Most business owners need to determine how to retain their key personnel. At the same time, they need to ensure a plan is in place that incentivizes key executives to achieve goals that maximize the company’s value.

For many employees, a “show me the money” type of cash payment performance-oriented bonus will work just fine. One of the problems with this approach, though, is that it often will not assure sufficient long-term loyalty. Should there be bumps in the road and bonus expectations are not met, key staff may decide to move along to another opportunity, perhaps with a competitor.

Another alternative is to design a compensation package that has a longer-term perspective by offering the employee a direct equity interest in the business. While minority ownership may have initial appeal, it offers the potential for a host of issues for both parties. For instance, most small to mid-size businesses are formed as pass-through entities and minority owners can experience difficulties with tax issues that can arise from owning an interest in a pass-through entity, particularly when they receive a Schedule K-1 requiring them to report income out of alignment with any cash distributions received. Plus, when a business experiences a loss, the allocation of the loss to minority owners may not be the best overall economic outcome.

Minority owners may also misunderstand their role in the management of the business, as well as their rights to access detailed financial information. And while a minority owner may offer significant value to the business, he or she often does not have the same entrepreneurial make-up as their employer. All of these factors can lead to unintended tensions.

One alternative to direct equity interest is a phantom stock plan. These plans allow an employee to receive current benefits in the form of periodic incremental compensation (in part reflective of a quasi-equity position) as well as participate in the growth in value of the business.

In a typical phantom stock plan, an employee earns interests in fictional equity rights subject to agreed-upon vesting provisions, often with an acceleration provision upon a sale or other liquidation event involving the business owner. Stock appreciation rights oriented plans may limit an employee's participation in quasi-equity rights to the enhancement in value of the company over the current value, rather than granting a full right in the value of the business.

The employee recognizes ordinary income when he or she exercises rights under the plan and receives a cash payment. The employee’s income will be treated similarly to other employment-related compensation and, therefore, will be subject to payroll reporting and related tax withholdings. This may be perceived as a disadvantage to some employees who would prefer capital gain treatment; however, with appropriate planning, the spread between ordinary and capital gain tax rates can often be effectively managed, although perhaps not entirely eliminated. The employer will realize a tax deduction equivalent to the income realized by the employee at the same time that income recognition arises for the employee.

Advantages of a phantom stock plan to employees include:

  1. Eliminating the need to fund an upfront economic investment that would otherwise arise if an employee were to acquire a direct equity interest
  2. Simplified personal tax reporting in avoiding the complications that would arise from reporting some share of the business’s profit
  3. Eliminating potential outside credit source requirement for owners to personally guarantee enterprise debt
  4. Otherwise economically subsidizing adverse operating results of the business

The advantages to the employer can include:

  1. Avoiding legal issues involving retirement of a direct equity interest by a minority owner should his or her employment relationship terminate
  2. An ability to provide an opportunity for employees to participate in the growth of the business without having to fund a current tax impact which could arise from a current direct equity interest
  3. The value of “golden handcuffs” in retaining key personnel who are motivated to continue employment rather than giving up their unvested phantom stock rights
  4. Tax deductions arising upon the realization of income by the employee