Phantom Stock Plans
by Benjamin R. Skjold, Esq. and Paul G. Christensen, Esq.
A phantom stock plan (“PSP”) rewards employees with incentive compensation measured by an increase or decrease of a company’s stock price. Employees, however, do not actually own stock or options to purchase stock. Rather, under a PSP, by way of a contract, a company can provide an employee with the same incentives as stock ownership without actually issuing new shares of stock.
Because a PSP is a contractual right instead of a stock ownership right, the parties are free to decide the appropriate measure of the incentive compensation. As a result, this type of incentive compensation is well suited for use by S corporations that might otherwise run into problems with limits on the number of shareholders or the prohibition on issuing more than one class of stock. PSP’s can also be an excellent method of compensating employees of family-owned businesses who are not family members but are vital to the company’s operations and need or deserve incentives that resemble ownership.
A PSP can also be viewed as a “golden handcuff.” PSP’s often have vesting schedules that require participating employees to remain employed for an extended period of time in order to achieve a payment under the PSP. The terms of payment of plan benefits vary from plan to plan, but payments are typically made over a period of years following the termination of employment or retirement. Consequently, a PSP’s payment schedule may be an excellent complement to a non-competition agreement because both obligations could arise post-employment.
As with deferred compensation paid under other forms of nonqualified plans, benefits under a PSP are subject to the Internal Revenue Service’s Economic Benefit Rule. Consequently, these plans must be unfunded in order to avoid the inclusion of benefits in an employee’s income when his or her interest vests and is no longer subject to a substantial risk of forfeiture. PSPs are also subject to Internal Revenue Code Section 409A and must be designed to avoid the constructive receipt of plan benefits before said benefits are received by an employee and the resulting twenty percent (20%) penalty. Amounts paid under a PSP are generally not subject to withholding or employment taxes until termination of the employee’s employment because a PSP is not an account balance plan and the amount of an employee’s benefit is not reasonably ascertainable while the employee remains employed. A disadvantage to the employee of a PSP as compared to stock bonuses is that all benefits are taxed as compensation income and will not receive capital gains treatment.
A PSP can be an outstanding alternative to stock grants or options resulting in actual ownership while providing employees additional incentive post-employment income based upon the company’s general performance. Skjold ▪ Barthel’s experience in tax, business law and stock transactions can provide the guidance necessary to design and implement a Phantom Stock Plan for your company.