In part I of this blog, regarding employee equity, I discussed how giving key employee’s equity in your start up business can make a lot of sense–to off set lower salaries, create buy-in and create “skin in the game”. I also addressed reasons that this might not be the most advantageous option.
Specifically that the tax implications for traditional employee equity may be off putting to key employees. There are other issues to consider as well. Once a key employee has been granted ownership, he or she will have certain statutory rights. She or he will have the rights to inspect the financial books of the corporation and will therefore know how much is being made and where it is being spent. He or she will also be entitled the access to legal documents such as its bylaws, operating agreement, etc. Finally, the majority shareholder or shareholders (in others words the boss) will now owe the employee fiduciary duties as a minority stakeholder. If there is a falling out, this could lead to complications–the company could be stuck with a a disgruntled former employee if there is a parting of the ways that does not include a formal buyout of the former employee.
Most of these issues can be overcome. For example, the employee can budget for the tax consequences of ownership, and the parties can agree on a buy-sell agreement that requires the employee to sell her or his shares if the employment relationship is terminated. But in some situations, an incentive compensation plan, (known informally as a phantom share plan) can offer a better solution.
Unlike true equity in which the employee receives an actual ownership interest in the company, phantom shares are just that—phantom. In other words, the employee doesn’t receive shares at all. Instead, the employer and employee enter into a contract under which the employee will receive some of the economic benefits of ownership. This contract is often called an incentive compensation plan. But, it is often referred as a phantom share plan or phantom share agreement.
A phantom share plan can alleviate many of the concerns that surround issuing real shares to an employee. This is because phantom shares are not real shares at all. Instead, they are treated like any other contract in which one party, here the employer, agrees to pay money to the other party if certain events take place—commonly called a “triggering event”. Because of this, phantom shares are not taxed to the employee. Instead, the employee will pay tax only if she or he is paid out of the phantom share plan. Similarly, the employee will not receive a K-1 for a share of the employer’s taxable income (assuming that the employer is taxed as a partnership or an S-Corporation).
Importantly, phantom shares do not give the phantom share employee the right to inspect the books and records of the company and the employer does not owe any fiduciary duties to the employee. These features make a phantom share plan attractive to employees who do not want to be taxed on the value of shares they receive or pay tax on the company’s income. It also makes the phantom share plan attractive to employers, who would prefer not to give employees voting and inspection rights.
I led off this blog with the question regarding an employee wanting a stake in your company. I will close this blog with another commonly heard statement. “He stayed long enough to get his bonus, and then left after receiving a better offer with another company”. Phantom stock helps protect your company’s investment in key employees by taking a long-term approach to that investment and combining this with your willingness, as a small business owner, to share the rewards of the success of your company with your key employees.
This is a general overview and not to be confused as legal advice. If you would like to speak to Jonathan about a business, tax or estate planning matter, please email him at firstname.lastname@example.org or call him at (925) 217-3255.