Ep. 32 — Understanding the Power of Employee Stock Ownership Plans with Kelly Finnell

Welcome to the "Show Me The Way" podcast with David Seitter

In this episode of “Show Me The Way,” Dave sits down with Kelly Finnell, J.D., CLU, AIF, President of Executive Financial Services, Inc., to unlock the mysteries of Employee Stock Ownership Plans (ESOPs). With an in-depth look at their strategic benefits for business succession and liquidity planning, along with the potential windfalls for employees as a retirement plan, this episode is a must-listen for business owners and anyone interested in financial planning.

Ep. 32 — Understanding the Power of Employee Stock Ownership Plans with Kelly Finnell

Dave opens by asking guest Kelly Finnell about his background, after which they diev into a detailed discussion about Employee Stock Ownership Plans (ESOPs). He begins by defining what ESOPs are - they are employee benefit plans that provide company workers with an ownership interest in the company. In an ESOP, companies provide their employees with stock ownership.

Kelly then elaborates on the complexities of setting up ESOPs. He emphasizes that establishing an ESOP requires a considerable amount of planning and effort from both the business owner and the employees. This process includes determining the company's value, deciding how much stock will be distributed, and setting up a trust where the shares will be held. Furthermore, ESOPs have to be administered following strict regulatory standards set by the Internal Revenue Service and the Department of Labor.

Despite these complexities, Kelly stresses the benefits of ESOPs. For employees, ESOPs represent a form of profit-sharing where they benefit directly from the success of the company. Employees receive a tangible stake in the company, which can be a powerful incentive for increased productivity and loyalty. For business owners, ESOPs can serve as an effective succession planning tool, allowing them to gradually transfer ownership to the employees while retaining some control over the business.

Kelly also points out potential drawbacks. If not managed correctly, ESOPs can lead to employees bearing too much financial risk if the company does not perform well. In addition, the cost and effort involved in setting up and maintaining an ESOP can be substantial.

ESOPs and Tax Benefits Simplified

Kelly then explains some requirements for a business to qualify for an ESOP. He emphasizes that, as a general rule, a company needs to have at least $2 million of adjusted EBITDA and at least 50 employees to be a good candidate. This, however, is not a legal restriction, but more of a practical guideline to ensure a favorable cost-benefit ratio for the business.

He then dives into the tax benefits of ESOPs, mentioning a provision added to the Internal Revenue Code in 1984, section 1042, which is a form of like-kind exchange. Essentially, this means that a business owner can sell their stock to the ESOP, receive cash, and reinvest that cash in like-kind properties, such as stocks or bonds of a U.S. domestic operating company, without having to pay tax on the gain from the sale to the ESOP.

Moreover, Kelly highlights that ESOPs can enable a company to operate on a tax-free basis post-transaction. This is possible because the ESOP-owned company will typically be an S-Corporation, which is a pass-through entity and therefore does not pay tax. Instead, the earnings flow through to the owner, in this case, the ESOP trustee who is tax-exempt.

Kelly also explains how ESOPs give business owners a way to protect and reward their employees. This makes ESOPs a popular choice among business owners who wish to recognize their employees' efforts and contributions.

Understanding ESOPs for Business Owners

Kelly gives an in-depth explanation of the process of setting up an ESOP and the key players involved in the process. He begins by detailing how the process usually starts with an initial phone conversation between the client, their advisors, and the ESOP consultant. This conversation is designed to introduce the concept of ESOPs, explain how they work, discuss their tax benefits, and answer any questions the client may have.

He then discusses the team that is typically assembled to facilitate the creation of an ESOP. This team includes the ESOP consultant, the ESOP investment banker, the ESOP trustee, an independent valuation advisor, legal counsel, and a bank. Each of these players has a unique role in the process, with the ESOP consultant and investment banker usually making the first contact with the client and leading the negotiation of the sales price and other terms of the transaction.

Next, Kelly highlights the differences between an ESOP consultant and an ESOP investment banker. While both professionals guide the client through the ESOP process, he explains that ESOP consultants, like himself, charge a fee based on their time, which is significantly less than the fees charged by ESOP investme