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Phantom stock plans can be valuable tool in retaining top managers

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As the construction industry labor market tightens, it’s more important than ever for companies to prevent their best employees, particularly top managers, from jumping ship to a competing firm. Losing a top worker to a rival firm always undermines competitiveness, but it’s also expensive.

As noted in a study by the Center for American Progress, it can cost about one-fifth of a worker’s salary to replace that worker. This takes into account the cost of hiring and training a new employee, plus the lower productivity level as that worker becomes acclimated to the role.[i] In January 2017, 5.3 percent of the construction industry’s workforce in the United States quit or was discharged; the costs of these separations can add up quickly.[ii]

Clearly, keeping the best and most experienced workers protects a construction company’s bottom line and competitive position. One way some companies are keeping top workers on board is by offering phantom stock options. This type of plan is different from an employee stock ownership plan (ESOP) or employee stock purchase plan, both of which are designed to cover all employees and aren’t necessarily an incentive for long-term employment. Plus, these plans aren’t always an option for contracting firms, the majority of which are privately owned and often owned by family members. These owners often don’t want to relinquish majority ownership or even sizeable minority ownership.

Phantom stock plans, however, offer targeted benefits to a limited few and do not require owners to sacrifice majority ownership. Phantom stock, also called a shadow or unit stock, isn’t actually stock―it’s a deferred monetary award that is indexed to equity value or stock. The most common phantom plans establish compensation units that derive their base value from the company’s overall value or, if a public company, the value of the common stock.

Advantages for employees and owners

These plans offer advantages to workers because they receive cash rather than stock with an uncertain future value. Essentially, phantom stock is simply a promise to pay a bonus in the form of the equivalent of either the value of company shares or the increase in that value over a period of time. Like any other cash bonus, the phantom stock bonus is taxed as ordinary income at the time it is received. Phantom stock plans are not tax-qualified, so they are not subject to the same rules as ESOPs and 401(k) plans, provided they do not cover a broad group of employees. An employee who has been offered a phantom stock plan is not required to invest in the company.

Unlike an ESOP, a phantom stock plan allows owners to handpick the employees that may participate. Owners may also have other reasons to consider adopting a phantom plan, including:

  • Company owners want to share the economic value of equity, but not equity itself.
  • The company cannot offer conventional ownership plans because of corporate restrictions.
  • The company’s leadership has considered other plans but found their rules too restrictive or implementation costs too high.
  • The company already has a conventional ownership plan, such as an ESOP, but wants to provide additional equity incentives to selected employees, without providing stock itself.

Establishing a plan

For those who want to establish a phantom stock plan, the process is relatively straight-forward:

  • Begin with a discussion of tax implications with a certified public accountant.
  • An owner must then decide how many units of phantom stock to hand out. Owners have to be careful they don’t hand out so many units they can’t do the same for future employees.
  • Generally, phantom stock plans are unfunded. If funds are set aside, they should be segregated into a “rabbi trust’’ to keep the employee from paying taxes when the benefit is promised. Owners may also set aside money in an annuity. Any monies set aside must remain subject to the claims of the general creditors of the business.
  • Phantom stock is taxed like other types of deferred compensation. The employee reports no taxable income, and the employer takes no deduction when the phantom stock is assigned to the recipient’s account. Once the employee retires, or fulfills the established tenure, he or she is paid in installments over a number of years and pays income tax. The employer then can claim a deduction each year a payment is made. Payroll taxes are due at the time of grant or vesting of the phantom stock award.

A company offering these plans must record a compensation charge on their income statement as the employee’s interest in the award increases. That means that from the time the grant is made until the award is paid out, the company records the value of the percentage of the promised shares or increase in the value of the shares, pro-rated over the term of the award. In each year, the value is adjusted to reflect the additional pro-rata share of the award the employee has earned, plus or minus any adjustments to value arising from the rise or fall in share price.

Companies have to be careful not to offer these plans to too many employees. If most employees are in a phantom stock option plan, the plan may appear to be no different than an ESOP or 401(k). Then it would be considered by the IRS to be a de facto tax-qualified plan and falling under the Employee Retirement Income and Security Act of 1974. Because it may appear to be a nonqualified plan attempting to operate as a qualified retirement plan, it may be ruled illegal.

Phantom stock plans offer several monetary and tax benefits to top workers who have been offered an opportunity to participate in such a plan. However, they must make a commitment to remain with the company until retirement or a set number of years, and that may be a long commitment.

For owners who are unable to provide profit sharing or ESOPs, phantom stock programs can offer a compensation plan that does not require much money upfront. Instead, the accumulated interest on existing investments can provide the compensation down the road when the employee is ready for retirement.

Contractors interested in studying phantom stock plans should talk with their accountants to see if their financial position makes these plans a viable option.

[i] Boushey, H., Glenn, S. “There Are Significant Business Costs to Replacing Employees” (Nov. 16, 2012) Center for American Progress[ii] Job openings and labor turnover, (Jan. 2017) Bureau of Labor Statistics

Published In: October 2017 Texas Contractor.

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