Trends & Developments - June 2011 - Rewarding Key Employees of Closely Held Businesses — Phantom Equity and Section 409A

Published: Jun 30, 2011
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Owners of closely held businesses continually face the challenge of motivating key employees to increase profitability and help grow the company. Allowing key employees to share in the profits and/or growth of the business is a common practice as it results in a win-win for both the owner and the employees, since the employees only receive a share of profits if the company grows over a period of time. Equity-based compensation gives employees a financial stake in the company and contributes to an ownership mentality. Such plans typically condition the receipt of the award on the attainment of certain performance targets or other vesting conditions (such as elapsed time), such that any unvested portion of the award is forfeited if the employee fails to meet the performance target or terminates employment prior to completion of the required service.

"Phantom equity" is a form of deferred compensation tied to the future growth and profitability of the company. Phantom equity refers to certain types of compensation which simulate the value of a predetermined number of shares of the company (or interests in a partnership) over a specific period of time. Phantom equity is an unsecured promise to pay a future amount represented by a unit that corresponds to an equivalent ownership interest in the business. As a result, such awards are designed to reward performance without the actual issuance of shares or other ownership interests that would dilute the ownership of current equity holders.

This article summarizes various types of phantom equity and their general treatment under Internal Revenue Code (IRC) section 409A, which broadly defines and taxes deferred compensation.

Observation: Any business contemplating a phantom equity plan for key employees must design the plan to comply with section 409A, otherwise participants will be subject to income tax on amounts earned under the plan retroactive to the first year the plan violated section 409A, interest on unpaid taxes, and an excise tax payable by the employee (not payable by the company) of 20% of the income recognized.

STOCK APPRECIATION RIGHTS

Stock appreciation rights (SARs) provide the employee with the right to receive the increase in value of the stock of the company. Each SAR is represented by a unit that corresponds to an equivalent share of stock. When the employee exercises the right, he or she receives the difference or spread between the fair market value of the stock on the date of grant and the fair market value of the stock at the time of exercise. Since SARs give the employee the right only to the appreciation in value of the company stock, such awards will not dilute the ownership in the company. SARs do not include dividend payments, if any. When the SAR is exercised and payment of the spread is made, the company receives a compensation deduction for the award. Since, in closely held businesses, SARs are typically settled in cash, companies will have to address cash flow needs to meet the future payment obligations.

SARs are exempt from the deferred compensation rules under Section 409A of the Internal Revenue Code provided that each equity unit (upon which the SAR is based) is granted at the fair market value of the underlying share of stock.

Observation: The regulations under section 409A contain extensive rules regarding the valuation of closely held and start-up companies with no public market for their securities. The rules also contain safe-harbor valuation methods that put the burden of proof on the IRS to rebut the valuation, if audited, rather than on the taxpayer.

PHANTOM STOCK AWARDS

Phantom stock provides a bonus based on the value of a stated number of shares of company stock. Like SARs, phantom stock is typically subject to vesting based on performance targets or elapsed time. Each phantom stock unit represents a share of stock. Unlike SARs, which may be structured to avoid falling under the parameters of section 409A, phantom stock is deferred compensation and so subject to section 409A. The regulations under section 409A include rules requiring that the plan document specify the time of payment at the time of the grant of the award and also prohibit acceleration of vesting and payouts except under limited circumstances.

To avoid section 409A restrictions, some phantom stock plans are designed so that the award is payable immediately upon vesting, thus meeting the short-term deferral rule (generally payment within 2 1/2 months after the end of the year in which vesting occurred) under the section 409A regulations. Whether a phantom stock plan is designed to avoid or comply with section 409A will depend on the purpose of the plan and its related goals.

Suggestion: To meet the short-term deferral rule under section 409A, it is advisable that the intent to settle the award within 2 1/2 months after the end of the plan year in which vesting occurs be stated in the plan document.

PHANTOM EQUITY IN PARTNERSHIPS OR LLCs

Like corporations, partnerships and LLCs may issue appreciation rights and phantom units based on the value of the partnership or membership interests. It is important to remember that these awards are subject to the same valuation rules under section 409A as SARs issued by a corporation, in order to avoid the adverse tax consequences of section 409A.

Partnerships and LLCs may also issue "profits interests" which provide employees with rights to allocation of a certain percentage of the earnings on membership interests. The partnership or LLC generally will not be subject to tax in connection with the transfer of a compensatory partnership interest.

Tax treatment: Currently, profits allocated to the grantee retain the character of such profits earned by the partnership. Thus, if the partnership generates capital gain, the grantee will recognize capital gain.

Phantom equity interests are a very valuable tool for business owners that want to attract, retain, and reward employees who are critical to the success of the business. In designing such plans it is important not only to consider the goal of the plan, but also to be vigilant about the pitfalls contained in IRC section 409A that can turn the best designed plan into a disaster, if income has to be recognized by plan participants upon a failure to comply with that section.

Trends & Developments – June 2011