Key employees generally want two things in return for their commitment and talent: annual compensation commensurate with their skills and a share in the financial growth that their efforts produced. To put this simply, they want pay and profits. The problem with sharing profits with key employees usually means giving them equity ownership. Most business owners seldom want to take in their key employees as owners.
Phantom Stock Plans can solve this problem!
- No dilution of the owner's equity
- A long-term incentive plan for key employees
- Helps increase the value of the business
- Can be discriminatory
- Great attraction and retention tool
- Financial privacy for the owner
Phantom stock is a contractual agreement between a business and its key employees. Phantom shares are given to the employee and can be cashed out for a designated triggering event. The value of the shares will be tied to a predetermined valuation formula. The amount of the payout will increase as stock prices rise, and decrease if stock prices fall, but without the employee receiving any stock. Phantom stock plans are an excellent way to encourage a key employee to contribute to the share value and encourage retention or continued participation of that key employee.
Phantom shares avoid taxable compensation and the need to give employees voting or other rights commonly associated with genuine stock. When the "stock" is initially given, there is no tax impact. When the payout is made, however, it is taxed as income to the employee and is deductible to the employer. Phantom plans require the employee to become vested.
Phantom stock can be taxable upon vesting, even if not paid out if the value of the phantom shares are pegged to shares that have value. A way to avoid incurring a taxable event at the time of vesting is to have the payout only increase in value from the time of the vesting to the time of payout. Thus, the value of the phantom shares at the date of vesting is zero and not subject to taxation as compensation.
For accounting purposes, phantom stock is treated as a liability. The liability changes each year, and an entry is made for the amount accrued. A decline in value would reduce the liability. These entries are not contingent on vesting.