To Own or Not To Own? Rewarding Employees With Phantom Equity

Written by: Fargo Inc

Business owners often consider allowing their key employees to become owners in the business. There are, of course, advantages to that, including rewarding people for good work and incentivizing them to work hard to build the company in the future.

On the other hand, there can be downsides, both because of the financial commitment that may be required to buy into a business, the tax implications of simply giving someone ownership, as well as the risk to the existing owner of losing some or all control over a company. Even a minority owner of a business does, under both North Dakota and Minnesota law, enjoy certain rights with respect to that ownership, which may impact the ability of a founder to operate the company as it has historically.

One potential solution to this problem is to use so called “synthetic” or “phantom” equity, which is a method of awarding employees financial benefits as if they were owners without actually issuing them shares.

How do phantom stock plans work?

A phantom equity plan is really a type of deferred bonus plan. Essentially, employees who participate in the plan receive a bonus payment based on the value of the company’s equity. That bonus payment can be based on the full value of the equity, or it can be based only on the future appreciation of the equity after a specific date. Employees may receive one or more phantom equity awards, and each award will typically represent a specific percentage of the company. The company does not have to grant the same percentage to each employee.

How do payouts work?

The benefit under the phantom equity plan can be subject to vesting, meaning that the employee must continue to work for some period of time to receive all or a part of the benefit. Complicated tax rules apply and restrict when the benefit can be paid, but the key is that it must be upon the occurrence of predetermined events.

Those events include termination of employment, death, disability and a sale of the business. The phantom equity plan must specify when the benefit will be paid and how it will be paid, i.e., in a single payment or in installments, and those decisions must be made when the plan is implemented. Once established, the tax rules make it difficult to change the payment terms, so changing these provisions later is not recommended.

What are the tax implications of granting phantom equity?

When payment of the phantom equity benefit is made to the employee, it is taxed as ordinary income and is subject to federal and state income tax withholding. At that time, the company is entitled to a corporate tax deduction for the amount of the benefit paid.

However, phantom equity is subject to FICA and FUTA taxes at the time it vests. That may occur before the benefit is paid. If the benefit vests while the employee is still employed by the company, the employee’s share of the FICA and FUTA taxes will need to be deducted from the employee’s other wages. The company will also need to pay its share of the FICA and FUTA taxes when the benefit vests.

How does this differ from actual stock?

Under a phantom equity plan, employees are not actual owners. They do not have voting rights and do not have the right to any dividends. While their benefit may be expressed as a percentage of ownership, they will simply receive a cash payment for the value of their phantom equity benefit when a payment event occurs.

Can I offer this plan to everyone in the company?

No. A plan of this nature is technically a retirement plan, and so it is regulated to some degree by the Department of Labor. When offered only to key and highly ranked employees, it can qualify for an exception from most regulations as a “top hat” plan. If it is offered to everyone, then it becomes a type of employee pension plan, and it is much more difficult to implement and administer. Therefore, participation in a phantom equity plan must be limited to relatively few highly paid employees.

How do you determine the value of the company for purposes of the plan?

Some companies are required to have an annual valuation, and if so, that valuation would be used for calculating the benefits under the phantom equity plan. If not, the plan can specify a valuation formula, such as a multiple of earnings averaged over several years.

In the absence of that, the plan could simply allow the board to select a value, but there is always a risk of a dispute if the valuation process is not clear. Therefore, we generally recommend having the plan include a formula that can be applied objectively. All that said, if payment occurs because of a sale of the business, then the plan would use the sales price in the transaction as the basis for the payment.

So for business owners who’ve been thinking about how to motivate their employees to think and act like owners, but are hesitant to give up full control of their company, developing a “synthetic” or “phantom” equity plan may be a terrific solution.

Debra Linder and Michael Raum

Fredrikson & Byron Minneapolis Attorney Debra Linder is a seasoned benefits lawyer advising clients on design, implementation and compliance matters relating to pensions, 401(k), ESOPs, health and welfare, fringe benefit and executive compensation programs. She can be reached at [email protected].

Fredrikson & Byron Fargo Attorney Michael Raum focuses his practice on commercial law, with a specific emphasis on tax matters. He works with public and privately-held companies on business transactions, including structuring, financing and advising on general corporate matters. He can be reached at [email protected]

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Brady Drake is the editor of Fargo INC!