Delta Dawn Gets Game

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Delta Dawn, what’s that flower you have on?
Could it be a faded rose from days gone by?
And did I hear you say he was meeting you here today,
To take you to his mansion in the sky?

All our yesterdays are lighted signposts on the way to a dusty death, it is said, but don’t tell that to Delta Dawn.

And don’t tell that to employees thinking about owning stock in their employer, who can’t resist the seductive daydream that a framed stock certificate over the mantel will bring endless visits from Santa.

Cold-eyed executives, the “show me the money” crowd whose clearheadedness could probably do your business some good, know better. The truth is that a small minority stake in a non-publicly traded company with no prospect of going public is — if unaccompanied by assurances of distributions of profit — a bit of a con, a “mansion in the sky.” And therein lies the allure of phantom equity plans: a no-frills formula for carving up the money, chocolates without the box, Playboy without the articles.

A phantom equity plan is in essence a structured bonus. The structure is built around the hypothetical (or “phantom”) issuance to an executive of shares of stock in the company. It is intended to give the executive the financial benefit of owning the otherwise “phantom” stock without the tax complexities and state law obligations attendant upon ownership of actual shares.

Here is what a phantom equity plan does:

The holder of the phantom equity right gets paid amounts, be they dividends equivalents or proceeds realized by the company from a capital transaction that the plan participant would have received had he or she owned the stipulated number of shares.

For example, assume that there are 100 actual shares of stock outstanding, and in a sample year there was $100,000 of taxable income and $100,000 of cash available after payment of all expenses, including executive salaries. Assuming that no phantom equity plan is in place, earnings per share is $1,000, that is, $100,000 divided by 100, the number of outstanding shares.

Now assume a phantom equity plan, with the plan providing for 25 “phantom” shares. The phantom equity plan, essentially a contract between the executive and the company, would provide that the company, before calculating its actual taxable income with respect to the actual 100 shares outstanding, go through a preliminary, hypothetical calculation assuming 125 shares outstanding.

Assume the same $100,000 of cash and (preliminarily) $100,000 of taxable income. The executive, with respect to his or her phantom 25 shares, is, in that sense, a 20 percent owner of the company (i.e., 25 out of 125 hypothetical shares). Were it really a 20 percent stake, the executive would be entitled to 20 percent of that $100,000 of net cash. Thus the “dividend” payable with respect to the phantom equity rights would be 20 percent of $100,000, or $20,000. The company therefore issues a check to the executive for $20,000, in discharge of the company’s obligations under the phantom equity plan.

Note, however, that the $20,000, despite the hypothetical calculations of the interest as a phantom shareholder, is in fact a payment to the executive in his or her capacity as an employee of the company.

It’s not a dividend; it’s compensation. If the executive’s regular salary had been $10,000 per month ($120,000 for the year), then the W-2 issued for the executive, assuming all the payments are made in the same taxable year, would show $140,000 in compensation (i.e., the $120,000 of regular salary plus the $20,000 paid under the phantom equity plan). End of story from the standpoint of the executive’s earned income.

What about the company? Well, it thought it had $100,000 of net cash and taxable income, but it paid the $20,000 to the executive under the phantom equity plan. Consequently, its cash position, as well as its true taxable income (remember the $20,000 from the standpoint of the company was just more cash compensation to an employee) is now $80,000, or $800 per share.

In the case of a sale of the company, precisely the same calculations occur. Assuming the company is sold for $1 million, the executive, to the extent that the phantom equity plan (remember, its simply a contract between the company and its employee, and can provide for whatever payments the parties agree to) provides that the executive gets a hypothetical “share” of capital proceeds. In the case of a sale of the company’s assets for $1 million, that’s 20 percent, or $200,000.

Since the phantom equity plan is a compensation plan, and not a stock ownership plan, the $200,000 is deductible compensation to the company, and ordinary earned income to the executive.

Hey, did I say ordinary income to the executive? Why not capital gains? Have the show-me-the-money wiseguys been Delta Dawned?

Consider that had the executive held stock with liquidation rights equivalent to that of the phantom equity plan, he or she would have been taxed at capital gains rates rather than suffering the dusty death of ordinary income. What to do?

Dress up the plan.

Phantom equity plans are written on a blank slate. The plan can provide that phantom equity is paid only with respect to ordinary operations, that is, cash flow or taxable income from year to year, but does not apply in the event of a capital transaction. Or it could provide for payments in both cases (with the sharing in capital either limited to appreciation from the date of the plan forward, or contemplating a straight-up percentage of proceeds). If the owner wants his or her executives to receive regular bonuses and share in the proceeds of a sale, the company can issue phantom shares that only pay out based on operating profits, and pair that with options or actual stock.

It’s the best of both worlds for the executive, with essentially no tax or cash flow detriment to the owner. * *

David Borinsky
©2003 Maryland Gazette

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