What are the tax benefits to owners and employees?
When setting up an ESOP in Canada it is important to know there are no federal laws that govern ESOPs specifically. ESOPs are set up following securities legislation and The Income Tax Act of Canada. However, a major consideration to designing a plan is the tax treatment to employee shareholders. Plans can be designed so that employees of a Canadian Controlled Private Corporation (CCPC) who become shareholders would not be subject to tax when getting the shares and can access capital gains tax treatment when the shares are sold (50% of the gain is taken into income and taxed at an individual’s marginal tax rate, the rest is not taxed). They would potentially also be able to access the Lifetime Capital Gains Exemption or LCGE, which is over $900,000 in 2022. This would mean all gains made on sale would be tax free.
Does it have to be offered to everyone in the company?
Eligibility can generally be categorized as a broad-based plan or strategic-person plan (a.k.a. key-person plan). The intent of a broad-based plan is to allow the majority of employees to be eligible, however there is a qualifying or waiting period that the employee has to be employed for before becoming eligible. That period can range from 3 months to 5 years, but usually is 1 or 2 years. A strategic person plan is meant only for specified employees or those in a certain position and above. A company with a hierarchical structure may indicate that only those in a manager position, or above are eligible, while smaller companies with less hierarchy, might have the owner identify individuals who they feel contribute most directly to the success of the company. The latter example is less common as it is difficult to communicate eligibility in a fair manner since it is very subject to the owner’s thought process.
How do I make sure it is fair?
There are many considerations when it comes to perceived fairness. Generally, they all boil down to one thing; communication. Designing a plan in a participatory way has been shown to lead to greater success (the ESOP achieves its goals). A participatory approach just means that you are not only considering the technical requirements (legal and tax) but also the cultural elements. It is important to think about what questions employees are going to have; how does it benefit them as individuals and what are the risks. Defining all the design parameters, including ones that won’t be in a shareholder’s agreement, like eligibility, share allocation, and purchase methodology, clearly with input from potential participants creates the conditions for a successful launch and sustainable ESOP. Many people are unsure and concerned that employees with more money than others will be able to own more of the company. Having a specific and transparent allocation methodology addresses the issue of fairness because it is easy to communicate, and everyone knows what criteria is considered and to what extent. When designing the plan, companies will usually come up with a formula that includes 1 to 4 criteria, such as tenure, position, salary and/or performance. Many companies prefer to make sure that the number of shares an employee owns is related to level of responsibility and impact they have on success of the company, rather than how much money someone has.
Can it be offered to non-employees such as independent contractors?
Independent contractors can participate in an ESOP. However, according to securities legislation, there is a rule that non-employees are considered investors and if the company has more than 50 non-employee shareholders, it may need to meet additional requirements such as issuing a financial prospectus. Employees are exempt form this rule. Out of ESOP Builders clients, owners who desired to include independent contractors are in the minority.
How do I get my money out?
Owners typically want their ESOP to achieve multiple goals. One of those goals is often an exit plan. Owners should, but don’t always, think of 3 things when it comes to planning for their exit. How to get their money out, how the company will run without them (or succession planning), and how to maintain their legacy. An exit doesn’t necessarily mean selling 100% of the company. A recent client of ESOP Builders set it up to achieve his exit and sell 50% of the company (his shares) in 10 years. When one of the goals is to exit, the owner should define their timeframe. The most convenient way to get their money out is to sell their shares directly to the employees rather than issuing new shares and diluting the owner’s ownership. Many companies might start off with a five-year time frame and plan to sell 10 to 20 percent in that timeframe, however consideration needs to be given to what employees can realistically acquire. This is why defining the exit timeframe is important and having multiple financing methodologies (cash, payroll deduction, loans, use of bonuses, etc.) can help.
By Joanna Phillips, CHRL, CVB, Vice President