Family Business Magazine , Autumn 2004, vol. 15, no. 4, pages 19-21.
By Robert A. Adelson
With the stock market apparently recovering from the “dot-bomb” crash of 2000-02, companies are again using their rising stock to lure top executive talent. If it’s time for your family business to recruit key technical employees or senior executives from outside the family, how can you compete with these non-family firms? What can you offer prospective employees instead of stock or options?
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. The good news is that today’s tax climate has made it easier for family firms to compete in the recruitment wars.
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, ways and means that are discussed in this article.
Recruiting talent from outside the family
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 best way to fill in the missing pieces is by hiring non-family employees.
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 a core family member.
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.
Non-voting stock and ‘rabbi trusts’
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’s operations and strategic choices.
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.
Phantom stock: 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.
Sarbanes-Oxley and phantom stock liquidity
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 illiquid. 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.
Phantom capital gains vs. incentive stock options
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 Election: Opportunities in new tax proposals
At this writing it is unclear whether the next administration will be Republican or Democrat, but the beneficial use of phantom stock appears likely continued and even enhanced regardless of the outcome of November 2004 election.
If the President and Congress are re-elected, the thrust of GOP tax policy in 2005-09 will be to make permanent the recent Bush tax cuts, including those for capital gains, dividends and marginal rates scheduled to sunset during that ‘05-09 period, with an added drive to eliminate all tax on dividends. If there is a change to Democratic rule, the Kerry program would roll back those same tax cuts for families earning over $200,000 and create new tax credit incentives for high-earning employers to hire new workers.
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. However, the well-designed plan can cope and even utilize the Democrat policy shift. The income deferral embedded in phantom plans allows beneficiaries to spread income. So, the Kerry $200,000 family income safe harbor is obtainable. Also, to the extent phantom stock aids hiring it gains the family business owner a tax credit, to benefit from tax changes.
A case example
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 over $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.
This example works for any family business in any American industry, whether the business valuation is $5 million or $5 billion. Although the company must incur the cost of paying out phantom stock, it derives a much greater benefit from growth. These plans give family-owned companies the ability to recruit and retain key talent, which more than offsets the cost involved.
Robert A. Adelson, J.D., LL.M, a partner in the law firm of Engel & Schultz LLP in Boston, is a corporate and tax who represents closely held and family businesses and executive employees.
© 2004 Robert A. Adelson
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Robert A. Adelson, Esq. can be reached at Engel & Schultz LLP,
265 Franklin Street, Boston MA 02110 radelson@engelschultz.com
(617) 951-9980 ext. 205
Business Law Blog by Robert Adelson, Esq. 