Before you decide to part ways with equity ownership in your business to get, retain, or motivate key employees, you should consider the options and benefits that a phantom stock plan can provide to both your business and your employees.
As a business owner, you recognize the importance of your key employees to the continued success of your business. As a result, you are constantly striving to obtain, retain, and motivate them. For example, you may have considered offering, or you may already offer your employees various benefits ranging from insurance packages to retirement plans. However, many of these options, in addition to being very costly, may not be sufficient to satisfy your key employees' needs or desires.
Offering key employees an equity ownership in your business is a commonly used tool and can be a great way to motivate key employees because they theoretically will take greater pride in your business and will be more driven since they will be sharing in the success of your business. However, giving away an equity ownership interest in your business doesn’t come without complications. Among those complications are:
Tax implications for both you and your employee;
Extensive legal costs;
Compliance requirements with state and federal security regulations;
Issues of control; and, of course,
Dilution of your equity ownership along with that of your other shareholders.
An alternative approach that mitigates these risks and can serve to accomplish the same goals is the use of phantom stock.
What is Phantom Stock?
Phantom stock is actually not stock at all. It is a contractual agreement between your business and an employee whereby your business issues hypothetical stock (i.e. phantom stock) to an employee, which gives the employee the right to a cash payment or conversion of the phantom stock into actual stock at a designated time or upon the occurrence of a designated event in the future.
The value of the cash payment or the actual stock received by the employee will be based upon either the value of your business's shares or the increase in your business's equity value over a period of time. The intent is for the phantom stock to mimic the price of your business's actual stock without actual shares being issued to the employee, which would give rise to the complications discussed above.
How to Structure a Phantom Stock Plan?
Phantom stock plans are extremely flexible, which can help you accomplish your goals and meet your key employees' needs. There are different tools at your disposal when structuring a phantom stock plan, such as:
Designated Time or Event. You can designate any time or type of event to trigger your employee's right to the cash payment or to the conversion of the phantom stock into actual stock. The time or event can be based on, among other things, your employee's retirement or death, the sale of your business, the achievement of set milestones, or just the passage of a certain amount of time during which your employee remains with your business.
Vesting Schedule. To create an incentive for your key employees to stay with your business for many years, you could include vesting schedules providing that your employee's right to the phantom stock does not mature until a certain time or the accomplishment of certain goals. If your employee leaves your business before the phantom stock has fully vested, the employee will forfeit the right to the phantom stock and will not receive any benefit.
Dividends. You can also structure your phantom stock plan to pay a dividend to your employees at various intervals. This can be very useful in order to prevent employees from getting frustrated while waiting for their benefits to either mature or pay out.
Tax Consequences of the Plan?
Phantom stock is typically granted to key employees as bonus compensation, rather than being sold to the employees. If you grant phantom stock to your key employees as bonus compensation, there is no immediate income recognition to your employees, as well as no deduction for your business. Instead the employee will recognize ordinary income, and your business will have a deductible expense at the time of the actual cash payment or the conversion of the phantom stock. This will allow your employee to receive the economic benefits associated with the phantom stock without an initial cash outlay of any kind. However, if you decide to issue periodic dividends to your employees on their phantom stock, each employee will have taxable income at ordinary income rates in the year the dividend is paid, and your business will have a corresponding deduction.
Traps for the Unwary
There are several traps for the unwary when structuring and administering a phantom stock plan that you should carefully avoid. A few of those traps are as follows:
Section 409A. A phantom stock plan is treated by the Internal Revenue Service as a nonqualified deferred compensation plan subject to the rules of Section 409A of the Internal Revenue Code (the "Code"). In particular, Section 409A of the Code governs the administration of nonqualified deferred compensation plans.
ERISA. Since a phantom stock plan is a nonqualified deferred compensation plan, the requirements of the Employee Retirement Income and Security Act of 1974 ("ERISA") generally will not be applicable because ERISA applies only to qualified plans. However, if your phantom stock plan operates like a qualified plan by offering benefits to most of your employees, then your plan could be deemed a non-compliant qualified plan and subject your company to considerable liabilities under ERISA.
Security Regulations. Although a phantom stock plan does not encompass the actual sale of stock, if your plan appears to provide for the sale of the phantom stock to your employees, there could be problems if the plan doesn't comply with the detailed technical requirements of state and federal securities laws and regulations.
Advantages and Disadvantages of Phantom Stock
As with any decision, there are advantages and disadvantages to using phantom stock. The main advantages are the ability for you to reward your employees without having to give up any immediate equity ownership and avoiding the complications of issuing equity ownership. In addition, unlike many employee benefit plans, your phantom stock plan can be selective. This means that you are not required to offer the plan to all of your employees, in fact, you are better off offering it to a limited number of employees.
On the other hand, a major disadvantage of phantom stock is that the payment of the phantom stock, whether via a cash payment or a conversion to actual stock, is considered taxable wages, subject to withholdings and applicable employment taxes and taxed as ordinary income. In addition, your employees could be disappointed that they have not received an actual equity ownership in your business if they see your competitors offering exactly that.
Phantom stock is a great alternative to issuing actual stock in your business since it can avoid most, if not all, of the issues related to selling and owning actual stock, motivate your key employees to continue to provide excellent service to your business, and make your employees feel they are sharing in the success of your business. However, there are pitfalls and traps making it important that you consult with your attorney and human resource advisors to better understand the use of phantom stock and which options can best serve your needs.
© 2016 Ward and Smith, P.A. For further information regarding the issues described above, please contact .
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.