Rewarding key employees with phantom equity

Business owners often use a phantom equity plan to incentivize senior management by giving selected employees certain benefits of equity ownership without transferring stock or other equity interests to the employees. A phantom equity plan is a type of employee benefit plan in which the value of the phantom ownership increases and decreases over time in parallel with the company’s value.

“Phantom equity plans and stock appreciation rights plans (plans) are a useful tool to reward key employees,” says Jill M. Bellak, Esquire, a member of Semanoff Ormsby Greenberg & Torchia, LLC. The plan is intended to provide deferred compensation to the employee through appreciation in the value of the business as if the employee owned equity in the company.

Smart Business spoke to Bellak about the basics for implementing a plan and the tax treatment to both the employee and the employer.

How is the phantom interest valued?

The initial fair market value of the company at the time the plan is adopted is typically performed by an independent third party business appraiser. Later, upon a payout event under the plan, fair market value of the company is determined either through an arms-length transaction with an unrelated third party or by an independent business appraiser or accounting firm.

What documents are needed to implement a plan?

The documents typically used to implement a plan consist of the plan itself, board of director and shareholder resolutions approving adoption of the plan and typically appointing a plan committee to administer the plan. Documentation also includes the award agreements, beneficiary designations and often a restrictive covenant agreement containing non-solicitation and non-compete provisions made by the employee in favor of the employer. The plan committee identifies the key employees to be granted awards, the percentage of equity granted and the vesting schedule.

The award agreement can provide for either 100 percent vesting upon the date of grant or incremental vesting over time. A change in control of ownership, a sale of substantially all of the assets of the business and similar fundamental transactions typically accelerate the vesting and payout of awards to key employees. The award agreement also specifies certain events that result in termination of the award, including termination of employment for cause or resignation by the employee. An award does not entitle the employee to dividends or voting.

What is the tax treatment of a plan?

Employees are taxed at the time the benefit is realized, calculated on the value of the award less the consideration, if any, paid by the employee. All payments made to employees under the plan are treated as deferred compensation and taxed as ordinary income to the employee when received and deductible by the company when paid to the employee. As a deferred compensation plan, the plan must be compliant with Section 409A of the Internal Revenue Code. Section 409A applies whenever there is a deferral of compensation. There are various exceptions including certain stock option plans, stock appreciation or phantom equity plans, 401(k) plans and short term deferrals in which payments are made within 2.5 months of the year in which the deferral is no longer subject to a substantial risk of forfeiture.

Are there any Employee Retirement Income Security Act (ERISA) filing requirements?

A ‘top hat’ filing is required with the U.S. Department of Labor in order to elect out of certain ERISA filing provisions. The top hat filing must be made within 120 days of adoption of the plan and can be accomplished by submitting a letter to the DOL identifying certain information relating to the plan.

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