Profit Sharing Plans & Phantom Stock Plans Explained

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Incentive Mechanisms that do not Transfer Stock Ownership.

Sharing ownership of a small company with the employees can create numerous conflicts. It is often wise to look to other incentive mechanisms that reward employees for increasing company profit without sharing ownership. Two such alternatives are profit sharing plans and phantom stock plans.

Profit Sharing Plan.

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

A profit sharing plan can be a “qualified plan.” A qualified plan offers tax advantage in that contributions to the plan are currently deductible by the employer. The employee’s tax obligation is deferred, however, until funds are distributed from the plan to the employee. To qualify, the plan must meet numerous requirements. There can be no discrimination in coverage or vesting. There are also disclosure and reporting requirements.

Contributions to a non-qualified plan are currently deductible by the employer and 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 economic result as ownership of company stock. The employee, however, does not actually have an ownership interest or the non-economic rights that come with an ownership interest.

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

For example, assume GM’s employee would receive a bonus of $10,000 in year one. The value of GM shares is $100 per share. Under a phantom stock plan, employee would receive 100 phantom shares in year one (i.e. $10,000 bonus / $100 per share). The plan would require distribution to the employee in a later year (e.g. year five). If the value of the shares was $200 in year five at the time of distribution, employee would receive $20,000.

Generally, a phantom stock plan will be a deferred compensation plan. This means that the employee would not be taxed until he actually receives a cash distribution. Assuming this is an “unqualified” plan, the employer does not receive a deduction until there is an actual distribution to the employee.

Employers can receive a current deduction even though the employee’s tax obligation is deferred if the plan is qualified. To be qualified, the plan must comply with numerous requirements. These requirements relate to who must be covered, when are benefits vested, funding, reporting and disclosure obligations.

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Source by John Huddleston