Key Employee Incentives—Perhaps a Phantom Approach?
Many private business owners find it desirable to issue or transfer some type of equity to a top manager or other valuable employee in order to retain such individual’s services. Not surprisingly, these types of non-cash equity transfers tend to be more frequent in expanding economic climates as key employees have more options available to them in an expanding job market—a phenomenon the Economist has described as the “pay and perks arms race.”
Advisors often suggest a variety of equity-linked alternatives such as restricted shares, non-qualified stock options, incentive stock options, LLC profits interests, and/or options to purchase LLC profits interests. These alternatives should be considered in conjunction with an analysis of the related form of business entity tax treatment, securities law compliance, vesting schedules, and administrative costs (for example, stock options may require annual independent valuations in order to comply with Section 409A under the IRC).
It is important, however, to first determine the key employee’s concerns and/or goals with respect to the company and the employee’s assessment of a fair return for the employee’s services. Many key employee situations may be resolved with something other than equity ownership in the company and still be a mutually agreeable solution.
Additionally, under North Carolina law, employees that hold an ownership interest in the employer may assert, in a termination of employment situation, an additional layer of protection under the Meiselman line of cases in North Carolina. Relief under this approach is normally based on a claim by the minority shareholder that his or her “reasonable expectations”—here, continued employment—have been frustrated by the majority owner. Accordingly, such interest may bring about undesirable employment issues.
A majority owner faced with the termination of an underperforming employee owner will likely face greater obstacles to proceeding with such termination due to the employee’s shareholder status unless very clear and enforceable documents are put in place covering the employee’s termination, including the repurchase of the former employee’s equity interest for an agreed upon consideration following termination.
Let’s return to the key employee/owner dialogue scenario. A key employee informs the owner that the relative contributions to the company between the owner and employee have, over time, become inconsistent with the returns provided to each of them. Perhaps the employee believes that if the current owner holds 100 percent of the company, surely out of general fairness such owner could part with an “insignificant portion” (say, 10 percent) of the company and simply “gift” such shares to the deserving employee.
In such cases, the owner should point out to the employee the tax issues generated with an equity transfer. Equity simply “given” to the employee by the employer results in the IRS treating such transfer as part of a compensatory arrangement with the employee needing to come up with funds to pay the tax bill relating to such value unless the employer is willing to “gross up” the employee’s cash compensation to assist the employee with his or her newly acquired tax obligation. Another distinct possibility is that the owner has personally guaranteed existing bank debt needed for operational cash flow and expects all owners to do the same. The employee may become less eager to jump into the ownership ranks if he or she would also be required to take on a portion of such contingent liabilities.
After a meaningful discussion with the key manager, the business owner may find out, for example, that the manager is satisfied overall with current compensation and annual bonus arrangements but is greatly concerned with what would happen upon a company sale or other change of control. In such case, the business owner might structure a simple phantom stock or stock appreciation rights (SARs) plan. These plans are quite simple to implement and involve granting an employee a set number of phantom stock units or SARs.
No tax is paid on the grant date; taxation occurs when the amounts vest. So at the time of a change of control, the employee would receive a payment taxed at ordinary income tax rates and the company would get a deduction. Such plans normally remain in place for the employee only so long as he or she continues to provide services to the company and can be structured to generate a cash payment solely upon the sale/change of control event, thus providing the key manager incentive to stay on with greater certainty as to the economic effects of any such sale/change of control. The key employee would not obtain capital gain treatment but may nevertheless regard the phantom units or SARs as a valuable “success” type of reward for staying with the company while allowing the owner to avoid shared ownership issues.
Bottom line—business owners willing to engage in active listening with key employees may just learn they have more options (pun intended) than actually issuing ownership rights.
Content contributed Shumaker, Loop & Kendrick, LLP, a full service law firm founded in 1925 with more than 240 attorneys practicing in Charlotte, North Carolina; Columbus, Ohio; Sarasota, Florida; Tampa, Florida; and Toledo, Ohio. Content written by Philip S. Chubb, Partner, Corporate Practice Co-administrator, whose principal areas of practice include corporate transactional and M&A projects. For more information, contact him at 704-945-2165 or firstname.lastname@example.org or visit www.slk-law.com.