Phantom Stock Plans in Privately Held Businesses

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by Steve Goodman

CPA, MBA – President & Chief Executive Officer

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Introduction

A phantom stock plan is a form of long-term incentive plan (LTIP) typically used by privately held businesses. Also known as simulated stock, shadow stock, or synthetic stock, these plans allow key employees to share in company growth without owning company shares. Stock Appreciation Rights (SARs) are a form of phantom stock.

Phantom shares are available for publicly held and private businesses. The most common use is for privately held businesses as this group is typically most concerned with minimizing the number of shareholders. Minority shareholders complicate transactions when the time comes to sell. The presence of minority shareholders can dissuade some potential buyers.

The phantom share program allows a business to reward and incentivize key employees to align with company goals, support long term growth, and retain talent. Phantom stock plans are available for any type of business, including LLCs and partnerships. Phantom stock is a tracking vehicle for company growth. It is independent of the type of business for which it is applied. For employees, phantom stock allows the employees to defer paying income taxes on the phantom stock and its appreciation.

Phantom stock plans are very flexible. They can accommodate a wide range of program options. When a company decides to move forward with a phantom stock plan, it needs to decide on various key plan provisions including the following:

  • Vesting
  • Dividends
  • What a share means
  • How shares are valued
  • How share distributions are determined
  • What happens if the company is sold
  • When employees can cash in shares
  • Voting rights
  • Conversion rights to company equity

Reasons to Implement a Phantom Stock Plan

There are two questions that must be answered when considering why a company would offer a phantom stock plan. The first concerns why a company would offer any long-term incentive plan (LTIP) of any kind? Once that question is decided affirmatively, one can then move on to consider whether a phantom stock plan is a right plan for your business.

An LTIP is a plan designed to accomplish multiple objectives. A long-term plan is fundamentally different than a short-term plan. Short term plans typically focus on cash bonuses for outstanding performance over a quarterly to annual period. Short term rewards systems may include middle and lower level managers. These plans offer relatively rapid recognition for hard work and diligence.

A long-term plan deals more with the execution and decisions made by those capable of changing the company’s fortune. Long term plans involve only those at higher levels of management. These are the people who define policy and make the decisions that affect a company’s future. Many public companies come under criticism for thinking quarter to quarter. LTIPs encourage managers to think long term. These plans reward key managers for taking a short-term financial hit in favor of a long-term gain. In short, LTIPs encourage key staff to think like company owners.

LTIPs serve to retain talent. They are a form of ‘golden handcuffs.’ Many plans require vesting. Vesting adds to an employee’s cost in leaving one company to accept a job with another. An LTIP helps to make a private company compensation package competitive with a public company capable of offering stock incentives.

LTIPs require policies and procedures in writing. Everyone involved in the process has access to the rules of the program. A written program instills a sense of fairness and equity in the program. This encourages the target audience to buy into the program.

Having determined that a long-term incentive plan will be advantageous, the question turns to what type of plan to implement. Privately owned companies with a requirement that ownership not be distributed beyond a certain few (or one owner) require a plan that does not involve stock. Tax considerations always play a role. Costs are important as are the regulatory restrictions on some forms of LTIP’s.

The phantom stock plan allows key company personnel to own something that has many of the characteristics of the stock. It tracks company performance, sometimes pays a dividend, and has a definitive value but it is not stock.The phantom stock becomes a liability that the company must eventually convert to either cash or company stock. In privately held businesses, company stock is rarely an option.

The holders of phantom stock have no minority shareholder rights and rarely have voting rights. Minority shareholders in privately held businesses require an operating agreement among the shareholders. These agreements can become very complex as the number of shareholders increases. Phantom stock plans are cheaper to implement than an ESOP and offer considerably less regulatory concerns. The plans can accommodate a wide range of reward programs and qualifications for grants. Key

employees like these plans as any phantom stock they receive is not taxable until converted into cash by the company. (See the Tax Consequences section of this article.)

Is Phantom Stock Appropriate for Your Business?

To be a good candidate to offer a phantom stock program, a company should meet the following requirements:

  • The company must be anticipating growth. A phantom stock plan works by allowing key employees to share in the company’s growth. The company’s success becomes the key employees’ success. A slow growth company offers little upside potential.
  • The company must be willing to share its growth with its key employees.
  • The upside for key employees needs to meaningful. If not meaningful, it will not retain talent nor provide the proper incentive for key staff to treat the company’s future as strongly tied to their personal fortune.

Companies that may not be good candidates exhibit the following:

  • If the goal is to develop a program that covers nearly the entire company, then the program will run into legal problems. Programs that look and act like companywide retirement plans must abide by ERISA regulations. A phantom stock plan is not ERISA compliant.
  • A company facing financial difficulties may find it difficult to buy back phantom stock in a timely manner. Delayed payments send the wrong message to key staff that negates the value of the plan.
  • Companies facing potentially consequential lawsuits are not good candidates. A lawsuit large enough to delay growth or possibly require a corporate retrenchment places the plan’s long-term value in doubt.

Plan Design

Phantom stock plans permit significant flexibility in their design and implementation. There are multiple aspects in which these plans provide a wide range of possible plan designs.

Vesting – the plan can offer immediate vesting, immediate vesting after X years of seniority with the firm, phased investing over a period of years, or a combination of these.

Voting Rights – the overwhelming majority of plans do not offer voting rights, but it remains an option.

Dividends – plans can pay a dividend or not.

Appreciation Only or Full Value – In the case of a full value structure, a key employee receives phantom shares – assume 100 shares at $10/share. The employee leaves/retires 10 years later. The stock is worth $20/share.The employee’s phantom shares are worth 100 x 20 =$2,000.In an appreciation only structure, the employee keeps only the growth (appreciation) in the share value. In this case, the employee collects 100 x (20-10) or $1,000.

Who May Participate – Company ownership can determine how far down the management pyramid the plan will apply. Ownership must be cognizant of various regulations, including ERISA, in determining plan eligibility.

Share Valuation – How one determines the value of a phantom share can be a very complex issue, especially when company financials are complicated with one-time events or non-operating related transactions. Examples might include an asset or subsidiary sales, distributions to owners, increases in owner capital investment, etc. Valuation policies must be specified in the plan agreement.

A basis for Phantom Stock Awards – The planned charter specifies the terms by which phantom stock is awarded. A company can develop a process by which annual performance targets are set for each plan participant. Upon review and scoring each year, the company issues share awards. Alternatively, awards can be issued on the basis of longevity and/or rank within the organization. Companies can develop awards criteria that mix and match from multiple schemes.

Tax Consequences

As deferred compensation plans, phantom stock plans must conform to IRS Section 409A. A compliant plan allows employees to defer paying income taxes on the phantom stock received. It is subject to ordinary income, not capital gains taxes when the phantom stock converts to cash. Additionally, the value of the phantom stock awarded is subject to FICA and Medicare taxes in the year the services warranting the phantom stock are performed or the year in which the phantom stock vests. Both the employee and employer must pay FICA and Medicare taxes, subject to the income limitation on the FICA tax.

Steve

CPA, MBA – President & Chief Executive Officer

About Steve Goodman

For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.

He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.

Email Steve today for the business succession planning you deserve.

It took a lifetime to build your legacy. Give us a call to see how we can help you preserve it.

It took a lifetime to build your legacy. Give us a call to see how we can help you preserve it.

Steve

Get in touch with Steve Goodman today

CPA, MBA – President & Chief Executive Officer

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