Corporate Succession: Passing the Torch to Your Employees

There are many ways to create opportunities for sharing ownership in your corporation. The success of a particular business or corporation is often a joint effort between the original founders and a key employee or handful of key employees.

When small or start-up companies have very little initial value, encouraging employees to become shareholders and share beneficiaries is very common. The potential for the value of shares to increase in the future is something that motivates current and future corporate leaders, and provides a great incentive to key 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 in exchange for the shares with the promissory note being paid over several years. This would allow the former business owner to spread the taxable capital gain over five years using the capital gains reserve. Another alternative is the business owner selling the shares to the successor(s) and taking back 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.

Another 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, though, 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. The charts on the following page provide a guide for corporate founders and leaders considering an employee succession plan.

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.

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, the employee beneficiary of shares issued by a trust may be eligible to use the capital gains exception on any gain realized on the sale of qualifying shares. The CRA offers minimal guidance on this topic, but it is likely that the employee beneficiaries could include both present and future employees. In other words, a trust can be drafted to provide that new employees could receive shares from the trust and realize the same benefits as an employee who has been employed since the outset of the corporation. This is attractive to both employers and employees because any profit on the sale of shares from the trust can be realized by short-term or long-term employees alike. The key point in this regard would be selecting employee beneficiaries who are most likely to invest in the corporation long-term.

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.

For more information about corporate succession or specifically succeeding your corporation to employees, please contact us directly and consult our website at: www.duplooylaw.com