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 December 3, 1999

Investment strategies: Phantom stock can retain key employees

Qualified long-term employees have become a hot item in today’s job market for many employers.

In some industries, competition for technical expertise is intense. Other than offering competitive salaries and the usual fringe benefits, a closely held business can offer little that compares to the potential wealth-building effect of stock options in a publicly held corporation. The lure of working for the next Microsoft and watching those stock options appreciate is an incentive that is tough to beat.

In a publicly held company, a typical stock-option plan gives the employee the ability to acquire a fixed number of shares for a set period of time at today’s price. Assuming the price of the stock goes up, the employee can exercise his or her options, purchase shares at a bargain price and make a tidy profit.

The bargain element at the time of exercise is taxable to the employee as compensation income, and the employer deducts a like amount of compensation expense.

A closely held, smaller business can also create a stock-option plan, but usually no market exists for the stock other than the company itself. In addition to issues of valuing the stock, the shareholders may be concerned with creating minority employee shareholders with full ownership rights in the stock. The ability to “put” the stock to the company at an inopportune time can also be a concern.

An alternative to a stock-option plan that can attract and keep hard-to-find key employees is a phantom stock plan. A phantom stock plan is a written agreement between employer and employee, which sets out the terms of the plan including initial shares, method of measurement (such as book value, average earnings, or some other measure), and terms of payment.

The goal of a phantom stock plan is to create a long-term incentive tied to the increase in the value of the company. The employee has an incentive to stay with the company because his phantom stock is not released until certain conditions are met, including length of service and profitability of the company. A limited liability company, partnership, S Corporation, or practically any business entity can use a phantom stock plan.

A phantom stock plan is a form of nonqualified retirement benefit (nonqualified means no deduction until paid). The amount of the benefit is tied to the performance of the employer. The employer can pick and choose which employees benefit under the plan.

Because a phantom stock plan is a not a qualified retirement plan, there is no annual filing of forms with the IRS, no antidiscrimination requirements, and the plan has no effect on other employer-provided retirement plans.

From the point of view of the employee, the phantom stock does not create taxable income until the benefit is payable to the employee. The amount of the benefit is ordinary compensation income to the employee in the year the employee may draw on the account. At that time, the employer deducts the payment as compensation. For tax-reporting purposes, the employee’s benefit is included on his W-2 form.

For example, Bob is a key employee at XYZ Software Inc. XYZ establishes a phantom stock plan under which Bob’s annual bonus is treated as if it were invested in shares of XYZ stock. Ten years after the plan is established, and if Bob is still employed by XYZ, Bob will be entitled to the value of the phantom stock shares. Because XYZ is a closely held corporation with no plans for going public, the value of the shares is defined by a formula established at the time the plan is created. The plan also accounts for dividends, stock splits and other equity changes, and provides for valuation and payment if the company is sold or if Bob’s position is involuntarily terminated. Payment to Bob under the plan is included in Bob’s W-2 form in the year of payment.

Funding a phantom stock plan can be problematic. An employer may wish to establish a fund as the benefit accrues. In the example described above, Bob deferred receipt of a bonus, which improved XYZ’s current cash flow, but created a liability due over the long term.

Whether this liability should be funded in advance is a business decision that must be considered in creating the plan. In any event, funds set aside to fund the liability must be subject to the general creditors of the employer in order for the employee to defer income tax on the account.

For financial statement purposes, the employer must report an expense and a liability as the phantom stock account grows. Because the exact amount the employee will eventually receive is not fixed, the liability payable to the employee is adjusted each year to account for changes in the value of the employer stock.

Advanced funding of the phantom stock account is reported as an asset of the employer, and earnings on the investments are reported as employer income. For income-tax purposes, the annual expense reported in the employer financial statements is not deductible until the employee has a right to payment. The income-tax deduction is the actual amount payable to the employee in a particular tax year.

Cecil McPherron, CPA is a shareholder with Anderson & Whitney P.C. in Greeley.

Qualified long-term employees have become a hot item in today’s job market for many employers.

In some industries, competition for technical expertise is intense. Other than offering competitive salaries and the usual fringe benefits, a closely held business can offer little that compares to the potential wealth-building effect of stock options in a publicly held corporation. The lure of working for the next Microsoft and watching those stock options appreciate is an incentive that is tough to beat.

In a publicly held company, a typical stock-option plan gives the employee the ability to acquire a fixed number of shares for a set…

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