Money-Preneuring

This pay strategy can lure key recruits thanks to changes in tax and securities laws.

By Robert A. Adelson

As employee appetites for stock and options rise anew, it’s important for family businesses to meet the competition by offering their own form of equity—without actually transferring ownership.

There are ways to give non-family executives a share in the rewards of ownership without actually transferring even one share of family business stock.

Your business may not be able to grow or face tougher competition if there are gaps in your family members’ knowledge, skills or experience. The way to fill in the missing pieces is by hiring non-family.

Even if there is no gap, it may be wise to recruit a senior manager to help train and mentor the next generation in preparation for a leadership transition—someone who would also be available to step in if illness, death or disability strikes.

Unfortunately, a family business’s stability and long-term perspective, while attractive, don’t go far enough to lure potential recruits. A non-family executive may fear that nepotism and family loyalty may supercede sound business judgment. Hopefully, if you are seeking non-family talent, your company can allay these concerns by citing its record of putting growth of the business before the personal concerns of the family owners.

Offering a stake in the upside
But even if you can show a track record of growth and sound judgment, there is something else that might make non-family candidates skittish about joining your company: the perception that as non-family members, they won’t get to share in the benefits of their hard work.

Because most family business owners want to ensure that their company stays in the family, they don’t offer their non-family employees the opportunity to own stock. But there are ways to give non-family executives a share in the rewards of ownership without actually transferring even one share of family business stock. The three strategies below—particularly the phantom stock approach—are powerful weapons in your arsenal. Recent changes in federal tax and securities laws have made these options even more attractive.

One option is to institute a non-voting stock plan for key non-family employees. Non-voting shares are allowable in LLCs, C corporations and even S corporations. This structure provides for all the capital appreciation of normal shares and permits shareholders to take advantage of the record low 15% tax rate on capital gains and dividends. Under this arrangement, non-family executives have no voice in the company.

The second approach is a non-qualified deferred compensation plan, which can provide a secure future payout to a key executive. Taxation to the executive is deferred via a “rabbi trust,” a trust that is set aside for the employee but remains subject to company creditors. (It was first used for a New York rabbi and the nickname stuck.) The plan can include “golden handcuffs,” or vesting arrangements in which benefits are lost if the executive leaves the company. It can also include “bad boy” provisions, in which benefits are forfeited if the executive violates confidentiality or non-compete agreements or other company rules and restrictions during employment or post-termination.

The most far-reaching solution
The third approach—a phantom stock plan, taxed in the same manner as deferred compensation—combines the first two. As the most far-reaching and innovative solution, it offers the family firm a real advantage.

Under a phantom stock plan, the company sets a share value benchmark at the time phantom shares are issued (phantom strike price). The phantom stock contract issued to the executive provides a vesting and redemption schedule as well as a method of future stock valuation. If the executive does a good job and the family business prospers, when redemption occurs the executive will be paid an amount equal to the value appreciation. That is, the executive is paid the difference between the share value on the date of “sale” (phantom stock redemption or payout date) and the original phantom strike price. This spread is the same kind of payout the executive would achieve if he or she had conventional stock options in a non-family business.

A family company’s phantom plan not only offers key employees a share in the company’s growth but also can do so on far better terms than plans offered by non-family competitors. Here’s how.

Many small public companies are going private or delisting their securities rather than face the heavy costs of compliance with provisions of the Sarbanes-Oxley Act, passed by Congress in response to several high-profile corporate scandals. Executives at those companies will now have equity that is liquid. This gives closely held family businesses a distinct advantage in recruitment. A well-designed phantom plan provides liquidity (i.e., an exit strategy) for executives that small-capital companies no longer offer.

A phantom stock plan can generate both phantom dividends and phantom capital gains by taking advantage of the deductions available in the tax law and sharing the benefit with key hires.

Under the 2003 tax law, capital gains are taxed at 15%, the lowest rate since 1933. Dividends also are taxed at 15%, the lowest rate since the introduction of the graduated income tax in 1916.

Plans that provide incentive stock options rarely allow executives to take advantage of capital gains or dividend tax treatment. Under today’s tax law, this is a huge lost opportunity.

2004 Tax law and new GOP proposals
The 2004 tax law placed these new restrictions upon phantom stock plans:

• Restrictions on deferral elections
• Bar to acceleration of distributions
• Restriction on Funding Deferred Comp
• Limits on pay-outs, access to funds

Most plans should be able to comply with the Act, but care needs to be taken because noncompliance carries harsh penalties.

Besides the 2004 law, it’s expected the GOP will seek to make permanent tax cuts to capital gains, dividends and marginal rates. As said a phantom stock plan that generates phantom dividends and capital gains is well positioned for these currently planned 2005-09 GOP tax initiatives.

Example of Use In Family Firm
An established family business (FamCo) has outgrown its current management and wants to recruit a chief operating officer from outside the family. The top candidate knows the industry, has managed a larger workforce with multiple offices and has proved his ability to take a company to a new level.

The current family CEO, at age 70, is looking toward retirement. The prospective COO, Bill Wilson, is 55 years old. Hiring this key player would bring new vigor to the company. The parties hope to see FamCo grow from its current valuation of $5 million to $10 million over the next decade.

FamCo offers Bill Wilson phantom stock that matches his annual salary of $200,000. During each year of a five-year contract, Wilson receives phantom stock units at a strike price of $5 per unit with the units vesting annually at 20% (half the vesting based on his remaining with FamCo and half based on achievement of his performance goals). In ten years, when Wilson retires, the company would again be valued and Wilson paid on the growth of his vested units, with a buyout over ten years.

Thus, if Wilson stays with FamCo 4 1/2 years, he accumulates 160,000 units. In that time, for example, if he achieves half his business targets, he’ll vest 60% of these units (vesting 80% based on four years’ tenure and 40% based on meeting half his targets). When he leaves after 4 1/2 years, 96,000 phantom stock units are vested (equivalent to almost 1% of the company) at the original $5 per unit. Wilson has no voting rights or rights to stock, but—assuming he doesn’t violate company covenants—he will receive a future payout for the units.

Now suppose that because of Wilson’s achievements over those 4 1/2 years, FamCo grows from a $5 million company to a $15 million company by 2014. The stock price (and, thus, the phantom unit value) grows to $15 per share. Under the plan, Wilson would be paid off at the spread between the $5 original strike price and the $15 current market price in 2014. With a $10 spread per unit, the payout on Wilson’s vested units would be $960,000, which would be paid over ten years with interest on the $960,000 note at The Wall Street Journal prime rate.

With phantom income spread over 10 years at $96,000 per year, this plan is well designed to be taxed at lower rates even if Kerry plans for a roll-back in tax rates occurs for families earning more than $200,000 per year. Under a phantom capital gains plan, the tax deductions generated by this payout would be shared between FamCo and Wilson to reduce his tax from 35% to 15%, thus achieving effective capital gains treatment on the payout, in line with low capital gains rate achieved by the Bush administration tax cuts.

Robert A. Adelson, J.D., LL.M, has been a corporate and tax attorney for over 25 years who represents closely held and family businesses, consultants and executive employees. Mr. Adelson is a partner in the law firm of Engel & Schultz LLP in Boston, Massachusetts, and can be reached at 617-951-9980, ext.205 or radelson@engelschitz.com.

(back to top)