In order to operate a successful business, it is critical that a closely-held company retain its key employees.
This can be accomplished by providing the key employee with equity in the company. However, in many cases, it may be undesirable to provide actual ownership (i.e., stock in a corporation or membership interests in a limited liability company) to the key employee.
Therefore, in lieu of actual ownership, a closely- held business can offer the key employee alternative forms of compensation, such as deferred compensation arrangements or phantom equity plans. This approach will provide the key employee with ability to share in the potential profits of the company and if the company is sold, share in the sale proceeds.
Typically, deferred compensation plans and phantom equity plans are “non-qualified” benefit plans. As a consequence, unlike “qualified” plans, the deferred compensation plans and phantom equity plans do not require the approval or qualification from the Internal Revenue Service. Additionally, non-qualified plans are not subject to the many rules, regulations and guidelines promulgated by the Internal Revenue Service. For example, an employer may “discriminate” or select only the key employee(s) to participate in the plan. Accordingly, the company is not required to offer the plan to all of its employees and is permitted to select only its key employees to participate in the plan.
Non-qualified deferred compensation plans are agreements to pay key employees compensation at a future date. Typically, the deferred payments are made upon the occurrence of certain “triggering events” such as the key employee’s retirement, disability or death; or if the company is sold to a third party purchaser.
Phantom equity plans are agreements that provide key employees with the benefits of ownership in the company (i.e., stock in a corporation or membership interest in a limited liability company without actual ownership). For example, a stated number of units representing shares of stock or membership interest in the company are periodically credited to the employee’s account.
Typically, each unit is equal to the current market value of one share of stock (or one percent of a membership interest) at the time the credit is made to the key employee. When distributions are paid to the owners (shareholders or members) of the company, the key employee will also be paid a pro rata share of the distribution.
Additionally, if the company is sold to a third party, the key employee can also share in the sale proceeds based upon the number of units awarded. Finally, the phantom equity plan may also provide that the company will pay the key employee the value of his or her units (based upon the value of the company) upon the key employee’s retirement or death.
Non-qualified deferred compensation plans and phantom equity plans are either “funded” or “unfunded” plans. In a “funded” plan, the company sets aside the necessary funds to satisfy the company’s future obligations to the key employee in a separate account. On the contrary, an “unfunded” plan consists of merely the employer’s unsecured promise to pay the key employee in the future. Thus, in an unfunded plan, there is no separate account held on behalf of the key employee.
In general, the unsecured and unfunded promise by the company to pay compensation to a key employee at a later date will not result a tax liability to the key employee until the payments are actually made or the payments are no longer forfeit-able. Additionally, the company will not receive a deduction until the key employee recognizes the taxable income.
The benefit of the non-qualified deferred compensation plans and phantom equity plans in neither arrangement will dilute any of the current owners’ equity in the company because the key employee does not actually receive an ownership in the company. As a consequence, the key employee does not possess any voting rights or obtain the privilege to attend shareholder/member meetings. However, the key employee will be awarded certain economic benefits as set forth in the plan which are typically only available to the owners of the company. Thus, the implementation of the non-qualified plan is a planning technique which will facilitate the retention of the key employee with the company.
Please contact me if you have any questions about this article, or would like to schedule a time to discuss your business.
David Deutsch, Attorney at Law