Phantom Stock Plans: Real Incentives for Key Employees

Despite the name, phantom stock plans are very real incentives used to attract, retain and reward key employees. These plans also have real benefits in terms of tax implications, ownership control, and, in comparison with qualified plans, the relative ease of planning and administration.

Essentially, a phantom stock plan is a form of deferred compensation, allowing employees to “share the wealth” without actually owing shares or otherwise having ownership rights in the company. These plans can have a positive impact in attracting and retaining employees by providing them with certain benefits of ownership and payment schedules that can effectively function as “golden handcuffs.”

Through a contractual arrangement, a company issues hypothetical shares – often called “units” – to the employee. Depending on the terms of the plan, the units can then be converted into cash (or other pre-determined value such as real stock) at the end of a specified period of time or a specified vesting period. Payout on phantom stock usually occurs at retirement, death, or termination of employment.

Many companies establish vesting schedules, preventing employees who leave before they are vested from receiving benefits; others make specified payments at predetermined intervals over time in order to keep key employees engaged.

Phantom stock plans are especially well suited for the family business that wants to maintain family control, yet provide a financial incentive to those non-family employees that are key to the businesses success – even more important if certain family members are not yet ready to assume a leadership or ownership role. They are also a valuable recruiting and retention tool for start-ups – traditionally short on cash yet high on both expectations and opportunities for growth.

Employer Flexibility, Control

In addition to serving as incentives, phantom plans also offer more flexibility and control than other more traditional employee benefits. As non-qualified stock plans under IRS rules, phantom stock plans are not subject to the same participation requirements under ERISA that apply to qualified plans, allowing companies greater latitude in determining exactly which employees to include. Some companies also use phantom stock as a supplement for standard benefit plans such as a 401k.

There is also more flexibility in terms of linking performance to end reward, whether based on individual, group or company-wide goals. A phantom plan also typically provides a less expensive alternative to qualified plans, as they are not subject to the same restrictions and administrative costs.

Caveats to Phantom Plans

While a phantom stock plan can be relatively straightforward to implement, it is essential that the plan is carefully drafted to avoid any conflict with IRS regulations, and state or federal laws governing employee benefits.

Business owners should always consult with their attorney and accountant to address the various contractual and financial issues involved. Equally important (since a phantom stock plan is usually un-funded) is for the company to properly plan for projected distributions.

Benefits

  • “Golden Handcuffs” – long-term incentive for key employees
  • No equity dilution or typical shareholder rights for participants
  • Flexibility – plan and participants based on company’s discretion
  • Not subject to same restrictions or administrative hassles as qualified plans
  • Tax deferral of employee compensation
  • No cash outlay or financial risk to employees
  • Payout can be treated as ordinary cash compensation for tax purposes

If you have any questions about phantom stock plans, ownership or succession issues, contact the Minneapolis business law attorneys of Foley & Mansfield at 612-338-8788.

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