October 7, 2021

by Gregory S. Dowell

Many closely-held businesses look for ways to attract and retain high-level employees who are key to the success of the business.  There is a huge desire to lock in and focus everyone's interests on what's best for growing the company, whether it's a matter of growing sales or improving the bottom line or improving the return on equity overall.  In a public company, it's much easier, because the stock is actively traded in the market place.  Public companies can use warrants or stock options or restricted stock units to achieve these objectives.  Due to the very broad ownership base in a public company and the oversight by the SEC, it is unlikely that there will be governance issues downstream.  However, giving up the equity of the company to key employees is often not the best choice for smaller non-publicly traded businesses, even though it might only result in a very minority position to the key employee.  That's because opening up the ownership ranks also opens up the company to more complications, scrutiny, and exposure.  Given those obstacles, businesses have to look for other means  to motivate employees and align interests for the betterment of the business.

One way that smaller businesses can motivate and retain key employees is to offer "phantom stock" in the business to non-owner executives.  Phantom stock, as the name implies, does not involve ownership of actual shares of corporate stock. Rather, under a phantom stock plan, the employee is assigned phantom stock units, the value of which is based on some formula relating to the stock. The company can determine what key metrics are most critical to the long-term success of the business and shape the phantom stock plan accordingly.  Components of the formula that affects the value of the units typically include amounts distributed by the corporation on actual shares of stock and the appreciation in the value of the stock that accrues between the date the units are issued and the date of settlement. The settlement date usually refers to the date on which the employee's employment with the corporation is terminated.  The formula must be respected and values determined on a regular basis.

From a tax perspective, the employee does not recognize income until the taxable year in which the corporation pays the employee the value of his phantom stock units.  In said year, the corporation can then deduct the amount of compensation paid to the employee based on the value of the phantom stock units.   Phantom stock plans have been recognized by the IRS as valid deferred compensation arrangements.  As a deferred compensation arrangement, a phantom stock plan should not violate the single class of stock requirements of Internal Revenue Code section 1361. 

If this strategy appeals to a business owner, it is recommended to engage legal counsel with familiarity in this subject area to draft the plan.