tell you about the incentives and then we'll talk about why they exist so the the government has just introduced alongside the employee ownership trust a tax incentive where the first $10 million of gain from a

sale of a privately held company in Canada to an employee ownership trust uh will be tax fruit so which let's just clarify one thing that is huge because under old tax capital gains rates that was the equivalent sale Savings of $2.5 million now it's probably closer to $3.4

million in taxation so that is enormous compared to the lifetime Capital games exemption which is now up to 1.25 million so 10 versus 1.25 is just in freaking order of magnitude it's enormous and there's also a new entrepreneurs incentive which we're not

going to get into it's more limited but the point here is this is the single biggest shot at liquidating your shares in a tax efficient way that any business owner will ever have access to now one thing to be clear on though this is per company correct not per share owner yeah it differs from the lifetime capital gains exemption in that way where it is

only available on for each company $10 million is available to be split among shareholders in whichever way the shareholders see fit but $10 million is available per company correct yeah it is also available as far as we can tell in addition to the lifetime capital gains

exemption if your company has been set up with one or more lifetime capital gains exemptions this is in addition to that so you can take advantage of both so great so I've got my 1.1 and a quarter so really effectively I'm the sole owner now I've got 11 and a quarter million and then if I was the founder of

the business within a certain industry then the the other incentive kicks in which make the number even bigger so it's very it's a very big number and it's a multi-million dollar savings fantastic okay this is all great news for anyone looking to sell their business and of course you can only get that 10 million through the employee ownership trust so there's one of your

incentives for why you would put up with a ventor takeback and for sure and maybe I just step back and talk about why they did this because that's is as you say a big number it is actually a smaller incentive than exists in either the us or the ukuk and the reason governments have been so supportive of sales to

employee ownership is because of the benefits to the country of these programs and we what's been proven in the US and in the UK is sales to employee ownership trusts tend to lead to more resilient companies they tend to uh create more jobs they perform better

in recessions they default on their debt less often they keep their companies owned by the by their within their countries right so in the UK keeps companies UK owned and in the US US owned and here will keep companies Canadian owned and of course they have all these amazing wealth benefits for workers so for governments there are

amazing outcomes to be gained from this and that's why they have been so supportive and they understand that if I'm a business owner and I'm doing this thing by virtue of the vendor takeback I am introducing a bunch of risk and I'm introducing obviously a delay in when I get paid as the owner so I making a sacrifice in order to do this thing that

I know will be of great benefit to my workers and to my community I'm doing it because I want to but this tax intensive levels the playing field for me as the owner almost it's still I think probably still harder but it levels the playing field for me versus my other sale options so it's interesting because the same line of reasoning first off the

behavior makes sense they have skin the game and they're aligned with the mission of what the Company's trying to do yes and they depend on they're going to depend on it for both their livelihoods but also their savings now right so that's huge and it's interesting because it's an interesting contrast to the the agency problem experienced with Executives in public

traded corporations right because the thinking is okay we have to incentivize these people with stock options to make sure the stock performs and all that other stuff but in the end the Agency problems is are they working for themselves or they working for their share owners right now you're trying to align those things but that can lead to necess not necessarily a fully aligned outcome whereas in this case the share

owners are the people making the decisions and the ones show today every day to work and making decisions to not waste time and not waste resources because it benefits them so it it gets everybody legitimately aligned around so it's not surprising that to me that the resilience numbers or the data is there to support this given the saying in

behavioral communities is that incentives are the most powerful force in the universe and you you've aligned them guess what gonna be a good outcome what I love about this one this is my favorite stat Jason from this industry in the US is that in recessions employee majority employee have majority owned employee majority employee owned companies in the US fire way fewer

people in recessions and are also much stronger coming out of recession so they dramatically outperform their peers in terms of growth and profitability coming out of a recession and the incentives are super clear as to why that happens right if you're a majority employee on company your fiduciary responsibility is

to your employees who are the shareholders in a troubled time if you can lower your profit margins for the period into that recession and keep people employed not only are you doing the right thing by your shareholders but you are going to be stronger coming out of the recession so it's a really fascinating finding and something that I

think defends this as an idea in terms of economic resilience and better for communities and better for workers yeah and for those who maybe have an issue with the idea of a business owner reaping $10 million tax-free again there other options were to basically not to

sell to employees and have these NE positive effects on the community the people they employed and all and everything else yes it is fair to incentivize them to do something that has a better long-term outcome for a larger community at whole as opposed to a smaller set of investors yeah it's exactly right okay so

basically we we have these incentives now is now wrong is the capital gains Reserve still available for the extended period of time or they take that back the 10year capital gains Reserve so they they've extended the capital gain reserve for this yeah so basically what that means just to clarify for everybody is that if you were a business owner and

you receive you don't get and you sell your business and or you sell or anything you sell a building you sell anything that's got a capital gain and you don't receive payment UPF front for all of it you can actually spread out the gain up to five years or the amount so and you every year you have to realize 20% or the amount you receive whichever is greater and that lets you

pay the capital gains as you receive the money now the extended timeline here is 10 years which means that now if I do manage if I'm lucky enough to sell my business business and basically net more than the let's call it over 11 to 12 to 13 million right let's just say I sold it for $20 million okay first off I'm going to be happy secondly the the

second piece is that yes I will have tax to pay every year but I will only pay one tenth of that tax bill or whatever amount I received that year yeah every year going forth in the next 10 years allowing me to to defer and spread out the tax build the match when I receive the money so another great incentive which on its own was not enough to make this happen but in conjunction with the

10 million is definitely enough to to make us want to do something like this that's exactly right and and look I think it's important to to say that like in the UK it doesn't matter how big the company is there is no tax so if I sell h100 million do to an eot in the UK I pay no tax and the fascinating thing about that is every single British uh

political party is supportive of this legislation because of the outcomes when you see the data how could you not be it's that's it and so here again it has support across the political the Spectrum it's just it's a it's an idea whose time has come we have a crisis of succession here in Canada it

is hopefully just in time to be able to take some of those companies that would otherwise have sold places that will not benefit the country will now be sold to their workers absolutely okay let's talk about the mechanics of this from the employee standpoint okay I go to work for a company that has on these employee

ownership trusts like how is my share established yeah yeah okay so it's the Canadian version is actually really flexible and so the owner the trustee these decisions can be made to as to how benefits are allocated and I'll just I'll talk a little bit about that the

simplest way as you you benefit as a worker is if the company is set up as a profit sharing trust and you know what that means is every year the company has a certain amount of additional cash flow whatever cash flow is left is just divided amongst the employees by a formula and the formula can either take

into account your wages the length of service you had at the company or the hours you worked or a combination of all those three things so in an example of a company where there's $10 million in labor costs and I make $100,000 I will

get one% of whatever a cash flow is available at the end of the day after for that company so that's the profit sharing Ben um if the company were to be sold right so if the trustee who governs the company has decided they have received an amazing offer for this

company and they cannot possibly reject it I will get a portion of the proceeds of that sale again according to a formula that's been determined by those three things we I think it'll be common for annual profit sharing to be divided based on wages and if there happens to be the sale of a company for it to be

divided based on a combination of wages and the time you spent there so if you've been an employee for 30 years even at a relatively low level you I would think the formula will be set up so that you'll be very well compensated if the company happens to be sold there is also the ability yeah I think that

makes sense I think the wages for income is a good argument for that because if not perfect but let's just say let's just say that basically effectively wages are a measure or metric of contribution to the firm's outcome yeah you can say that in some cases they are in some cases they're not then that is a

relatively good breakdown methodology whereas when it comes to sale then the tenure and contribution over the life of the company absolutely should have relevance yeah yeah there's a loyalty benefit or one could see people deciding that there'd be a loyalty benefit and you could do in the US and the UK

there's all sorts of formulas and people can make up their minds based on what's right for their company the other thing that we can do in Canada that you can't do in the UK is allocate benefits all allocate share benefits so me as an employee I can start to accumulate

shares in the company through the trust and so the the owner of the trustee can decide we're going to pay out some profit sharing we are going to also allocate some shares so that people feel like when they sell the when they leave the company they can actually sell their shares back to the company and receive some sort of payment when they leave so

there's all sorts of different ways in which this structure can be set up up and it the way you do it will depend on the company uh and its particular situation which is very exciting right it really provides a ton of different options for different companies looking to do this a Manufacturing Company in leth Rouge may have a very different H

profit profile may have a very different asset profile than a food distributor in I mon so all of these factors can be uh put into play when you think about how the formula is works the one other thing I will say is in the event of the sale

of a company there is actually a vote that gets transferred to the employees so the employees have a couple of important rights okay yeah let's go first a third of the so a trustee board can be any size right and the trustee board governs the trust then there's a board of directors that governs the

company but there's a trusty board that govern so they they make decisions on how share how benefits are allocated they make decisions on whether to accept a sale for the company they make a they make decisions on appointing board of directors and a third of that trustee Board needs to be employees so if you have a three person board one of them

needs to be an employee if you have a five person board two of them needs to be an employee it can be more than a third but it has to be at least a third so that's an important right for the employees in these structures the second important right is if there ever to be considered a sale a a vote will happen

by the employees on that sale right and civil majority rules so if there 100 people at the company and 100 of them vote 51 of them need to say yes it's time for us to sell the company we have we understand the benefits we'll receive we understand what we're giving up and we will make that decision so there's some interesting benefits for or rights

for workers in these structures okay so basically we've gone over that what else should people know about this from the owner standpoint or from the shareholder standpoint or employees shareholder standpoint there's a few things that's worth knowing in terms of qualific as far as business owners go so how so

do I qualify for this tax incentive so the tax incentive has some qualifications that are important H first of all and I'm GNA try to get as many of them as I can Jason I'm sure I'm gonna miss some for it the sale needs to be at least 51% of the company so majority of the company needs to be sold to the trust the tax incentive is

available only to people who have at one point worked at the company right so if you're a passive investor and you've never worked in the company you don't have access to the tax incentive it's designed for people who have grown and managed companies so as long as you've worked for at least two years um at the

company you have access as an owner to the tax incentive or your spouse has access one of the things that they were worried about in design and they got a lot of things right when it came to this design which I'm very grateful for one of them is you envision a scenario where someone owns um a company and then dies

right and now the spouse owns the company they made sure that spouse will have access to that tax incentive the tax incentive is available to most companies but not certain professional companies right the government has excluded seven there's a set of seven and you probably know this list off top of your head professional corporations

for example cannot be done which makes perfect sense and only certain cons for example and where I want to make sure there isn't any confusion is a lot of engineering companies our professional corporations a lot of architecture firms are prot they are they're not part of this it's doctors veterinarians chiropractors lawyers

accountants and do you I know a couple others but it's a very narrow set that are excluded and as you say there is some logic to it because those professionals need to be the owner from a regulatory perspective anyway Mo most regulatory bodies require that and would be would have trouble with a trust yeah

and In fairness professional corporations are largely permitted in most cases as tax planning Vehicles more than anything else uh some cases they were liability limiting vehicles but most for the most part taxpaying Vehicles so the incentive was never the design the purpose was never to permit them to to scale a large operation

however there are there are you know in some of those cases we mentioned there are companies that can actually qualify that are in those fields just not professional corporations yeah that's exactly right that's exactly right and the only other one that I think is worth mentioning is that you have to be an individual to qualify so companies don't qualify

yeah same Bas principle lifetime capital gains exemption and when we missed that back and listen to that episode but end of the day only an individual can claim these exemptions not a holding company yeah I've listed a bunch of constraints which then people make people think oh my God this is complic it's really not right vast majority of companies vast

majority you own a Manufacturing Company in Lethbridge you're an individual who has worked at the company you are going to qualify for this tax in yeah okay let's let's go over a couple points we haven't gone over yet so one of the things I think we didn't discuss was I have an employee who's worked there for 15 20 years I go to leave the company to

retire what happens it depends on how it's set up so if it's set up as a profit sharing trust and the company is not sold and you decide to leave then you leave the company you leave the company during the time in which you have been you worked there while the trust has existed you probably got paid extra bonus every year but you get

nothing yeah if if it's set up with a share allocation structure where instead of profit sharing we as the trustful allocate shares to you and then we'll track the shares when you leave the company you may have you may be able to sell those companies those shares back to the company which will have kept some

cash and so you'll have a kind of a bonus when you leave the company as opposed to bonuses along the way my guess is most of these will be set up as profit sharing trusts in Canada with perhaps some people using additional benefit for shares but yeah so it will depend a little bit on how the trust is set up any reason why you think that at

curiosity I think from a Simplicity perspective right I think it's just easier I think as a business owner looking to do this once you start into share allocation into the structure it just gets a little bit more complicated fair enough I think some people will definitely do it but I do think most will end up being profit Shar that's

from my standpoint is simply looking at the St looking at it as well if someone works there for 20 years and then two years later the place gets sold they didn't participate in that that does that seem fair so the government has done another good thing at here they have allowed you to include former employees as as beneficiaries which is

not available in the US and it's not available in the UK so that makes it for a very easy exercise then to basically not have to worry about do the profit sharing one and then have this back door that basically you can include anyone who worked there for and recognize them as part of it which is fantastic yeah exactly yeah it's really well thought

through I think it wasn't an easy road to get here as as we talked about last year but the but the end results pretty good and and I think will be a model for the world as as more countries adopt programs like this just got to get rid of the cap and make it unlimited but I say that as someone who basically does want that for their clients ping his own

business but the reality is is that if this is having the net social impact we're talking about and if someone's legitimately selling a business for north of $10 million of profit that business is substantial and probably employs a lot of people and that just it's a with the exception of and this and there's not software Industries really don't do this from what I've seen

but from from that very simple correlation of the bigger the gain likely the more employees means that likely the more people are going to benefit which it's just a net positive in the end and whether that was concentrated in the hands of one person or five people it's the end result we really want to get over there so if we got to reward the one person who created it so

be it in my mind yeah and we're hopeful the story in the US has been continually improving incentives over the years right it's existed for 50 years and it just gets better and better in terms of the incentives to do it because of its outcomes of course we hope the same thing will happen here in Canada and

look what we haven't talked about yet is this is thing is time limit as as it stands so the tax in but it's set to expire at the end of 2026 why do you think that is I got my own Theory uh why don't you go with your theory um it is a dip in the water to

look for future issues and not commit to it until they've had time to test it and see what the actual net impact is yeah I think there's a lot of that I think the other thing that is probably true is there's the it it it makes the number smaller for the budget today because budgeting is done on a fiveyear time period this is three years means you're

only capturing three years of the potential cost I think both of those are true and both of those are not unreasonable we are of a strong belief that it will be extended as I say it has support across all Canadian political parties be hard to take this back quite honestly unless there was something really detrimental that's it that's why these conversations are so important

right we need people to know it exists we need people to know it's doable we need people to know it's real and then we need advisors to ensure that people do it well so these are good viable thoughtful transactions where the employees then succeed with the company

after the sale yeah let's just high level this again as to the night let net benefits before we finish up and by the way I want to also take the time to thank you for your advocacy on this because I legitimately think something wonderful has been done for the country here in this regard and I hope it continues on and one other statement before we go on we're not really used to things expiring

in this country the Americans are very familiar with this in in the concept of sunsetting so I think it's not without its Merit that it was given a limited time so let's let's see how then that impact and and hopefully prove that they should do something bigger in five years and I think really that's the incentive is not just extending it but let's

actually take a look at this and oh boy did this work out all right this worked out pretty well may we should run with this I I think where we hopefully want to land on so let's sum it up again so employer if you were to high level the the net benefits in a couple bullet points yeah so for the employee for an employer you are getting all of the

Legacy benefits that folks in the US and the UK get you are keeping your jobs in your community you're keep you're doing something amazing for your employees you are um ensuring that the legacy of your company continues on after you have left it there is a $10 million capital gains tax incentive available to you when you

sell Plus some additional benefits around the timing of taxes versus when you get paid and then you also get to stay connected to the company some people want to clean break but a lot of people don't a lot of people want to stay connected to their company involved you can stay at on the board of directors you can stay on the Board of Trustees you can help guide the company going forward as these benefits acre to

all of these people who have helped you create the great company that you're selling so a ton of benefits for a selling owner excellent and yeah let's working through the math just to be clear 10 million from this incentive on top of your 1.25 lifetime capital gains exemption uh and also oh we didn't talk about this lifetime capital gains

exemption and other exemptions are subject to Alternative Minimum Tax meaning that you could pay some tax but you'll get it back later over time the 10 million is not which means is legitimately 10 million taxfree no clawb no things coming later or anything like that so that's big so the bottom line is the opportunity to if you qualify for

all three benefits north of $13 million tax-free and again and anything beyond that the ability to spread that tax bill out over 10 years so yeah you may have to be the bank in this instance but at the end of the day you're not going to get that other anywhere else and for those and I

hear this all the time why would I do that I just take the profit for 10 years the profit is coming out in form of dividends and you're paying tax on that so guess what you were losing 40 some odd percent of that if not more you were getting half so this is effectively doubling what you're taking out over that period of time as an exchange for

releasing the shares so yeah not bad and now the employee the benefits so the employee they don't pay anything for their shares because it's debt financed it means you don't have to pay for your shares so you as a worker will get benefit just by virtue of being a worker at that company you're likely going to get additional profit sharing probably

after the debts paid off but once the debts paid off there will be additional cash flow to be paid out to workers and then if the company were to be sold the proceeds of that sale flow to the workers and not to anyone else so all of the financial benefits of the company going forward go to workers plus you have some Now voice in governance of the company through the Board of Trustees

and again in case of a sale the thing you don't have to do which scares a lot of people is you don't have to run the company now if you had a job before you have the same job now right the folks who ran the company still run the company so you don't have to worry about the company then becoming a very different place to work in I maybe it

will but you don't have to worry about that the in in Theory the governance structure should stay exactly as it did before and that's one of the virtues of these indirect trust-based ownership structures excellent perfect John thank you so much for your time and thank you so much for your advocacy this has been wonderful no hey thanks Jason look there's a fire under us right now right

this thing is you know we are now how do we make people aware of this and we're now working on an awareness campaign we are working on helping to support an an association that will back these companies going forward so we're incredibly excited about the opportunity ahead for Canada here and anyone who wants to reach out and chat about this

I'm always available and where can people find you uh I'm usually available LinkedIn is a is a reasonably good place to find me although I wouldn't follow me because you you probably won't like what I say but you can also reach me at John social capital partners.com

talk to a professional about employee ownership trusts excellent John thanks for your time thank you Jason appreciate it you enjoy that podcast and wouldd like to learn more about employee ownership trust please reach out to John Social Capital Partners otherwise as always if you enjoyed this podcast please review an apple podcast SoundCloud Spotify Stitcher what your podcast until next time take

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