Like any business, a family-owned business needs to attract, retain, motivate and reward key employees. A competitive salary and benefits package may not be enough to do this in today’s market. Many businesses issue stock or stock options to employees as a form of long-term incentive compensation. For most family-owned businesses, though, issuing stock to non-family member employees is not a viable solution. Family members may not want to dilute family ownership or manage the corporate governance and fiduciary issues associated with having non-family member minority shareholders. Issuing stock would give non-family members voting rights, rights to attend shareholder meetings, rights to inspect books and records, and other fiduciary rights as shareholders.

A phantom stock plan is one way for family-owned businesses to provide long-term incentive compensation to key employees without actually issuing stock. Phantom stock is a way to give key employees the economic benefit of owning stock without requiring family members to give up any equity in the business.

With phantom stock, the company awards hypothetical or “phantom” shares to key employees under the terms of a phantom stock plan. The company has a contractual obligation to pay the phantom shareholders at a future date based on the terms of the plan and the value of the phantom shares, which typically track the value of the company’s actual shares. A plan participant may be entitled to receive a payment annually or at retirement based on the appreciation in the value of the phantom shares. Some plans also make payments to phantom shareholders equal to dividends paid on actual shares. Under other plans, payments are due only when the company is sold. In this case, the phantom shareholder typically receives an amount of cash for each phantom share equal to what the participant would have received in the sale if the participant owned the same number of actual shares in the company. An award of phantom shares may also be subject to vesting over time. Payments are generally contingent on continued employment with the company. The financial metrics, vesting schedules and payment triggers can be tailored for each plan.

There is no tax impact when phantom shares are awarded to a key employee. When payments are made under the plan, they are taxable wages for the employee and subject to applicable withholding taxes. There is no opportunity for capital gains treatment. The company generally receives a tax deduction for each payment. It is important for family business owners to consult with employee benefits counsel to confirm that the plan is structured to avoid being subject to certain complex rules under the Employee Retirement Income Security Act (ERISA) and Section 409A of the Internal Revenue Code, which imposes restrictions on the timing of certain deferred compensation payments.

If granting equity to non-family member employees is not feasible in your family-owned business, adopting a phantom stock plan may be a good solution for rewarding key employees and better aligning their interests with those of the family member owners.