A phantom stock plan is a tool that may be used to transfer equity to key employees or valued team members while maintaining complete dictatorial control over your company. Virtually absolute protection is available from claims against the issuing corporation or company for claims related to management or operations by participants in the phantom stock plan.

I first designed and utilized a phantom stock plan in the mid-1990s. I assisted a company that manufactured metal racks, stands and other items with a particular emphasis on the wire industry. To complete the sale, the buyers obtained bank financing. However, the buyers needed to utilize an outside investor at the last minute when a transaction term change caused the bank to withdraw financing.

They reached out to a very successful investor, who negotiated a very favorable interest rate along with an option to acquire 20% of the company for a stated amount. The sale closed just before a big boom in the wine industry. The company was way more profitable than anyone ever expected.

The outside investor who provided financing exercised his option to acquire his 20% interest in the much-improved company. At the same time, he objected to the “excessive” salaries being paid to the two other owners. This began an expensive, emotionally draining shareholder dispute that was eventually settled for a substantial sum. One of the shareholders was so affected that he retired and sold to his partner.

The remaining partner vowed never to have another partner or co-owner. However, he wanted to compensate and more fully engage a key salesman critical to the company’s continuing success. We utilized a phantom stock plan to provide this salesman an ownership interest if the company was sold to a third party.

How a phantom stock plan works

The phantom stock plan is a form of deferred compensation providing an incentive, which increases as the company value increases and falls when the company value decreases. The participant has a binding contractual right to become a shareholder if the stated triggering event occurs, such as the sale of the company or a change in control of the company.

The participant is not a shareholder, member or owner prior to the occurrence of the event. The participant does not have any voting rights or say whatsoever in the management of the company. The IRS recognizes that the participant is not a shareholder in an S corporation, so there is no effect on a corporation’s subchapter S election. Similarly, because the participant holds only a contractual right to obtain actual shares in the future, there are no payroll tax consequences, and a participant is not considered to be an employee due to his or her participation in the phantom stock plan.

The phantom stock plan can be drafted to provide the participant direct ownership in the company upon the occurrence of the triggering event. The plan can also be drafted to provide an amount, such as the value of the increase in the stock value after the participant joined the plan.

What to keep in mind

When drafting, consider who first would be desired participants and the behavior and performance that the company seeks to incentivize. Consider whether participants should receive direct ownership or units with some base value. Should the participant share in only the growth with share or membership value or the total value? A specific vesting term or schedule should also be spelled out in the phantom stock plan document.

The phantom stock plan provides a unique, safe way to incentivize key team members or employees with an equity interest without giving away any of the day-to-day or long-term control of the company.