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Numerous studies have found less staff turnover and more productive and innovative employees at firms where employees share a financial stake in the company’s success. But, granting employees shares of stock can also be tricky and implicate tax issues and shareholder conflicts. So what’s the solution? Well, a phantom stock plan may give you the benefits without the baggage, read this article to learn about phantom stock plans and whether or not they are right for your company.

What are Phantom Stock Plans (PSPs)?
Companies implement phantom stock plans to recruit, motivate and retain key employees by giving them a financial interest in the company without transferring shares of ownership in the business.  A company awards an employee “phantom stock,” which grants them the right to future cash in the amount of appreciation in the corporation’s stock, with a fixed exercise date and a fixed formula for calculating. For instance, some companies fix the exercise date only upon sale of a majority of the corporation’s assets, and also condition employee benefits upon perpetual employment as well as confidentiality, non-competition and non-solicitation agreements. Most companies limit the plan’s eligibility to key employees or those who have worked with the company for at least one-year. Employees then accrue phantom stock units often based upon their length of employment.

Company owners can align their incentives with their plan-participant employees when they implement a well-designed formula that rewards employee behavior for the corporations’ increased profitability and overall equity value.

Pros:
  • Incentivizes and motivates employees by giving them an increased stake in the company’s growth and success, while allowing owners to retain 100% of control and ownership of the business.
  • Provides a flexible structure to accommodate a company’s specific needs or criteria.
  • Exempts a properly structured plan from Section 409 of the Internal Revenue Code, which usually regulates non-qualified benefit plans such as deferred compensation. (Consult a qualified CPA for all tax considerations.)
  • Allows start-up companies low on cash, but high on expectations and growth opportunities a way to reward employees’ success and encourage them to continue their career with the company.
  • Eliminates conflicts associated with minority interested shareholders since the participant does not hold any shares—he or she cannot elect directors, receive dividends or demand the fair market value for stock.
Cons:
  • The plan’s benefits constitute cash benefits and thus will not qualify for capital gains treatment. (Consult a qualified CPA for all tax considerations.)
  • An employer cannot deduct contributions until it actually pays the benefit to the employee.
Tax treatment and Financial Statements
A plan-participant employee pays ordinary income tax on the amount received under the plan as if he or she received wages, while the employer deducts from its income the amount paid as an ordinary and necessary business expense. On a financial statement, a company includes the value of phantom stock as a compensation expense charged against company earnings in the year granted and then prorated over the applicable vesting period. The company then annually adjusts the award’s value as it grows or declines.

Planning
A company’s phantom-stock plan represents an unfunded contractual promise, and the company usually does not set aside funds or establish a reserve for purposes of making the contemplated payments. Therefore, a company wishing to implement a phantom stock plan must carefully project a plan’s value in order to anticipate the company’s cash needs. Companies interested in PSPs should seek advice to ensure the plan is carefully drafted, tailored and designed to not run afoul federal and state employee benefit laws.

Overall, phantom stock plans can provide employees unique benefits and also serve as a mechanism for companies to retain and reward talented and dedicated individuals.

DisclaimerThe information in this article is presented for informational purposes only, and should not be taken as legal advice. Before acting on any information presented in this article, you should consult an attorney regarding the facts of your specific situation. We would love to hear from you, so please feel free to contact us for a consultation.

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