Phantom Stock: Aligning Key Employee Benefits With Company Goals

There are quite a number of fringe benefits a company can offer their employees, and yet if the company is trying to retain key employees they may not be enough.  For this conversation, let’s define ‘key employees’ as anyone considered to be of high value to the success of the company.  If you are a business owner, or sitting on a board of directors, then it is important for you to understand that there is an arsenal of tools that can be used to incentivize key employees to stay.  However, we may fail to consider that these employees are looking for something more than just extra perks.  These employees want to know that they are working for a larger cause, one they can be a part of, both professionally and financially.  To this end, anyone who could be considered indispensable will typically want “a piece of the action”.  The desire for a larger financial windfall can translate into higher annual compensation or potential equity in the company they are working for. This is where a clash between the company’s owner(s) and the key employees can lead to a disruption in the company’s operations.  Does this mean owner’s are stuck giving up equity in their firm to appease the key employees?  Not necessarily.  There is another way!  Let’s peel back the differences between traditional stock ownership and phantom stock ownership in order to find a way to solve this contentious situation.

Phantom Stock

What is phantom stock?  No, it is not something out of a Sci-Fi movie; and no, it is not a form of Monopoly money.  Phantom stock is a contractual arrangement between a company and a select employee.  This arrangement does not have to be provided to all employees and can be custom created for each employee.  Essentially, this arrangement promises to make a cash payment to the employee at a predetermined date in the future.  The cash payment is tied to the price of the company’s stock.  This cash payment attempts to simulate the proceeds from the sale of company stock.

Phantom stock plans are commonly used by smaller companies, namely family-owned companies, that do not want to relinquish company equity.  However, in the wake of the financial crisis, larger organizations have started to build these plans into their employee compensation packages.

There are two types of phantom stock plans; one that is based on the value of the entire company’s stock price at the time of vesting, and the other that is tied to the appreciation of the company’s stock between ‘The Grant’ and ‘The Vesting’.  The second plan is thought of as an ‘Appreciation Only’ plan.  Both plans allow the owners of the company to tie a key employee’s compensation to the value of the company thereby mimicking equity ownership without transferring company stock.

Phantom Stock Tax Treatment

How is phantom stock taxed?  Regulated under Section 409a, a phantom stock plan is considered as a non qualified deferred compensation plan.  Under this arrangement an employee receives a grant of phantom shares with a corresponding vesting schedule.  Each year the company conducts a company valuation for accounting purposes which allows each equity owner to value their shares.  After every valuation, an employee will look at their vesting schedule to assess their upcoming tax liability for any shares that might vest.  Upon the phantom shares vesting, the company is required to value those shares and within 10 days make a payment of cash to the share holder.  Alternatively, within the same 10 day window, the company can elect to convert the phantom shares into company stock.  However, if this were to happen it may generate other tax issues for all parties involved.

Assessing and addressing an upcoming stock payout can be essential to an investor’s personal tax planning.  If poor planning is done, an individual can subject themselves to potentially higher tax liabilities.  Liabilities may include a higher capital gains tax, alternative minimum tax, and exposure to the net investment income tax.  It is important to be aware of tax considerations when managing one’s ordinary income.  The employee may need to max fund their qualified retirement plan, manage net investment income, and coordinate the trades within an investment portfolio to tax loss harvest capital gains and losses.  All of these strategies can play an important role in minimizing tax liability in years phantom stock vests.

Phantom Stock Plan Example

Let’s attempt to break down this plan into its most basic components, and illustrate how it can be used to align senior management’s efforts with the company’s performance.

John is an executive with ABC Corporation and has been a loyal employee for the last five years.  John has become so integral to the day-to-day operations of the company that the owner decided he wanted to reward John for his efforts.  However, he was perplexed with how to show John value without providing him direct equity in the firm.  After speaking with his CERTIFIED FINANCIAL PLANNER (TM) he realized he could give John equity in the company without actually transferring physical stock.  To do this, the owner would essentially give John “ghost stock”, or more aptly named “Phantom Stock”.

In this agreement the owner decides to award John phantom equity through a grant of 10,000 shares of phantom stock.  The phantom stock mimics the characteristics of traditional stock with a few key exceptions.  They are:

  1. Phantom Stock does not come with actual stock certificates because there are no actual shares that transfer from the company to the individual.
  2. Phantom Equity does not come with voting rights.
  3. Phantom shares are typically not transferable, assignable, or marketable to anyone other than the employee.  There are a few exceptions to this rule, like the death of an employee.

The owner decides to let the phantom stock vest over a five year period in equal amounts. John has only been with the company for five out of the twenty years the company has been open.  In light of this, the owner decides to go with the ‘Appreciation Only’ phantom stock plan, and make the phantom share vested value based on the appreciation between the grant date and the vesting date.

After the two parties have entered into the agreement together, the company is required to carry the liability on their balance sheet for the duration of the agreement.  As the shares vest and the company makes the cash disbursement to John, the company is allowed to deduct the distribution in the corresponding year.  Additionally, at the time John was granted the phantom stock he did not realize any income.  Instead, he will be required to record each distribution when it vests as ordinary income.

Over the next five years these phantom shares will create a mutually beneficial arrangement between the company and one of its key employees.  As the company continues to grow and John continues to provide indispensable value, this arrangement can be re-created every year.  Doing this will aid in the employee’s retention and act as a set of ‘golden handcuffs’ for John.

Conclusion

Providing traditional stock to a company’s employees as a reward for there efforts creates ongoing value for many years, even when the employee is no longer employed.  However, for smaller companies granting traditional stock to employees can create governance issues.  It is for this reason that a phantom stock plan can offer simplicity to the company’s owners and equity to the key employee(s).  Utilizing a phantom stock plan allows an employee to participate in the growth of the company while not requiring the company to sell equity directly to the employee; essentially creating a win-win for both parties. 

**Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

Phantom stock is subject to complex rules governing deferred compensation that, if not properly followed, can lead to penalty taxes.

LPL Financial and its advisors do not provide tax or legal advice. You should consult with your personal tax and legal advisors before making any decisions. Strategy may not be suitable for everyone.

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