Attracting and retaining the right people has always been a top concern for small business owners. They ask: How do we attract the right talent and how do we keep them from becoming a competitor? Additionally, how do we motivate these people and align them with our objectives of maximizing profits and business value? Compensation and benefit strategies play a crucial role in this discussion.
Traditionally, companies have issued stock as an incentive tool to reward key employees in the business. Stock awards help answer many of the questions raised – it provides a valuable attraction and retention benefit and it aligns these employees with the business owners’ objectives of maximizing profits and value. However, issuing stock has its share of cons for small businesses:
- Business owners give up control as their shares are diluted.
- “Bonused” shares of stock are taxable to the employee at time of receipt.
- Employees who purchase shares of stock may have to borrow funds personally to acquire the shares.
- Employees holding shares of stock are liable in the event of legal actions against the company.
- Employee-Stockholders may have to sign personally on business debt.
“Phantom” Stock, on the other hand, is a fairly new incentive tool that is used to reward employees without relinquishing control of the company. This method of granting “stock without ownership rights” offers the same advantages of actual stock awards to attract, retain, motivate, and properly align top talent – profits, distributions, and proceeds from the sale of the business are shared the same as actual stock. However, Phantom Stock also eliminates many of the cons of issuing actual stock. Unlike actual stock awards, Phantom Stock plans provide the following:
- Business owners do not give up any control of the business when issuing Phantom Stock.
- “Bonused” shares of Phantom Stock are not currently taxable to the employee.
- Employees who elect to purchase shares of Phantom Stock avoid having to borrow funds personally to acquire the shares.
- Phantom Stock plan participants carry no liability in the event of legal actions against the company.
- Phantom Stock plan participants do not have to sign personally on business debt.
Phantom Stock plans are essentially employee bonus plans where the value of that bonus depends on the performance of the company. By design, Phantom Stock plans are more flexible than actual stock awards. Participants may defer receipt of their Phantom Stock payouts. This means that the deferred portion of the company profits that otherwise would be “bonused” out to the participants are instead not currently taxable to the participant. These deferred payouts can then be invested by the company and grow tax-deferred for the participant.
However, since the company is not currently paying out these profits to participants, such profits are currently taxable to the company (i.e. shareholders/partners of “pass-through” entities). The company gets its tax deduction when the deferred profits are paid out to the participants in the future.
Although business owners lose the current tax deduction on the deferral of Phantom Stock payouts, they can improve participant retention by adding a vesting schedule to participant deferrals.
Thus, Phantom Stock plan participants have three distinct motivations for staying with the company:
- They will continue to share in the future profits of the company.
- They will receive their deferred payouts at specified points in the future.
- They have the opportunity to share in the net proceeds of the business if it is sold.
No incentive plan is perfect; however, Phantom Stock plans are flexibly designed to produce creative ways to attract, retain, motivate and align key management.