Motivating and keeping key employees is an essential part of maximizing the value of any business. Many business owners feel that giving key employees an ownership stake in a company is the best way to do this. WE DISAGREE. Consider the following. Using phantom stock you can "have your cake and eat it too".
Phantom stock or phantom equity is a concept that many business owners are not familiar with. Phantom stock can be a very powerful and cost effective way to motivate key employees so that they work to increase the value of the owner's company using the "motivation of ownership".
Instead of giving employees regular stock, a phantom equity program gives the employee something that looks and feels like stock but is not stock. Instead, the employee is awarded “Phantom Shares,” which have many of the attractive features of shares of stock without some of the drawbacks. Many business owners like phantom shares because they allow employees to participate in the financial rewards of ownership without having a voting interest and without the complications associated with having additional shareholders involved in the company.
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 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.
Phantom shares can also be valued using any 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 was started. That way the employees only participate in the additional value that they help to deliver and do not participate in the value that already existed.
Phantom equity programs also have several significant tax advantages that are attractive to both business owners and the key employees.
First, 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 or when the employee retires and is cashed out (assuming the employee's phantom shares are vested). This is very attractive considering that regular shares are taxes as ordinary income and the employee basically has to pay the associated tax even though he or she didn't receive any cash.
When the phantom shares are redeemed, the key employee would receive ordinary income, rather than capital gains, tax treatment on any amounts received for his or her phantom shares. However, keep in mind that the employee was not taxed while employed by the company, meaning that 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.
Second, 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 and the company receives a tax deduction. If the company were redeeming traditional shares the event would have no tax benefits to the corporation. In that situation, the company must use as much as $1.40 or $1.60 of its pre-tax cash flow to repurchase the shares on an after-tax basis. This makes repurchasing real shares very expensive relatively speaking.
We encourage you to discussion phantom equity programs with your attorney or CPA to see if one would be an effective way to motivate your employees to increase the value of your company. It is important that you consult with professional advisors to discuss your specific situation.
Richard E. Jackim, JD, MBA, CEPA is author of the critically acclaimed book, “The $10 Trillion Opportunity: Designing Successful Exit Strategies for Middle Market Business Owners” available at www.exit-planning-institute.org.