When it comes time to reconcile the tax implications of the transaction above, the company benefits from a $20,000 tax deduction, and the employee declares the amount on his or her tax return as ordinary income.
Notice that the original grant of phantom stock by the company is not a taxable event; nor was the eventual receipt of the proceeds from the stock considered a capital gain on the employee's tax return. These are two of the ways that phantom stock differs from actual equity and options and are factors that need to be considered when contemplating the pros and cons of establishing a phantom stock plan.
Unique Benefit - Comparatively Modest Cost
There are some administrative costs to establishing and maintaining a phantom stock plan - legal fees, accounting fees and periodic reviews to help determine the value of these pseudo shares. However, these costs compare favorably with those of a relatively inflexible ESOP or a qualified or non-qualified stock option plan.
The set-up and administrative expenses are no match for the price of losing just one of your key managers or executives. In fact, some experts estimate the cost of turnover at the senior level to be between 100 and 150 percent of the person's annual salary.
For both the company and the key employee, the phantom stock "option" can truly be a win-win solution.
The Story of Acme Construction
In many respects the benefits of this arrangement outweigh the drawbacks for both sides, which was the case for a company we'll call Acme Construction, Inc.
The company, a family owned and operated commercial construction firm, was enjoying years of steady growth and profit, thanks in part to two dedicated executives – its chief estimator and its lead project manager. Recognizing their value to the company's success the owners set up a phantom stock plan and issued each executive phantom units equivalent to 5 percent of outstanding common stock as an incentive to stay with the company.
The vesting schedule was built around a combination of time periods of continued employment and certain economic milestones. The units would be re-purchased (i.e., the executives would receive their payouts) only in the case of certain triggering events – their eventual retirement at age 65, liquidation of the company or the merger or sale of Acme Construction to another owner.
About six years later the company was approached by a national player in the commercial construction industry that was attracted by Acme's track record and prospects for further growth. Buy/sell negotiations ensued, and within the year, Acme was sold.
As a result, the value of the owners' original equity increased nearly three-fold. And because the value of the phantom units held by the two key executives mirrored the owner's common stock, both benefited handsomely when one of the triggering events that had been planned for (the sale of the company) eventually came to pass.
Paul Bardaro is a partner in the Boston-area accounting and business advisory firm Rucci, Bardaro & Barrett, PC. Through the firm's Construction Business Services Group, he offers business valuation, financial and strategic planning advice to companies in transition. For a complimentary copy of "Top 10 Questions to Ask When Considering a Phantom Stock Incentive Plan," contact Mr. Bardaro at (781) 321-6065 or email@example.com.