Selling to an employee ownership trust: protecting the seller without keeping control

Most owners who sell to an employee ownership trust are paid over time, out of the company’s own future profits. Their instinct — a sound one in any other sale — is to hold on to control until the last dollar arrives. The EOT rules forbid exactly that. You end up as the company’s largest creditor, often for six to ten years, and the statute says you may not be its boss for any of them.

Banks lend to companies they do not control every day. The structuring job in an EOT sale is to give the seller a bank’s protections and nothing a shareholder would have. I have written separately on how employee ownership trusts work in Canada; this piece is about the deal terms.

Where the statute draws the line on seller control

The $10 million exemption in section 110.61 of the Income Tax Act only applies to a “qualifying business transfer.” The definition in subsection 248(1) requires that, at all times after the sale, you deal at arm’s length with the company, the trust and any purchaser corporation, and that you do not retain “any right or influence that, if exercised, would allow” you — alone or with related or affiliated persons — to control any of them “directly or indirectly in any manner whatever.”

Two features of that wording matter more than the rest. “In any manner whatever” is the language Canadian tax law uses for de facto control — the influence that exists without a majority of the votes, which the Federal Court of Appeal examined in McGillivray Restaurant Ltd. v. Canada, 2016 FCA 99. And “if exercised” reaches rights you hold but never use. A springing right to take over the board on default is a right that, if exercised, would give you control. The safer reading is that its mere existence is the problem, not its use.

The test also runs “at all times after the disposition” — not just at closing. A protection package that is clean on signing day and gets tightened in year three, when the note falls behind, can put the original qualification in question.

The numbers that set the governance

The statute does not leave board and trustee composition to negotiation. These figures come from the definitions of “employee ownership trust,” “qualifying business” and “qualifying business transfer” in subsection 248(1) and from section 110.61, as amended to June 2026:

You also cannot be a beneficiary of the trust once you claim the deduction, and neither can anyone related to you. If your children work in the business, that is a family conversation to have before the letter of intent, not after.

What the seller can keep: protections that stay onside

Every item below is something a commercial lender routinely gets from a borrower it does not control. That is the test I apply when drafting: would a bank ask for this, and would anyone think the bank was running the company because it had it?

• A vendor take-back note with real terms. Interest at a commercial rate, a fixed amortization schedule, a cash sweep of a defined share of excess cash flow, and acceleration on default. The note is your claim; everything else protects it.
• Security. A general security agreement over the operating company’s assets, a guarantee from the operating company if the trust or a purchaser corporation is the borrower, and a pledge of the purchased shares. The pledge should leave voting rights with the trust until enforcement — a pledgee who votes the shares before default looks like a controller, not a lender.
• Negative covenants. No new senior debt above an agreed cap, no dividends or distributions to beneficiaries while the note is in arrears, no sale of material assets outside the ordinary course, and no change to the trust deed that would end EOT status. These restrict what the borrower may do to your collateral. They do not tell anyone how to run the business.
• Financial covenants. A minimum debt service coverage ratio or maximum leverage ratio, tested quarterly, with a cure period.
• Information rights. Monthly management accounts, annual financial statements, the budget once the board approves it, and prompt notice of litigation, a covenant breach, a trustee change or anything that could be a disqualifying event. A board observer seat is often easier to defend than a director seat, because an observer has no vote to count.
• A minority of board and trustee seats. Up to 40% on each. Your expertise is in the room; your votes cannot carry it.
• A transition employment or consulting agreement. At market pay, for a defined period, reporting to the board. Your knowledge of customers and suppliers keeps the cash flow — and the note — healthy.
• An intercreditor agreement with the bank. The senior lender will want you subordinated. Negotiate what you get in return: a standstill period of defined length rather than an indefinite one, permitted scheduled payments while the senior loan is in good standing, and notice of senior defaults.

Where the price is partly contingent on performance, an earn-out can sit alongside the note. A price adjustment confers no control, though the employees will reasonably ask why they should carry both a debt and a performance target.

What crosses the line

These are the terms I would take out of a seller’s first draft. Some are clearly fatal; others are risky enough that the exemption is not worth the argument.

• Vetoes over operations. Approval rights over the annual budget, hiring or firing the CEO, executive pay or strategy. That is what control looks like when a shareholder has it.
• Quorum or casting-vote mechanics. A board quorum that requires a seller-nominated director, or a seller who chairs the board with a casting vote, turns 40% of the seats into a working majority.
• Springing control on default. Automatic board-majority rights, or a power to appoint additional trustees, when the note goes into arrears. Rely on acceleration and enforcement of security instead.
• Options to buy the shares back. A call right in your favour is a right that, if exercised, gives you control.
• Trustee appointment and removal powers. If you can remove the arm’s-length trustees, they are not really arm’s length.
• The cumulative picture. Two board seats, the CEO’s office, the only security interest and every key customer relationship can add up to influence that none of them confers alone. The CRA looks at the whole arrangement, and so should you.

Enforcing your security in the first 24 months

One consequence surprises most sellers. If the company defaults early and you enforce against the pledged shares, the trust loses control of the company and may stop being an employee ownership trust. If that happens within 24 months of the sale, section 110.61 treats your own exemption as never having applied. Your remedy against the buyer can reverse your tax result.

The practical answers are structural. Size the note so that the first two years are conservative. Draft a workout period — a payment holiday or capitalised interest in exchange for tighter reporting — that applies before acceleration. And treat enforcement of the share pledge as the remedy of last resort, with remedies against the operating company’s assets first.

Why the employees’ protections are also yours

The trust deed must distribute among employee beneficiaries using only hours worked, pay (capped at roughly twice the threshold of the top federal tax bracket) and length of service, applied in the same manner to everyone. More than half of the employee beneficiaries must approve a winding-up, an amalgamation or merger of the company, or anything that would cost a quarter of them their beneficiary status. Those rules exist for the employees. They also mean the company cannot be quietly sold out from under your note.

The money that pays you is the money that would otherwise reach employees as distributions. A note that eats all free cash flow for a decade leaves the people you sold to with ownership on paper and nothing in their pockets — and an unhappy workforce probably runs the business less well than the one you sold. A workable deal usually leaves room for some distribution, even a modest one, from the first year.

The second shared interest is the trust’s tax status. After the first 24 months, a disqualifying event no longer touches your deduction, but for a further eight years the trust is deemed to realise a gain equal to the elected amount. That tax bill lands on the party that owes you money. A covenant from the trust to maintain EOT status, with notice of any trustee change, is a protection for you and a governance discipline for them.

How I would sequence an EOT sale

1. Feasibility. Can the business carry the debt? Bank appetite, realistic free cash flow and a payout period both sides can live with. The EOT feasibility checklist covers the first pass.
2. Valuation. An independent valuation. The trustees owe duties to the employees and need one to justify the price.
3. Governance design. Board composition, trustee slate, the distribution formula and the trust deed — settled before the price is final, because they shape what the price can be.
4. The financing package. Senior debt, vendor note, security, covenants and the intercreditor terms, drafted against the creditor-not-controller test above.
5. Closing and the joint election. The trust, any purchaser corporation and each claiming seller elect jointly and allocate the $10 million among sellers by percentage, filed by the trust’s filing-due date.

The exemption is now permanent — Bill C-30 removed the 2026 end date and received royal assent on June 18, 2026 — so there is no reason to rush the governance work. If you are weighing an EOT against a third-party sale or a staged sale to managers, my pieces on business succession options and selling your business over time set out the alternatives, and the employee ownership trusts page explains how I act on these deals.

The owners who do well in an EOT sale accept early that they are now the bank. Banks get paid by structure, not by staying in charge.