In today's competitive business world, it is difficult to attract and retain key employees for your business. There are several incentive plans available to attract employees, but few plans have mastered the components of phantom stock plans.
Phantom stock enables your key employees to share in the increase in company value over a time period. Unlike "real" stock, phantom stock does not convey any actual ownership in the business. A phantom share is a credit in an employee account for an amount equal to the value of your company's "real" shares. Over time, the account is credited with changes in share value, along with dividends and other distributions. There is no taxable income for the holders of phantom stock until the employee redeems it. On the other hand, there is no tax deduction for the company until it becomes obligated to pay the employee.
This article will explain the advantages of phantom stock plans, the tax effects to both the company and the employee, and review significant provisions that should be included in every phantom stock plan. If you are able to include these components in your phantom stock plan, then you should be able to attract and retain key employees for your business.
Advantages Of Phantom Stock PlansHow do these incentive-oriented plans operate? Suppose Company A gives an executive 2,000 shares of phantom stock or hypothetical shares at $30 a share. The phantom stock is not actual equity; however, it is tied to the value of the company's stock. The company should schedule a company valuation and construct a formula that will determine the stock's value each year. If the valuation and the constructed formula reveal that the company's stock has increased by $20 a share over the course of the employee's employment, to $50 a share, then you send the executive a $40,000 check. As a result, your company qualifies for a $40,000 tax deduction. The employee is subject to ordinary income taxes on the "bonus."
Phantom stock presents employees with the ability to share in the company's success without giving the employee any actual equity in the business. As a result, phantom stock plans provide ideal flexibility for private, family-owned businesses. On the other hand, an employee enjoys the financial benefits of stock ownership without the headaches of cost and risk of ownership. Because phantom stock is not actual company stock, the employee is not considered an owner of the company. Therefore, the employee does not have to receive announcements of shareholder meetings, is not eligible to vote the phantom shares, and has no authority concerning the potential sale of the company. In addition, the phantom stockholder generally has no rights to liquidation except as indicated in his individual agreement.
Phantom stock plans also do not dilute the ownership percentages of the company's stockholders. However, for cosmetic purposes, the business can create phantom stock certificates that closely resemble actual stock certificates in appearance so that the shares the employees receive look very much like company share certificates. Be sure, however, that the employee knows such documents are for "phantom" stock and not for "real" stock ownership in the company.
Tax Effects Of Phantom StockWhether the payments made to employees are through cash, stock or some other form of consideration, each is taxed at ordinary income tax rates on the phantom stock increases at the time they are redeemed. The employer is generally entitled to a deduction in the year in which the employee reports income. The income is reported on the employee's W-2 and is subject to withholding requirements. These incentive stock plans receive no special tax treatment nor do they benefit from any deferral of tax beyond the time of payment.
As mentioned above, the company has the opportunity to receive a tax deduction for the amount of the phantom stock at the time the payment amount is required to be included in the employee's income and is taxed to the employee. The amount of the tax deduction is equal to the amount of the bonus payment. The business is still responsible to withhold federal and state income tax, social security, etc. However, depending upon the actual date in the taxable year the phantom stock amount is paid, the FUTA and FICA may or may not be required to be paid. If the payment occurs late in the year, the employee may be over the required wage base amount for FICA and FUTA taxes. However, since the Medicare tax is not subject to a wage base limit, it applies, regardless of the timing of the payment.
The use of phantom stock plans has raised tax concerns, particularly with S corporations, as to whether the phantom stock constitutes taxable income on the date it is awarded or vests with the employee, as well as whether the phantom stock is a disqualified second class of stock in an S corporation. This is important because an S corporation cannot exceed a maximum number of shareholders and can generally only issue one class of stock.
Phantom shares are the vehicles of choice when you do not want to dilute either ownership or control, or when you have an S Corporation and are not worried about exceeding the maximum number of shareholders. Establish a vesting period for phantom shares by requiring a minimum holding period. If the employee leaves before the holding period expires, he or she forfeits the value of the shares. You can also establish a payout period, after which time you will redeem the phantom shares for cash. In other words, your people do not have to leave the company in order to cash in their stock. You have some flexibility in determining the timing of the payment of phantom stock.
According to the IRS, the granting and vesting of units under a phantom stock plan are not treated as transfers of property subject to tax. The Internal Revenue Code (IRC) states that a grant of property is subject to taxation upon receipt of the property. Consistent with the general view of phantom stock plans as deferred compensation, the IRS concluded that phantom shares do not constitute "property" for these purposes. Instead, for tax purposes, the employee receives the income in the year in which the redemption value of the units is paid or made available to the employee.
The IRC has also stated that an S corporation can have only one class of stock. The IRS concluded that phantom stock is not stock in the corporation for purposes of applying the S corporation limits on classes of stock. Consequently, an S corporation may have a phantom stock plan without terminating its S corporation election.
To avoid losing the "S election," the phantom stock plan must be structured carefully. Some of the criteria for an effective phantom stock plan for an S corporation includes:
- Liquidation rights must be limited.
- No capital contributions should be required.
- No attributes of immediate stock ownership should be transferred, and
- An acceptable business purpose for the plan should be established.
Drafting The Phantom Stock Agreement
Rights of the employees, particularly as to their ability to redeem phantom shares, must be carefully structured and drafted to ensure the correct tax treatment and the desired deferred compensation incentives to attract and retain employees. When drafting a phantom stock agreement, consider it as one more asset in the portfolio you offer to maintain key employees. A well-defined compensation package offers short-term incentives, cash bonuses tied to certain objectives, intermediate-term incentives, and long-term incentives like phantom stock.
In any basic phantom stock agreement there are several provisions that should be included to make the agreement complete. Some of the provisions to consider are:
- The number of shares granted;
- How the shares will be valued and who will determine the value;
- The starting date of when the shares are offered and the ending date to redeem shares;
- A designation of beneficiary and a contingent beneficiary for the employee; and
- Provisions to make the contract binding, even if someone else purchases the company.
By enclosing these provisions, when it is time for the employee to redeem his or her shares, there should be no miscommunication by either party regarding the terms of the agreement.