by Charles Epstein
Have you yet faced problems in hiring or keeping key employees who are not family members? Because they’re outsiders you don’t want to offer them stock, and therefore face a competitive disadvantage compared with firms that offer stock options and stock ownership. This article summarizes two valuable benefits that can help: Deferred Compensation Plans and Phantom Stock Options.
Deferred Compensation Plans
- Sometimes referred to as “salary continuation” plans, deferred compensation plans (DCPs) are of great value in structuring incentive programs for key employees. From the business owners’ perspective DCPs are attractive for these reasons:
- The owners can select specific employee(s) for participation.
- The owners can decide how much to allocate for costs of the plan(s), and attractive funding strategies are available.
- There are no IRS limits on amounts contributed for participants, and different participants can have different plan designs.
- Vesting and forfeiture provisions become the golden handcuffs that help retain the key person(s).
- When DCPs are personalized for the specific circumstances and priorities of key employees the plans are highly valued by them-for both economic and “personal recognition” reasons.
- DCPs are almost entirely free of governmental regulation.
To the participating employee(s), deferred compensation plans are valued:
- The heavy personal income taxes that would be due on any increased current compensation are postponed until benefits are received; at that time the tax bite may be less.
- Whatever combination of retirement, survivor, and disability benefits the plan provides will be tailored to individual needs and priorities.
- Key employees feel appreciated and recognized for their value to the employer.
How DCPs Work
The design of any particular DCP is tailor-made. A typical DCP provides the selected key employee with a set dollar amount (or percentage of final salary) per year for a set number of years after retirement–salary continuation. Often, provisions are also included for pre-retirement death or disability benefits. The business can control its costs by insuring all or part of its obligations under the DCP.
Each DCP is designed with appropriate vesting/forfeiture provisions that make sure the participant has a very strong incentive to stay with the employer for the specified time period. This makes for the “Golden Handcuffs” concept.
One major attraction to participants in such plans is the benefit flexibility. For example, with a relatively young participant who has significant family responsibilities, a substantial survivors’ benefit provision may be especially appreciated. For an older participant with few or no family concerns, the DCP could emphasize retirement income and/or disability income.
Non-qualified deferred compensation plans often are the benefit of choice to supplement qualified plan benefits.
…Companies use [DCPs] for a variety of reasons. The principal one is to allow a select group of executives to defer income beyond the limits imposed by Congress on qualified plans. (Journal of Accountancy, February 1998, page 47)
Phantom Stock Option Plans
The term phantom stock options refers to the fact that the options granted to key people are not based on actual stock shares. They are actually only rights to the appreciation in value of a certain number of shares of the employer’s stock over a designated time period. Thus they allow the participant to profit from the company’s growing value, without actually owning or controlling shares of stock.
How Phantom Stock Plans Work
Key steps in setting up a phantom stock plan include the following:
- A written agreement and a corporate resolution are drawn up.
- The key employee is credited with “shares.”
- The employer establishes a “share account” for the participant.
- A bookkeeping entry is made to that account each time shares are granted to the participant.
- Each year the employee becomes vested in shares in accordance with the written agreement.
- Valuation of the “shares” is based on a simple standard such as the current book value of actual company stock.
- As the value of the company stock rises, so does the value of the participant’s phantom shares.
- The employer can fund phantom stock plans using the same methods as in a deferred compensation plan, thus helping to control plan costs.
From the employer’s viewpoint, the attractions of such a plan include these features:
- No government regulation
- No anti-discrimination testing such as required in qualified plans
- Phantom stock becomes the golden handcuffs which retain key people and encourage productivity
- Employer is free to pick as few or as many participants as needed, with complete flexibility for each participant’s plan design
- Tax deductions for benefits paid out to participants.
From the employee’s viewpoint, the attractions of phantom stock plans include the following:
- No current income tax to pay
- No cash outlay to purchase shares of stock
- Accumulation of wealth
- Death and disability benefits may be included.
Summary
Either deferred compensation or phantom stock option plans are highly attractive to key employees. Such plans can improve the ability of family businesses to recruit and retain the kinds of key people that help a business prosper. These plans are extremely flexible, so they can be tailored to precise business objectives. Either kind of plan can also be used to reward family members.
Charles Epstein spoke at the Family Business Center of Pioneer Valley October 1999 meeting regarding these kinds of plans. He was featured in the September 13, 1999 Business Week article “Sharing the Wealth While Keeping Control.” Charlie assists clients in a wide range of financial matters, with a particular expertise in the problems and opportunities for family owned businesses. He founded and is the Advisory Board Chair of the Family Business Center of Pioneer Valley. Charlie welcomes your inquiries and can be reached at (413) 734-1218