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HUMAN RESOURCES

The ABCs of Phantom Stock

An S Corporation retains key personnel by giving them phantom stock as an incentive.
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William Reidy, the chairman and CEO of $8.2-million Fine Organics Corp., a chemical manufacturer in Lodi, N.J., had a problem: "We were buying two small companies and wanted to figure out how to retain key personnel. But giving them stock shares in Fine Organics -- even without voting rights -- wasn't an option for us." That's because Fine Organics had been incorporated as an S corporation and, according to IRS regulations, could not create two tiers of stock. But the company's six original shareholders didn't want to dilute their ownership control by broadening the base of regular shareholders.

"We were trolling about for some kind of compromise solution and heard about phantom stock," recalls Reidy. The basic scheme was simple: "Instead of real stock, we'd give these key individuals a document that, at the time it is issued, has a value of zero. As the book value of the combined equity -- that is, Fine Organics and the acquired company -- increases, the amount of that increased value is added to the original zero value of the phantom-stock document." At an agreed-upon point, the individual cashes in the phantom stock for the difference between its current and original value.

Reidy has used this easily administered benefit twice, and both times it has been successful. Here are his basic guidelines:

* Keep the financial terms simple. "These plans can turn into accounting nightmares if you have to keep calculating the present value of this and the inflation index for that," Reidy says. "We just pegged everything to the book value of our stock, which is easy to calculate and easy for everyone involved to understand." One of Reidy's staffers who received phantom stock in 1986 has watched its value rise $1,350, as the company's book value has risen from $150 per share to $1,500 per share.

* Present the plan as a win-win benefit. Instead of using the massive plan documents offered by most accounting firms, have your own staff prepare a brochure that spells out key advantages, from both the employee's and the company's vantage points. One plus, for example: unlike regular stock shares, there's no tax bill due when the employee receives phantom shares. That's because the IRS considers phantom stock a form of deferred compensation, taxable only when those shares are cashed in.

* Offer plenty of cash-in options. One of the best things about phantom stock is that it gives employers the flexibility to design a stock benefit that fits individual employees' needs. "They can receive profits outright in the form of a cash bonus they'll immediately owe taxes on, or receive the cash over a deferred-payment schedule that makes sense for them," Reidy explains.

* Tailor vesting schedules to individual circumstances. Phantom-stock plans help companies retain key individuals through the use of vesting schedules, which give employees financial ownership of their shares gradually over a specified time period. Rather than settling upon one specified vesting schedule, as most large plans do, Reidy negotiates each person's vesting individually. "That way you can take into account factors like a person's age and how much value you expect him or her to bring to the company over the short and long term." At Fine Organics, vesting periods of 5 and 10 years have been used. -- Jill Andresky Fraser

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