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A Reality of Phantom Stock Plan: It Can Be a Key Incentive in Hiring

September 20, 2000|JUAN HOVEY

For many business owners, qualified retirement plans--most commonly profit sharing, money purchase, defined benefit and 401(k) plans--are the tools of choice when it comes to cementing the loyalties of the people who work for them.

Another option, the phantom stock plan, can be just as powerful in attracting and retaining top-flight employees, and it has the added advantage that it invites little oversight by the government. Best of all, the phantom stock plan allows you to give special treatment to those most responsible for your success.

Phantom stock plans differ from ordinary pension plans in important ways:

* They are not qualified retirement plans, meaning that they do not receive the special treatment accorded to pension plans under federal law.

* They allow any business entity--a sole proprietorship, a C or S corporation, even a limited liability company--to grant special treatment to special employees without running afoul of federal pension law.

The second item makes phantom stock plans appealing to many employers. They are not, of course, cost-free; in fact they establish a financial burden on you as the employer. But they allow you to give your key people a real stake in the future of your business--and to reward them to the extent that they help you bring that future about.

How?

The stumbling block to understanding how these plans work has to do with their name. Phantom stock is not real stock in your corporation, and in setting up a phantom stock plan, you do not give up equity in your company. Instead you create a vehicle by which you allow your key employees to create wealth for themselves to the extent that they increase your own.

Assume that you run an incorporated business with 20 employees including three key senior managers, and that you already have a profit-sharing plan which, of course, does not discriminate in favor of your top people. Assume also that the value of your stock is $100 a share.

Your first step is to set up special bookkeeping accounts for your key people and credit each with a certain number of the plan's essential measuring tool--"units" whose value reflects the value of your stock. Each unit, however, represents a share of your stock only in the sense that your shadow represents you; put another way, each unit is the phantom of your stock, having the appearance but not the reality of the stock itself.

You also draw up a written document--the phantom stock plan itself--to reward your key people in one of two ways:

* It can promise to pay the employee the difference between $100 and whatever value your stock reaches when the employee retires or dies, multiplied by the number of units in the employee's account.

* It can promise to pay the employee the difference plus the original $100 value of each unit.

The first scenario rewards the employee in accordance with the increase in the value of your stock. The second does the same but in addition promises that the reward will be no less than the original value of your stock.

Thus, in the first scenario, assuming that the employee has 5,000 units in his or her account at retirement and that your stock has grown in value to $500 a share, you owe the employee $200,000--5,000 multiplied by $400, which is the difference between the original and the current value of your stock.

In the second scenario you owe the employee $250,000.

Note that the phantom stock plan imposes a future, not a current, financial obligation on you as the employer; you promise to give your employees a sum of money in the future--a bigger or lesser sum depending on the fortunes of your business enterprise. The harder they work to help you, the more they help themselves.

You, of course, must make good on the promise should your business prosper. One option is to set aside cash every year in an amount reflecting any increase in the value of your stock--in essence, to make contributions to your phantom stock plan just as you make contributions to your pension plan. Contributions to a phantom stock plan are not deductible when made. Instead, you get a deduction when you turn the value of the account over to your employee upon retirement or death. The employee pays taxes on the proceeds the same year.

Another funding option is to buy cash value life insurance on your key people structured to meet part or all of your obligation when the need arises. Given the nature of cash value life insurance, it will take time before the cash value exceeds the sum of your premiums--so that this option may seem an expensive way to put money aside to satisfy the obligation. But life insurance in a phantom stock plan has one important benefit: It guarantees that you can meet the obligation should the employee die before retirement.

As you can see, phantom stock plans are flexible. It is not a given, however, that a phantom stock plan will escape government regulation under the Employee Retirement Income Security Act, so make sure you consult your attorney, your accountant and your pension advisor when setting one up. Call in your insurance agent too to discuss funding your plan.

*

Recent Financing and Insurance columns are available at http://www.latimes.com/finin. Juan Hovey can be reached at (805) 492-7909 or at jhovey@gte.net.

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