Incentive mechanisms that do not transfer share ownership.

Sharing ownership of a small business with employees can lead to numerous conflicts. Often, it is wise to look at other incentive mechanisms that reward employees for increasing company profits without sharing ownership. Two of these alternatives are profit sharing plans and phantom stock plans.

Profit sharing plan.

A profit sharing plan is one that provides annual employer contributions (which can be zero) and allocation to employee accounts according to a formula. The amount of the employer contribution can be specified by a formula or left to the discretion of the employer (possibly within specific limits).

A profit-sharing plan may be a “qualified plan.” A qualified plan offers a tax advantage in that contributions to the plan are currently employer-deductible. However, the employee’s tax liability is deferred until the plan funds are distributed to the employee. To qualify, the plan must meet numerous requirements. There can be no discrimination in coverage or acquisition of rights. There are also disclosure and reporting requirements.

Contributions to a non-qualified plan are currently deductible by the employer and are currently included in the employee’s income. The employee, however, can have immediate access to the funds.

Phantom Stock Plan.

Phantom stock plans are designed to give the employee the same financial result as ownership of company stock. The employee, however, does not actually have an ownership interest or the noneconomic rights that come with an ownership interest.

Under a phantom stock plan, an employee’s bonus is immediately converted to phantom stock. Phantom stocks track the value of the underlying stock. The value of the phantom shares will increase each time the value of the underlying shares increases. At the time of distribution, the employee will receive cash equal to the liquidated value of the shares in the employee’s account. If the underlying stock is not listed on an established market, the value can be determined through a pre-established formula.

For example, suppose the GM employee would receive a bonus of $10,000 in the first year. The value of GM stock is $100 per share. Under a phantom stock plan, the employee would receive 100 phantom shares in the first year (ie $10,000 bonus / $100 per share). The plan would require the distribution to the employee in a later year (for example, year five). If the value of the shares was $200 in year five at the time of the distribution, the employee would receive $20,000.

Generally, a phantom stock plan will be a deferred compensation plan. This means that the employee would not pay taxes until he actually received a cash distribution. Assuming it is a “non-qualified” plan, the employer does not receive a deduction until there is an actual distribution to the employee.

Employers may receive a current deduction even though the employee’s tax liability is deferred if the plan qualifies. To qualify, the plan must meet numerous requirements. These requirements relate to who must be covered, when benefits are provided, funding, information and disclosure obligations.

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