Phantom Stock Plans

Phantom stock can be a great way for entrepreneurs to offer incentives to key employees

In today’s uncertain economic times, savvy business owners must be ever so diligent in sharpening their pencil to ensure a positive bottom line. Key employees are a crucial component to a business’ ability to sustain a positive bottom line. Recruiting and / or retaining key employees and incentivizing them during tough economic times could be considered more critical than during flush economic times.

There are several incentive plans available to retain key employees and attract top-notch candidates for critical positions within a business. Few, if any, of these plans have mastered the components of phantom stock plans. Phantom stock can be a great way for entrepreneurs to offer incentives to key employees and tie their compensation to the performance of the company without taking the traditional risks and without allocating as many resources as they would if they issued restricted stock or stock options. The savvy key employee will also embrace the phantom stock plan as a way to receive cash from the business at a designated time, rather than holding stock options, which (in a closely held company) rarely lead to cash in hand upon exercise.

There are two types of phantom stock plans utilized by owners of closely held businesses. The first, what is traditionally referred to simply as “phantom stock,” is essentially a promise of a cash bonus that is directly related to the value of the company. Employees issued phantom stock are typically not able to sell or purchase the ‘stock’ but instead simply receive a bonus per the terms of the phantom stock contract, which is tied to the company’s value. The second type of phantom stock is referred to traditionally as “stock appreciation rights,” or SARs. SARs act as an imaginary form of company equity, which carries no voting rights and is directly tied to the value of the company.

With either type of phantom stock, the key employee gets to share the value of the company or share in the increase in company value over time. Unlike real stock, phantom stock does not convey any actual ownership in the business. A phantom share is simply a credit to the key employee’s account for an amount equal to the value of the company’s “real” shares. Properly created, there is no taxable income to the key employee who holds phantom stock until it is redeemed under the terms of the contract. On the other hand, an agreement properly drafted to not prematurely tax the key employee creates no tax deduction for the company until it becomes obligated to pay the key employee under the phantom stock plan.

Generally, the income is reported on the employee’s W-2 and is subject to withholding requirements when the phantom stock is redeemed. The company is responsible for withholding applicable federal and state income taxes, together with Social Security and Medicare taxes. Timing the payment of the phantom stock late in the calendar year may reduce or eliminate the need to pay certain Social Security and FUTA taxes.

At the inception of a phantom stock plan, the value of the company should be set by obtaining a certified business valuation. This valuation will provide the business with an independent, certified value for the company, and this value can be utilized and relied upon in the creation of the plan. The plan should clearly state that updates to the valuation will be completed on a periodic basis in order to ensure that there is an independently determined value for the company to withstand scrutiny. Anything less than an independent certified business valuation can lead to several problems including the doubt of your key employee as to the true value of the company.

Phantom stock presents key employees the ability to share in your company’s success without giving away any actual equity in the business. As a result, phantom stock plans provide ideal flexibility for private, closely held and family owned businesses. At the same time, the employee enjoys the financial benefits of stock ownership without the risks and burdens of actual ownership. Since phantom stock is not actual company stock, the employee is not an equity owner of the company, and thus not eligible to vote shares, receive announcements of shareholder meetings or have any say in your decision to eventually sell the business.

As with any employee benefit, careful consideration, design and structuring of the phantom stock plan is key. You want to ensure the desired results are achieved to attract and retain key employees. When creating a phantom stock plan, consider it as one more asset in the portfolio you offer to maintain key employees—looking also to short-term incentives as well as the designed long-term incentive associated with the phantom stock plan.