The benefits of phantom stock for employees

It’s quite common in our industry for financial advisors to have equity in their businesses. If an advisor starts her own shop, she owns all the equity. If she goes into partnership with another advisor, the two will share in the equity. And if she recruits a seasoned advisor to join her, there’s a good chance that advisor will have an opportunity to be an equity owner.

But what about the rest of the employees? Is it wise to share the equity with all the staff, or should it be reserved only for financial advisors and perhaps a few others who contribute to the revenue of the firm?

Personally, I like the concept of all employees participating in the future success (or failure) of our wealth-management firm. In a perfect world, I would simply allocate shares of the business based upon some formula, and all employees would be owners.

The challenge lies in the implementation, the taxation, and the regulatory environment. For starters, when shares are given, this creates a taxable event for the employee. Who is responsible for paying the tax? What happens if the employee leaves the organization? If the employee must pay for some of the shares, how will he get the money? Will the company lend him the money? These are just a few of the hurdles.

Perhaps the biggest challenge with all employees being shareholders is the K-1 they will receive each year. Many of them will be accustomed to receiving a W2 from their employer in January of each year. They file their taxes early with the expectation of receiving a tax refund.

With corporate tax compliance, K-1 may not be completed and distributed until August or September of each year. The employees now have to file an extension every year rather than having their tax returns in by April 15. Plus, if the firm has much in the way of profits (distributed or not), the employee may be required to pay quarterly tax estimates.

From my personal experience, unless the employee has a substantial stake in the company, the tax burden can feel so onerous that it negates the benefits of being a shareholder.

A better way to deal with rank-and-file employees is with the use of a phantom stock plan. These carry their own complexities for the wealth firm, but they are easy to understand for the employee and don’t create the tax compliance hassles that occur with direct equity ownership.

With a phantom stock plan, the employee does not have an equity stake in the company. Rather, the employee invests in a plan in which the growth of their investment is tied to the performance of stock of the company. There is no K-1 to deal with and no tax reporting unless the employee cashes out or there is a liquidity event.

We created a plan for our employees a few years ago and have seen wide adoption across the organization. Each year, we give our employees the option of buying into the plan. Their principal is guaranteed by the firm and their growth is tied to the growth of our shares.

Employees appreciate the chance to be an owner of the firm without the complexity that accompanies direct ownership. We’ve found this is a great tool to attract and retain talent.

Scott Hanson is co-founder of Allworth Financial, formerly Hanson McClain Advisors, a fee-based RIA.