Most entrepreneurs are always looking for ways to incentivize and reward key management and top performing employees in order to keep them within the organization. A common incentive is to offer ownership in the company to key employees through a stock plan. While ownership may seem to be an attractive option, adding an owner to the business creates risks for the current and potential new owner. Risk could arise from disagreement between new and old owners in leadership styles, the direction of the company and use of company funds. Additionally, key employees may not have the financial capability of purchasing their shares of ownership or dealing with the consequential tax burden.
An alternative to offering key employees ownership is to set up a phantom equity plan. Phantom equity is a promise by the company to pay key employees a bonus equivalent to the value of the company’s shares or the increase in the company’s shares over a period of time. The key employees would receive this deferred bonus based on a particular vesting period. Essentially, phantom equity allows key employees to participate in the upside of company as the company’s shares increase in value without the burdens of ownership.
Phantom equity generally is non-taxable until the bonus is paid. At that time, the employee recognizes income and the company may take a deduction. Compared to offering ownership, the key employee does not have to purchase ownership or face an immediate tax burden upon introduction into the phantom plan.
Phantom equity plans may be an ideal incentive for employees; nonetheless, business owners should consult with legal counsel to make sure these plans comply with IRS regulations and avoid complex ERISA rules governing employee benefits. If you have questions or are interested in implementing a phantom equity plan within your organization, we can assist you in implementing this plan.