A common challenge faced by owners of family-run businesses is how best to reward and retain key executives while maintaining control of the company until such time as the owner’s children are ready to take the helm. One solution: the life insurance-funded phantom stock plan, which ties the executive’s compensation to the employer’s performance without diluting the owner’s controlling interest in the company.

Facing reality

In a perfect world, the children of business owners would be ready to take over the reins of the family-owned company just as their parents were ready to let go. But in the real world, this often is not the case because the children are not yet mature or experienced enough to assume control.

When their children need more time, it’s important that business owners take steps to retain their key non-family managers to link them to the business until the family’s next generation is ready. Employers have increasingly looked to incentive-based compensation to reward and retain key employees.

Employers often believe an employee’s economic success should be tied to the economic success of the business. By linking an employee’s remuneration to the employer’s performance, an employee is rewarded much like an owner and, thus, has an increased interest in the long-term performance of the business.

Equity-based incentives, which often serve as “golden handcuffs,” are effective tools for accomplishing this. They motivate and lock in valued employees by linking their fortunes to the performance of the business. The key employee is rewarded much like an owner and therefore has an interest in the company’s long-term success.

Family business owners, however, often reject equity-based incentives, seeing only a potential threat to future family ownership. This is where you, as a financial services professional, can step in to show business owners how to largely eliminate the threat.

You can do this by pointing out that there are several ways to provide equity-like incentives to non-family members without risking loss of family control. The incentives include stock options (both qualified and non-qualified) with a buy-back agreement, phantom stock plans, non-qualified deferred compensation and cash bonuses. The right incentive depends on the circumstances of the case.

The situation

Consider this scenario: A client, Jim Smith, is the owner of Smith Electrical Supplies, a $10 million wholesale electrical business. Jim is approaching retirement and, although he wants ownership to remain in the family, he recognizes that his son and daughter, both active in the business, lack the experience to run the highly competitive company. However, Jim’s general manager, Kevin Keyperson, has the expertise to guide the company in the interim. To bridge the time gap until his children are ready, Jim has to retain the services of this talented manager.

The solution: A phantom stock plan

We discussed this situation in great detail with both Jim and Kevin to arrive at a solution that would be agreeable to both. Non-qualified stock options and incentive stock options were ruled out because of possible difficulties in valuation of the shares and the complexities involved. Annual cash bonuses did not create the long-term golden handcuffs that were needed. We determined that a phantom stock plan best addressed the client’s need.

A phantom stock plan offers Kevin the ability to benefit from the success of the business without diluting Jim’s current ownership. Under this incentive plan, no stock is transferred. Instead, Kevin is granted hypothetical units of the business. These units may rise or fall in value based on a specified formula or the value of Smith Electrical Supplies.

For example, the appreciation may be defined by a change in book value, a change in revenue or by another measure of company growth. Annual valuations provide a method of reporting the phantom stock’s performance to Kevin. At the end of the specified period, Kevin will receive income, either in installments or in a lump sum, based upon the appreciation in the hypothetical units.

The participant in a phantom stock plan is a general creditor of the company, and the value of the hypothetical units is analogous to a deferred compensation right. The value of the hypothetical units is paid at retirement, termination, death or disability. Often, the plans provide for a vesting schedule.

The current value of Smith Electrical Supplies is $3 million, or $3,000 per share. Under the terms of the phantom stock agreement, Kevin is given the appreciation on 75 shares. Assume that the value per share rises about 7% a year to $6,000 by the time Kevin retires in 10 years. The $225,000 ($3,000 appreciation per share times 75 shares) Kevin would receive is taxed as ordinary income to him when received. And to the extent that his total compensation is reasonable, it is tax-deductible to the company as paid.

Summary of positive results

The phantom stock plan gives Jim the missing link that he needed for his own retirement. He already trusts Kevin to run his company. Now as a phantom owner, Kevin has additional incentive to protect Jim’s interest as well as his own. Kevin’s equity interest through the phantom stock plan does not conflict with Jim’s long-term objective to keep the business in family hands or his hope that his children will eventually be able to run the company.

The funding

Under the phantom stock plan, the company is accruing a future obligation (as it would have under the nonqualified stock option, deferred compensation or incentive stock option plans). The company has 3 options: fund the obligation out of cash flow, borrow money to meet the liability or pre-fund the estimated obligation.

Employers usually determine that pre-funding the obligation over an extended period is the least expensive approach. To assure that the business has sufficient cash on hand to pay the benefit under the phantom stock plan, the company should create a sinking fund to meet that future expense.

While businesses have a variety of investment vehicles, most create taxable income and this tax reduces the overall return. Life insurance is generally the ideal funding vehicle. A company-owned life insurance policy on Kevin’s life can informally fund that future obligation. Cash values can grow on a tax-deferred basis inside the policy and can be accessed income tax-free by withdrawals up to basis and by policy loans to pay all or a portion of the benefit.

In the event of Kevin’s premature death, the proceeds can be used to fund the obligation, and any excess amount could serve as key person insurance to offset the loss to the business. This advantage is not available with other investment vehicles

Keeping an eye on 409A

Phantom stock plans are subject to Internal Revenue Code section 409A and its regulations. This legislation imposed strict rules affecting deferral elections, funding and distributions. It also imposed taxes and penalties for violations of these rules.

Kenneth M. Cymbal, J.D., LL.M., CLU is assistant vice president of advanced markets at MetLife, New York, N.Y. He can be reached at kcymbal@metlife.com