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Explanation of Profit Sharing Plans and Phantom Stock Plans

Incentive mechanisms that do not transfer ownership of the shares.

Sharing ownership of a small business with employees can create numerous conflicts. It is often advisable to seek other incentive mechanisms that reward employees for increasing company profits without sharing ownership. Two of these alternatives are profit sharing plans and phantom stock plans.

Profit sharing plan.

A profit sharing plan is one that provides annual employer contributions (which can be zero) and allocations to employee accounts according to a formula. The amount of the employer contribution can 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 a tax advantage in the sense that contributions to the plan are currently deductible by the employer. However, the employee’s tax liability is deferred until the plan funds are distributed to the employee. To qualify, the plan must meet numerous requirements. There can be no discrimination in coverage or acquisition of rights. There are also disclosure and reporting requirements.

Contributions to a non-qualified plan are currently deductible by the employer and are currently included in the employee’s income. However, the employee can have immediate access to the funds.

Phantom Stock Plan.

Phantom stock plans are designed to provide the employee with the same economic outcome as ownership of the company’s stock. The employee, however, does not actually have a proprietary interest or the noneconomic rights that come with a proprietary interest.

Under a phantom stock plan, an employee’s bonus is immediately converted to phantom stocks. Ghost stocks track the value of the underlying stocks. The value of the phantom shares will increase each time there is an increase in the value of the underlying shares. 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 trading on a set market, the value can be determined using a pre-set formula.

For example, suppose the GM employee would receive a bonus of $ 10,000 in the first year. The value of GM shares is $ 100 per share. Under a phantom stock plan, the employee would receive 100 phantom shares in year one (that is, a $ 10,000 / $ 100 bonus per share). The plan would require distribution to the employee in a subsequent year (for example, the fifth year). If the value of the stock was $ 200 in the fifth year at the time of distribution, the employee would receive $ 20,000.

Generally, a phantom stock plan will be a deferred compensation plan. This means that the employee will not pay taxes until they receive a cash distribution. Assuming this is a “non-qualified” plan, the employer does not receive a deduction until there is an actual distribution to the employee.

Employers can receive a current deduction even if the employee’s tax liability is deferred if the plan qualifies. To be qualified, the plan must meet numerous requirements. These requirements relate to who should be covered, when benefits are granted, financing, information and disclosure obligations.

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