Newland's Business Notes

The Phantom Knows . . . SAR!

Volume 3 Issue 1-- January/February 1999

Only the Phantom knows . . . SAR! No, the Phantom, of old-time radio fame, has not developed a bad British accent, SAR. SAR refers to Stock Appreciation Rights, which along with Phantom Stock plans, are commonly used by small and moderately sized, non-publicly traded corporations as incentive compensation for employees.

The term Phantom Stock is an older, generic term for the idea of passing along financial rewards for making a business "grow." Conceptually, SARs are essentially the same; the differences are shades of gray.

If you adopt a SAR or Phantom Stock plan at the most basic level, the corporation is entering into a contract with the employee which promises extra compensation if the business grows. Using some benchmark -- such as a formula, or the value of the stock today versus future growth, or growth in earnings -- the employees will be paid for staying with the company and making it successful. Two important concepts are:

SARs can be viewed as devices to keep valuable employees and let them share in future appreciation in smaller businesses while deferring and conditioning the incentive pay on the success.

Phantom Stock and SARs provide employees of smaller businesses with rewards for business appreciation without actually giving or selling them stock.

Let's say, Mervin Miserly ("Merv") is a good manager and you want to retain him for a long time. Despite Merv's value and effectiveness, you are concerned about a non-family member owning stock in your company. You might be aware of problems experienced by your sister's business when non-family minority shareholders objected, and prevented, a sale of business assets. They, in effect, "killed the deal."

Or you might also be concerned Merv's ability to get along with other family members, such as your son, who may be joining the business. If Merv and your son, who likes to chant sutras, don't get along, it may be difficult for Merv to find a market for his stock. While larger, publicly traded, employers can offer incentive stock option (ISO) plans that allow employees to obtain publicly traded stock, there would be scant opportunity for Merv to sell stock in your company or to convert it to cash.

What if Merv leaves the next year after you adopt a SAR plan? After all, the SAR is designed to keep employees, not fund their departure. The SAR benefits can be postponed by adopting a "vesting" schedule. That is, each employee must remain with the company for a certain amount of time (e.g., five years) to receive the benefit.

Additionally, if the business does poorly and fails to meet the projected goals, nothing has to be paid to the employees holding such rights. If the value of the underlying business increases and amounts are paid to key employees, the payments are usually a form of compensation deductible to the employer and included in the income of the employee.

One BIG advantage of Phantom Stock and SAR plans, often overlooked, is they allow a small business a degree of flexibility. Consider this scenario. Merv was given stock in your business. Later, he is unexpectedly killed in a car accident. Now Merv's wife, Lulu, is a shareholder of the business. Nothing against Lulu, but it may be hard to get her to agree to an asset sale or merger.

Merv provided services, the payment for which - his salary - was deductible compensation to the employer. Lulu, has never provided services (and never will), but she expects something to flow from Merv's ownership. What she expects are Dividends, which are not tax deductible to the business.

There are alternatives to giving or selling stock to employees that reward them for their sustained efforts and put tax deductible benefits in their pockets. If you need help with this, or other business subjects, call Newland & Associates.

Copyright 1999
Published by the law firm of Newland & Associates, PLC
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