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Conjure up employee benefits with a phantom stock plan

by on
in Employee Benefits Program,Human Resources

As a small business owner, you want to reward your top performers. But there’s a drawback to doling out stock to highly valued employees: You’re diluting your ownership interest.

Strategy: Consider a “phantom stock” plan. With such a plan, payments are credited to employees in units instead of actual stock. Thus, the setup gives the illusion of giving employees stock or stock options, without actually giving away either one.

Best of all, you’re not required to include all employees in a phantom stock plan.

Here’s how it works: You credit the accounts of plan participants with a specified number of stock units. Each unit has the same value as a share of the company’s stock on the date it is credited.

If the company pays a dividend on its common stock, it also credits the employee’s account with the amount that would have been received if he or she held the shares.

The plan can provide benefits after a stated number of years or upon the employee’s retirement (or death or disability). At that time, the employee is entitled to a cash bonus equal to the appreciation in the stock’s value from the time the units were credited to the account, plus any dividend equivalents.

The total amount in the account can be paid out to the employee in annual installments (e.g., over 10 years). Therefore, the employees never have to shell out any cash for the stock rights. At the same time, you retain full control of the company.

Tax payoff: Since a phantom stock plan is a non-qualified deferred-compensation plan, you don’t have to file documents with the IRS or comply with stringent nondiscrimination requirements. The benefits generally aren’t taxable to employees until payments are made. At that same time, your company can deduct the payments.

However, this assumes you’re using an “unfunded” phantom stock plan. In other words, the funds must be subject to the claims of general creditors. If the plan is “funded” and amounts are set aside for employees, the employees will owe tax before they actually receive any benefits.

How do you value the shares in a closely held company? The valuation can be based on a formula established when you adopt the plan. But be aware of the risks. If the formula turns out to be overly generous, you could stunt your company’s growth or deplete its reserves; if it’s not generous enough, employees won’t be encouraged to stick around.

Tip: Have your tax pro establish a reasonable method for valuing the stock.

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