Phantom Stock Plans Demystified: Benefits, Compliance, and Strategic Use for Businesses

Wayne Zell on phantom stock: long-term incentives to boost employee loyalty; tax considerations and key features (financial disclosures, participation rights); vesting, performance metrics, and payout-triggering events; payout structures and IRC 409A compliance. Reasons for owners to consider them.

Key Points

• Phantom stock plans offer key employees the benefits of stock ownership without actual stock ownership, aligning their interests with the company's success.

• Unlike qualified plans, Phantom stock plans are not subject to ERISA regulations, making them simpler and less costly to implement while still incentivizing long-term loyalty among managers.

• Phantom stock plans must comply with Internal Revenue Code section 409A, and payouts are only taxed when the employee actually receives the benefits, not when they are awarded.

Timestamps

0:00 Introduction and explanation of phantom stock plans and benefits

1:13 Long-term incentives, loyalty, and tax implications

2:35 Characteristics, financial disclosures, and participation rights

4:52 Vesting, performance metrics, and triggering events

7:55 Payout structures and IRC section 409A compliance

9:16 Reasons to use phantom stock plans and closing remarks

Quotes

Phantom stock is a form of employee benefit referred to as deferred compensation.

- Wayne Zell

Phantom stock plans are designed to cover key employees and managers, not the entire population of the company.

- Wayne Zell

Key employees and managers are really the only ones supposed to participate in a phantom stock plan.

- Wayne Zell

Phantom stock plans qualify for a special exemption under the Department of Labor rules called the top hat exemption.

- Wayne Zell

Transcript

Wayne Zell: Here we go. What's a Phantom stock plan? And what is Phantom stock, and how does it work? Well, it's basically a form of employee benefit that is referred to as deferred compensation. It's typically referred to as a nonqualified deferred compensation plan.

Wayne Zell: In a Phantom stock plan, selected employees, key employees, receive the benefits of stock ownership without actually receiving ownership of the stock. But it's worth money just like real stock, so it has value, and the value rises and falls with the company's actual stock or whatever the company is valued at if it's a privately held company and not a publicly traded company. In the end, the employees are paid out of the profits after some predetermined event or time. Phantom stock has lots of benefits to those who participate. The managers and key employees get to act like managers because they're incentivized to stay with the company.

Wayne Zell: This is a long term incentive, so it instills loyalty in the managers and key employees. It gives them a head start on their business succession planning, and it's not a qualified plan. Qualified plans are governed by ERISA, the Employee Retirement Income Security Act. And by virtue of being covered by ERISA, there are many reporting and filing requirements. Phantom stock plans don't have those requirements, but they also lack the income tax advantages of qualified plans.

Wayne Zell: For example, an employer who sponsors a qualified plan gets a deduction for payments into the plan, but the employee doesn't have to recognize income until they actually withdraw the benefits from a trust that holds the plan contributions. There are no formal valuations or audits that are required for Phantom Stock Plans unlike qualified plans. And most importantly, Phantom Stock Plans are designed to cover key employees and managers. Therefore, they're not allowed to cover the rank and file or the entire population of the company. So the nondiscrimination rules that do apply to qualified plans don't apply to Phantom stock plans.

Wayne Zell: There's no funding required of Phantom stock plans like in qualified plans. In fact, you're not allowed to fund Phantom stock plans. Phantom stock plans have the following characteristics. First, it's a binding contract between the company and the employees to pay out these benefits if the employee satisfies the requirements of the contract. Terms and conditions, however, vary from plan to plan, and the these types of plans typically require financial statement disclosure and may require recognition of compensation expense, meaning that it will reduce the net income of the company by the value of the plan benefits being accrued.

Wayne Zell: By contrast, in the tax context, a Phantom stock plan does not generate a deduction until the actual payment is made. So there are big timing differences for tax and financial reporting purposes. In Phantom stock plans, you have different participation rights. The the participant might participate in the entire value of the equity allocated to the Phantom stock. They only might participate in the appreciation above a certain level after they join the company, or they can participate in income and profits, and some plans provide for hybrids of all of these benefits.

Wayne Zell: Who gets to participate in a phantom stock plan, and how do they participate? Well, key employees and managers are really the only ones supposed to participate in a phantom stock plan. This allows the plan to qualify for a special exemption under the Department of Labor rules called the top hat exemption. A letter has to be filed within a hundred and twenty days of implementing the plan with the Department of Labor, and it's a very simple filing unlike what's required in a qualified plan. Units are awarded either based on past service, based on the position of the individual with the company, usually a high ranking individual or a key employee who's very important to the success of the company, or based on performance.

Wayne Zell: How did they do? Did they earn the benefit under the plan? Then they can be awarded the benefit under the plan. Vesting is also an important component. You hear about vesting both in terms of qualified plans and in stock option plans.

Wayne Zell: Well, they might be time based vesting. So if an employee has three year vesting, they may be able to vest in one third of the Phantom units every year for three years. There could also be cliff vesting after a period of time. Some plans allow for the individual who receives the benefit to vest immediately upon award, and others yet require performance metrics to be met before a phantom unit can be awarded or vested. In a change of control situation, there may actually be a payout, and investing could be accelerated on a change in control.

Wayne Zell: Some key issues to consider that usually arise in structuring Phantom stock plans, what are the triggering events that either cause the individual to forfeit the plan benefits or receive the plan payments? Let's say somebody's terminated from employment with cause, which is defined in the plan. They've done something really, really bad, and therefore, they may be required to forfeit their rights to the benefits under the plan entirely. What happens if the individual is terminated without cause as it's defined in the plan or they leave with good reason? In some cases, they may still might be required to forfeit the benefit, and others, they could be allowed to keep the benefit of the phantom units.

Wayne Zell: Yet if they're terminated without cause, I've seen plans and I've written plans that have varying incentives depending on what the situation is. So if they're terminated without cause, they may still get a reduced payment based on net book value or some other metric that's less than the real fair market value of the shares, or they may be allowed to hold on to their units and cash out and get full fair market value when the company is sold. Plans need to consider when somebody resigns. Again, they may forfeit their rights. They may keep their rights.

Wayne Zell: They may get a reduced payout equal to net book value, or they may get full fair market value. It really depends on the employer. If there's a sale of the company, many plans provide for the acceleration of vesting on the sale of the company even though the individual may have just received the plan benefits, the phantom unit benefits. And they should usually participate in a pro rata share of the net proceeds received by the shareholders in the company on the sale of the company. Phantom plans also build in provisions to deal with the death of a plan participant, disability, and retirement.

Wayne Zell: Payouts occur and struck are structured in different ways under different plans. So you might see plans that pay out over several years, and it's stated in the plan that, say, upon retirement from employment, you might receive a payout of your phantom unit benefits over five or ten years. In other cases, the plans may be modified to allow for acceleration of benefits or other events. But in all cases, these plans must comply with the rigorous requirements of Internal Revenue Code section four zero nine a and its regulations under that code section. Those regulations and that section are very difficult to comply with, so make sure you're consulting with a qualified tax professional who understands those rules.

Wayne Zell: And again, if there's a change in control, there may be a payout either upon the change in control of the company, the sale, merger, acquisition of the company, or within a certain period of time after that. Here are the reasons to use Phantom stock. They're uncomplicated. Phantom units are only paid out if the employee meets certain terms under the Phantom unit award agreement or the plan. And I use the term units and shares equip they're equivalent.

Wayne Zell: It really depends on how you define them under the plan. Phantom unitholders don't have voting rights like shareholders, so they can't block the company from taking certain actions like shareholders might be able to. And importantly, shareholders who have the right to receive an information about the company and inspect the books and records, That rule does not apply to Phantom unitholders. They have no such rights. Yet they remain invested in the success of the company because they can participate either in the profits or the upside of the value of the company as it grows.

Wayne Zell: Phantom units are less less expensive to offer, and Phantom unit plans, Phantom stock plans are much less expensive to implement than, say, employee stock ownership plans, ESOPs. And they offer more flexibility. Privately held companies use them. Publicly traded companies use them. Small companies use them.

Wayne Zell: Large companies use them. And it really doesn't matter what type of entity you are. You can be an LLC, a limited liability company, an s corp or a c corp, and you can have a phantom unit plan. Most importantly, taxes are not imposed on the recipient generally until they receive a payout under the plan. If you want more information on how to implement and draft and structure a phantom unit plan, give us a call at (571) 203-9355 or visit us on the web at Zell Law.

Wayne Zell: I'm Wayne Zell, and thank you so much for listening to Blueprint for Wealth's educational moment. Stay tuned for our very special guest.