Business owners in the construction industry understand the importance of retaining talented employees. Yet when asked what they are doing to keep their critical team members from jumping to a competitor, many are hard pressed to articulate a clear strategy other than that they offer generous compensation packages. Compensation, however, is not in and itself a retention tool.
Phantom equity is a useful strategy that can be used to retain key employees and align their incentives with the growth of the business. A form of nonqualified deferred compensation, phantom equity offers key employees a benefit based on the value of underlying shares of company stock (or LLC units, partnership interests or other type of equity). Like a share purchase or stock option program, a phantom equity plan gives employees a means to share in the economic growth of the business. But unlike these more traditional forms of equity compensation, phantom equity also does so without diluting the value of existing owners’ shares or creating new minority shareholder interests.
How does a phantom equity plan work? A typical plan grants power to an administrative committee to select recipients from among the employee’s management and highly compensated employees. Recipients sign an award agreement, which identifies the number of phantom equity units awarded and any vesting provisions or other associated terms and conditions attached to the award. Each unit of phantom equity is defined in the plan document as equivalent in value to one equity unit of the underlying company or, alternatively, can be defined more narrowly; for instance, if the company is not appraised on a regular basis, an equity unit could be valued on the basis of revenue or some other business metric. (Exercise caution, however, when creating custom valuation metrics, as outlier years can cause the value of phantom equity units to fluctuate more than anticipated.)
At the payment date specified in the plan (typically three to seven years down the road), participants receive a cash payment in the amount of the value of their phantom equity units at that time. The deferred nature of the payment, combined with any vesting provisions, help ensure that the employee stays long enough for the benefit to mature. A phantom equity plan might provide, for instance, that benefits are payable five years after the grant date, and that the participant forfeits the entire benefit if employment terminates prior to the payment date; or, alternatively, that 20% of the benefit vests each year. Either way, employees are incentivized to remain employed for the duration to maximize the cashout.
If designed properly, a phantom equity plan is exempt from the Employee Retirement Income Security Act, which means that benefits are not required to be pre-funded. 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 for 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. Knowledgeable benefits advisors can help design a phantom equity arrangement custom-tailored for the needs of any particular employer.
