Deferring Income Taxes With Phantom Stock

Question:  I want to issue shares of stock of my corporation to a loyal employee but my accountant says it would be too expensive from a tax perspective.  Can you explain?

 Answer:  When a corporation issues shares of its stock to an employee for no consideration, the employee must report the fair market value of the shares as ordinary income.  The higher the value of the shares, the larger amount of tax imposed on the employee. Your accountant is likely referring to the prohibitive income tax cost that will arise if shares are issued to your employee for no payment in return.  An even greater financial burden would be imposed on your employee if the shares are sold to the employee for fair market value consideration.

One viable alternative entails issuing your employee an equity instrument providing the benefits of equity ownership without the upfront tax cost.  A phantom stock arrangement involves granting an employee “phantom shares” of stock. Shares of phantom stock are not actual shares of stock but rather an equity entitlement in the form of a contractual promise to compensate the employee as if the employee actually owned corporate shares. If the business is sold, the employee can receive payments from the corporation comparable to what the employee would have received if the employee-owned shares of stock in the corporation.  If the corporation pays dividends to its shareholders, the employee can also receive payments comparable to the dividends the employee would have received if the employee was a shareholder.  If desired, the arrangement can be expanded to provide payments upon the employee’s death, disability or retirement.

One variation from a traditional phantom stock arrangement involves granting an employee a stock appreciation right.  While a share of phantom stock is intended to mirror an actual share of corporate stock, a stock appreciation right is designed to reward an employee for the increase in the value of a share of stock between the time the stock appreciation right is granted and the time of payment.  Assume, for example, that the value of each corporate share on the date of the grant of the equity instrument is $1,000 and that the company is sold for an amount entitling each shareholder to $1,500 per share. Under a phantom stock arrangement, the employee would receive a payment of $1,500 for each phantom share owned at the time of the sale. With a stock appreciation right, the employee would instead receive a payment of $500 for each share, the difference between the value of each share on the date of sale and the value of each share on the date the stock appreciation right is granted.

There are generally no tax consequences to the employee upon the grant of phantom shares as the receipt of a contractual right to payment is not taxable to an employee.  An employee is taxed as and when payments are received, such tax being imposed at ordinary income tax rates.  The corporation will receive a tax deduction for the amount paid to the employee at the time of payment.

Other factors must be considered before implementing a phantom stock arrangement.  Holders of phantom stock generally do not enjoy voting privileges and other legal rights afforded holders of corporate stock. As a holder of only a contractual right to payment, an employee may not have the same degree of comfort with the arrangement as would be the case if the employee-owned shares of the corporation. Also, when shares of the corporation are sold, the holder of phantom stock, unlike a regular shareholder, will be taxed at ordinary income tax rates on the payments and will not benefit from capital gains tax rates which would apply if the employee owns shares of the corporation. 

A phantom stock arrangement may be an appropriate fit for your situation where the upfront tax cost for corporate share ownership is prohibitive for the employee.  Many employees appreciate the opportunity of benefitting from equity ownership without the costs and other burdens of acquiring actual shares. As an employer, you may also benefit by permitting your employee to share in the growth of the business in a tax efficient manner.

 

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want to be answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.