The Payoff

A Phantom Variety

For companies organized as S corporations or LLCs, there are other strategies available, but for the most part, they don't offer any real tax benefits. For example, owners of closely held companies can use phantom stock arrangements or stock appreciation rights rather than issuing actual stock. Phantom stock has the property of stock, but it isn't actual stock and therefore, doesn't represent actual ownership, Powell explains.

At a later date, when the employee retires, becomes disabled or dies, the phantom stock can be converted to either actual stock or cash, based on the stock's fair market value. The plan can define the stock's fair market value as book value--value based on a prescribed formula or value based on an appraisal--according to Powell. Generally, the conversion will be on the gain on the stock, rather than the stock's complete value.

Unfortunately, awarding phantom stock isn't currently deductible as a business expense for the company until the employee reports its income. For the employee, there's no economic benefit until a conversion date, such as retirement, is reached. In addition, he or she isn't required to pay income tax until the stock is converted or sold; however, the corporation must record the phantom stock award on its financial statement, indicating a future liability, says Powell.

Rich believes business owners should consider alternatives to phantom stock. A good one is something called a performance plan. Under such a plan, a company creates a "performance unit" with value tied to the earnings of the company, says Rich. The business owner could award top executives, managers or employees a specific number of these units. If the company grows, the units owned by the employees will appreciate regardless of whether the owner takes earnings out of the company because the units are based on earnings before distribution of profits.

When using performance plans, there are negative tax consequences in the short term to the owners of closely held businesses because they can't take a tax deduction for the amount set aside, Rich points out. "They don't get one until the benefits are paid out at a later date," he says.

While standard pay arrangements are fairly straightforward as far as their deductibility as business expenses are concerned, don't neglect to consider the various tax aspects of some of the other pay and compensation strategies that are now gaining a greater role in today's marketplace. No matter which strategy you select, your aim should be to keep more for yourself and pay less to the IRS.

Contact Sources

David Berdon & Co. LLP, 415 Madison Ave., New York, NY 10017, (212) 832-0400

Grant Thornton LLP, 625 Eden Park Dr., #900, Cincinnati, OH 45202, (513) 762-5000

Lyons Compensation & Benefits LLC, Watermill Ctr., 800 South St., #660, Waltham, MA 02453, (781) 647-5700

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This article was originally published in the August 1999 print edition of Entrepreneur with the headline: The Payoff.

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