February 5, 2019 How Phantom Equity Works

Many closely held employers have difficulty attracting and retaining key talent.

January 31, 2019

By Shad C. Fagerland

While startups and publicly traded companies alike can lure executives with generous equity awards such as stock options and restricted stock, privately held businesses may not be in a position to grant actual equity ownership to their employees.

Is there a compensation tool that mimics equity ownership, allowing employees to share in the upside of the business’s growth without diluting the current ownership structure? Phantom equity may be the solution your organization has been looking for.

A phantom equity arrangement is a type of non-qualified deferred compensation plan that awards participating executives a benefit measured on the basis of hypothetical (“phantom”) equity units. Instead of receiving fifty shares of employer stock, for instance, a participant in a phantom equity arrangement might receive the right to a cash payment equal to the fair market value of fifty shares of stock. Just like actual shares of stock, the value of the participant’s phantom equity award would increase as the value of the underlying business increases. Unlike actual equity ownership, however, the phantom equity award would not convey any shareholder voting rights.

Phantom equity plans can be adapted by all types of business organizations, from stock corporations to partnerships to LLCs and in some cases, even nonprofits. The governing plan document should be drafted to specify the objective valuation metrics used to measure the value of awards over time. While valuation is typically tied to an existing equity unit such as a share of stock or an LLC unit, an employer may instead create custom metrics designed to capture a more narrow area of business performance. For instance, an employer with two distinct lines of business (shipping and manufacturing, say) might create a phantom equity arrangement solely for executives of the shipping unit. Rather than basing awards on shares of the parent corporation stock, which would reflect fluctuations in value of the enterprise as a whole, the employer might choose to value awards based on some objective metric (such as revenue or sales growth) specific to the shipping line of business.

A typical phantom equity arrangement includes vesting provisions designed to incentivize executives to remain for a period of years. A phantom equity award might become 100% vested after five years, for instance, or might vest 10% per year over a period of ten years. So long as the arrangement is offered only to a select group of management or highly compensated employees, the phantom equity arrangement is exempt from the more stringent vesting standards that apply to ERISA plans such as 401(k) plans. Phantom equity awards are usually payable in cash immediately as they vest, although plans may be designed to provide for a delay in distribution if additional tax deferral is desired.

As with any non-qualified deferred compensation plan, phantom equity awards are payable directly from the employer’s general assets. An employer may choose to set cash aside in a “rabbi” trust to ensure that funds are available to make payments under the plan when due; however, funds in the rabbi trust would remain available to creditors in the event of the employer’s insolvency.

Taxation of a phantom equity arrangement is governed by section 409A of the Internal Revenue Code. Recipients of a phantom equity award recognize taxable compensation income (wages) in the year the reward is paid out. The employer is allowed a corresponding compensation deduction in that same year. Section 83(b) elections, which permit individuals who receive property in exchange for services to elect to pay tax up front based on the fair market value of the property as of the date of grant, are typically not available under phantom equity arrangements, since the benefits are typically payable in cash rather than property. However, in some cases, such as an award of partnership interests, section 83 taxation may be available. Tax counsel should be consulted to determine the appropriate tax treatment based on the design of the particular phantom equity arrangement.

In sum, phantom equity is a flexible tool that can be used to attract and retain key employees without impacting a business’s existing ownership structure. Consult knowledgeable benefits advisors for help designing a phantom equity arrangement that suits the needs of your particular organization.

Shad C. Fagerland is a former IRS attorney specializing in employee benefits and deferred compensation. Currently a benefits consultant with the Pittsburgh office of accounting firm Schneider Downs, Shad can be contacted at sfagerland@schneiderdowns.com.

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