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 Phantom Equity / Stock Plans

To retain or recruit key employees companies are implementing “phantom” stock plans. Phantom stock is the grant of a right to the appreciation in the corporation’s stock, with a fixed exercise date and method of calculation. Since phantom stock does not dilute shareholder equity, it is a popular form of executive compensation for outside executives in closely held and private corporations. Often defined as deferred compensation unit plans, phantom plans grant chosen employees the financial advantages of stock ownership without granting them an equity interest in the company. Employees are given “stocks”, usually for each year of employment, which are actually fictional shares. At the end of an agreed upon future date the employee can receive the value of those vested shares. With the use of these plans on the rise, it is important to recognize the positives and negatives of the phantom stock plan.

           1. Pros—a. Phantom stock plans provide a method where employers can compensate key employees while still retaining corporate control. This is because “shares” received under such a plan carry no voting power. This may be especially useful for small closely-held businesses;

          –No capital investment on the part of the employee is required;
          –Employees have an increased stake in the company’s success and growth;
          -Key employees can be retained because the employee realizes the full value of the stock only by remaining with the company; and
          -These plans can be specifically tailored to suit the employers need and are simple to establish. Once the plan is accepted by the Board of Directors, an employer can choose which employees will participate in the plan.

          2. Cons—a. Basing financial rewards on the success of the company rather than individual performance may result in undercompensation or overcompensation to the employee;

          –Because no capital investment is required by the employee, it is less likely the employee will stay on board should the company hit rough waters;
          -Phantom stock plans with fixed settlement dates may be less desirable that traditional stock options, which can be exercised at any time; and

          – Determining the value of the phantom stock may be difficult, especially when employed by a small, closely-held company whose shares are not traded daily on an exchange.

Generally courts will not interfere in the exercise of a phantom stock plan except in cases involving claims of fraud or bad faith. In such instances, the corporation has the burden of showing good faith with respect to a phantom stock appreciation plan.

 Be sure to refer to IRC section 409(a)

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