Phantom Stock Plans a Tool Worth Considering

By Jim Jordan

Jim Jordan is director of construction services for Dallas/Fort Worth-based Weaver and Tidwell LLP.

In the construction industry, keeping the best employees has never been an easy task. And it's getting harder. In the race to retain the best employees, phantom stock plans are an option worth exploring.

According to the Bureau of Labor Statistics, the nation will face a shortage of 10 million workers by 2010, and the construction industry will require one million skilled workers by 2012. This is not good news for an industry that already has the second highest employee turnover rate.

To succeed in coming years, contractors need to do all they can to keep their best workers, particularly managers. Losing them not only jeopardizes the ability to compete, it's expensive. A mid-size company of 500 employees with a 10 percent annual turnover rate can waste up to $5 million on employee attrition, according to the Construction Financial Management Association.

Retaining the most valuable managers is a process requiring more than pats on the back and annual raises. All employees want a position that pays well, challenges, provides for advancement and brings recognition for a job well done. But these things don't guarantee that top employees will remain.

What the most experienced and skilled employees say they truly want is a share of their company's ownership. That's why Employee Stock Option Plans and Employee Stock Purchase Plans are so common. These types of plans, however, aren't always an option for contracting firms, the majority of which are privately owned. Owners often don't want to relinquish majority ownership or even sizeable minority ownership.

An option worth exploring is the phantom stock plan, also known as shadow or unit stock plans. Phantom stock isn't actually stock - it's a deferred monetary award that is indexed to equity value or stock. The most common phantom stock plans establish compensation units that derive their base value from the value of a company's common stock. When awarded, these units carry tax advantages similar to those of other deferred compensation.

Phantom stock plans offer numerous advantages to employees because they receive cash, not stock with an uncertain future value. In addition, they aren't forced to invest in the company. Among the advantages to owners is that a phantom stock plan, as opposed to an ESOP, allows owners to hand-pick those who will be given ownership.

An owner can do this by offering select employees the opportunity to participate in the growth of the company. For example, a key employee would receive a certain number of phantom units. Each unit would have the same value as a share of the company's common stock on the date the unit is issued. The employee gets nothing until retirement, death or disability. Depending on how the plan is established, when an employee ends active employment, they may receive a sum equaling the difference between the original unit price and what that unit is worth at the end of their tenure. A variation would be that the employee receives full value.

Phantom stock is taxed like unfunded deferred compensation. The employee reports no taxable income, and the employer takes no deduction when the phantom stock is assigned to the recipient's account. Once the employee retires, or fulfills the established tenure, he or she is paid in installments over a number of years and pays taxes on the income. The employer then can claim a deduction each year a payment is made.

To enact a phantom stock plan, the owner's first step is to decide how many units of phantom stock to hand out. Owners should be careful not to hand out so many units that they can't do the same for future employees. Owners must decide how to fund the plan. If funds are set aside, they should be segregated into a "secular trust" to keep employees from paying taxes once the benefit is promised. Owners may also set aside money in an annuity.

Top managers need to realize they will have to make legally binding commitments in order to participate in a phantom stock plan. They may have to promise to remain with the firm for a set number of years and likely will be required to sign broad non-compete agreements.

One caveat: If a company's phantom stock plan benefits more than just key employees and defers some or all payments until after termination or retirement, the plan may be considered a de facto ERISA plan. ERISA refers to the Employee Retirement Income and Security Act of 1974, which governs formal retirement plans.