May 01, 2014
Phantom stock is one particular way to enhance the value of your business, while motivating and keeping key employees at the same time. One of the many ways to motivate essential employees is to offer them an ownership stake in the company. However, if cost, regulatory requirements or other corporate considerations make that an unappealing option, we recommend considering phantom stock for key employees.
Phantom stock or phantom equity is a concept that many business owners may not be familiar with. It can be a very powerful and cost effective way to motivate employees to work hard to increase the value of the company through “motivation of ownership.”
Instead of offering employees regular stock or partnership interest, a phantom equity program gives the employee something that looks and feels like stock, but is not actual stock. Instead, the employee is awarded phantom shares, which allows the employee to receive the financial rewards of ownership. It is simply a contractual promise to pay a bonus in the form of the equivalent of either the value of company shares, the increase in that value over a period of time and/or when shareholders pay a dividend/distribution or even when the business sells. It’s a win/win situation, because the employee is happy, and the business owner does not have to deal with the complications associated with having additional shareholders in the company. It’s a classic case of having your cake and eating it, too.
In addition, from the business owner’s perspective, phantom shares are often preferred over traditional shares because they can be subject to vesting requirements, they can be forfeited upon an employee’s termination or departure, and they can be repurchased using payment schedules. Unlike traditional shares that may need to be repurchased under the terms of a buy/sell agreement when an employee departs or is terminated, phantom shares can disappear based on certain triggering events, all of which is stipulated in the contract.
Phantom shares can also be valued using a formula that an owner and his advisors deem appropriate. For example, the phantom shares in one client’s company are valued based on the value of the company over and above the value of the business when the phantom equity program began. That way, the employees only participate in the additional value that they help to deliver.
Phantom equity programs also have several significant tax advantages that are attractive to both business owners and key employees. When a key employee receives shares under the company’s phantom equity program, the IRS does not recognize that receipt as taxable income to the employee until he or she actually receives the money. This usually occurs when the company is sold, when the employee retires and is cashed out (assuming the employee is vested), or perhaps when distributions are made. This is very attractive, considering that regular shares are taxed as ordinary income.
When the phantom shares are redeemed, the employee would receive ordinary income, rather than capital gains tax treatment on the amount redeemed. However, keep in mind that unless cash was received, the employee was not taxed while employed by the company, meaning that the employee can effectively defer payment of taxes on this benefit until a liquidity event or retirement occurs. The time value of deferring these taxes can be significant.
When the company pays a key employee to redeem phantom shares, the company can treat it as an expense rather than a repurchase of shares, which gives the company a tax deduction. Redeeming traditional shares would have no tax benefit to the corporation, as the company must use cash flow to repurchase the shares on an after-tax basis. Repurchasing traditional shares can be relatively expensive to the company.
We encourage you to discuss phantom equity programs with your attorney or CPA to see if this would be an effective way to motivate your key employees, to retain key employees, and to increase the value of your company. It is important that you consult with your professional advisors to discuss your specific situation.