Corporate Succession: Passing the Torch to your Employees

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pass the torch

Establishing an effective succession plan is vital to a company’s future success and longevity. This process often involves a joint effort between the original founders and a key employee, or handful of employees. Depending on the corporate structure, there are several opportunities for sharing ownership, including:

  • Shares can be financed by the successor(s) with a loan from the business owner or a bank
  • Shares can be sold by the business owner to the successor(s) in exchange for a promissory note
  • Shares can be sold in specified percentages over a specific period of time
  • Shares can be held in an employee trust indenture
  • Shares can be purchased through stock option plans
  • Shares can be issued through share pool agreements

While each approach has its pros and cons, company ownership motivates current and future corporate leaders, and provides a great incentive to employees with an interest in the corporation’s future.

 

What’s best for your corporation?

If your successor(s) do not immediately have the funds to purchase shares of the corporation, he or she may finance the purchase with a loan from the business owner or from the bank. For example, the former owner could fund the purchase by taking a promissory note paid over several years in exchange for the shares. This would allow the former business owner to spread the taxable capital gain over five years using the capital gains reserve.

Another alternative is for the business owner to sell the shares to the successor(s) in exchange for a promissory note that doesn’t have any set terms for repayment during his or her life. This promissory note could then be forgiven on the business owner’s death. However, the owner may require payments on the loan, in which case the promissory note would protect the successor in the event that he or she decides not to continue being involved in the business. In this case, it is crucial to remember that the promissory note should not be forgiven during the business owner’s lifetime, as the note would be considered an income inclusion and could then be subject to double taxation.

A third option is selling the shares over a specific time period. For example, the employee or successor may purchase 10% of the outstanding shares each year for 10 years. A disadvantage of this arrangement is that the fair market value of the shares being purchased must be recalculated each year to account for changes in the corporation’s value or the trade market.

 

Trust Indenture: Shares issued by a trust

According to section 82 of the Business Corporations Act, the term “trust indenture” means any deed or other instrument made by a corporation after its incorporation, under which the corporation issues debt obligations and in which a person is appointed as trustee for the holders of the debt obligations.

In this scenario, an employee trust holds shares in the business.  An employee trust allows management to remunerate employees via dividends from the after tax profits of the corporation, rather than through a salary/bonus plan. If shares in the corporation were to be transferred or sold, employees may be able to receive a share of profit on the sale. The beneficiaries of the trust are the employees, and the trustee holds the shares for the benefit of the employees, its beneficiaries.

Any employment benefit is calculated as of the day the trust purchased the shares, and the two-year hold period begins as of when the trust acquired the shares. The benefit of using this type of employee trust is that the shares can be issued to the trust early in the corporation’s development, when the shares do not (yet) have any real value.

In addition, since the employee acquires the trust’s holding period for the shares, the employee may have a better chance of being able to use the Capital Gains Exception on any gain realized on the sale of qualifying shares. The Canada Revenue Agency (CRA) offers minimal guidance on this topic, but it is likely that the beneficiaries of the trust could include both present and future employees such that employees who join the corporation at a later date can be distributed shares from the trust and realize the same benefits as an employee who has been employed since the start of the corporation.

 

Stock Option Plan

Stock options, also known as share options, come into effect when an employer provides their employee with a right to purchase a certain number of shares for a stated exercise price. There is a vesting period in which the employee may exercise his or her right to purchase shares, and if an employee leaves their employment with the corporation before the option vests, it is no longer available.

When an employee exercises an option, the difference is calculated between the fair market value of the share on the date of exercise and the exercise price. If the corporation issuing the option is a Canadian-controlled private corporation (CCPC), the employment benefit will not be added to the employee’s income until the year the share is sold. With regard to income tax, if the exercise price of the option is equal to the fair market value of the share at the issue date of the option, only half of the employment benefit will be taxable. This is the case so long as the share is held for at least two years. The employment benefit is otherwise taxed as regular employment income.

If for some reason the employee shares are transferred, sold, or otherwise disposed of for an amount less than the fair market value on the date of exercise, the difference will be a capital loss to the employee. This means that the employee may find him or herself in one or many of the following positions: reaping a taxable employment benefit, suffering a capital loss, or lacking partial or entire funds with which to pay the potential tax liability.

 

Share Pool Agreement / Pooled Voting

Since the principle of majority control applies to corporate affairs, a voting agreement or share pool gives way to collective, pre-emptive decision making regarding the corporations’ board of directors or any other voting matters. In a pooled voting agreement, two or more employee shareholders may enter into a limited agreement to vote their shares in a certain way. Pooling agreements are contemplated in section 145.1 of the Canada Business Corporations Act (CBCA), where it is stated that a written agreement between shareholders may provide that in exercising voting rights, their shares shall be voted pursuant to the agreement.  During the term of the agreement, each of the shareholders will vote all of his or her shares in the capital of the Corporation and all other voting securities, whether beneficially via a trust or otherwise in accordance with the agreed upon provisions.

The purpose of establishing a voting agreement or share pool can vary depending on the agreement. Shareholders can enter into an agreement for the sole purpose of preemptively determining how they will vote their shares to elect directors. Shareholders may also decide to include a pooling provision in a larger shareholder agreement or as a supplement to a trust indenture whereby shares are held in trust for those employees seeking ownership in the corporation, for example.

 

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