Phantom Stock, Deferred Comp and Succession Planning

Here’s a question I get asked quite a bit from business owners who are looking forward to their business succession: “Can I use phantom stock as a way to facilitate my transition out of the business?”

Their intuition is pretty good. Phantom stock and other forms of deferred compensation can be part of the toolkit you should consider—especially if your exit plan might include a sale to existing employees. Here’s how an internal sale usually happens.

First, the current owner decides that a sale of the business to an outside buyer is either unfeasible or undesirable. Selling to an outside buyer may bring a better price or terms but is often not available to certain types of businesses. In other cases, the seller may prefer to transfer ownership to internal employees such as family members or long-time contributors.

Next, a price and terms are established. An installment sale is the preferred technique. Perhaps the parties agree on a ten year note with a reasonable down payment. The buyers must forecast their ability to make the note payments, including interest, from the cash flow of the business. Most of the payment amount (the principal) will not be tax deductible so the cost must be measured carefully. Very often, the after-tax cost of the payments is a deal-killer. In addition, the employees may have a problem coming up with a meaningful down payment.

Here’s where the compensation tools come in. First—phantom stock. Suppose the current owner awards phantom shares today to the key employees (future buyers). Should the value of the shares appreciate in value the employees will become entitled to a future payment. That future value can be used in a number of ways: (a) part of the down payment, (b) cash flow to help support the future employee-owners’ lifestyles when company money will be needed to support installment payments, (c) cash flow to make payments, or (d) conversion to actual stock to reduce the shares at the time of the ultimate redemption. There are other uses as well. The bottom line is that offering phantom shares today can possibly result in future cash to help the buyers with the transaction.

And then there is deferred compensation (DC). It may be possible to install a DC plan today on behalf of the current owner-employee. Payments under the plan may become due at the same time as his retirement/sell of the business. The existence of the plan on the company’s books would result in a liability that would reduce the net value of the company at the time of sale. What would this do to the size of the installment payments? Reduce them! The exiting owner would make up the difference through the DC payments, thereby receiving the same amount as before.

The only catch is the change in tax results. The old owner would need to pay ordinary taxes on the DC payments when received. However, this would also result in a better tax deduction for the new owners—making the cost of the purchase more affordable. The exiting owner may find this arrangement palatable.

There are a number of other ideas to consider when looking at compensation in the light succession planning. Ask one of our experts if you are interested in further discussing this topic.

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