As a business owner, you know the sleepless nights aren’t always about cash flow or clients. Often, they are about people. Specifically, the two or three key employees who hold the institutional knowledge, drive the sales, or manage the operations that keep your business thriving.

In today’s competitive talent market, a good salary and a standard bonus aren’t always enough to keep top-tier talent from looking elsewhere. You want these key players to have “skin in the game.” You want them to think like owners, make decisions geared toward long-term growth, and feel tethered to your company’s future.

The obvious solution seems to be offering them equity. Give them a slice of the pie, right?

For many closely held businesses, however, granting actual ownership opens a Pandora’s box of governance issues, complexity, and loss of control that founders aren’t prepared for.

Fortunately, there is an alternative that offers the financial upside of ownership without the headaches of partnership: Phantom Stock.

Here is a breakdown of the two approaches, and why many business owners find Phantom Stock to be the superior tool for balancing retention with control.

The Traditional Route: Actual Equity

Granting actual equity means giving an employee real shares or membership units in your company. They become a legal owner.

The Appeal for the Employee: It’s the ultimate form of buy-in. Beyond the psychological boost of being a “partner,” real equity offers significant tax advantages. If structured correctly (often involving an 83(b) election), the eventual sale of those shares can be taxed at lower capital gains rates, rather than ordinary income rates.

The Headache for the Owner:
While it sounds simple, bringing on a minority partner is practically a marriage.

• Loss of Control: Even minority shareholders have rights. Depending on your operating agreement and state laws, they may be entitled to review the books, vote on certain major decisions, or block specific actions.
• The K-1 Complication: If you are an S-Corp or LLC, that employee now receives a K-1 tax form. This complicates their personal taxes and requires you to share intimate financial details of the business every year.
• The Messy Exit: What happens if this key employee ultimately doesn’t work out? Getting a shareholder out of the business against their will can be an expensive, litigious nightmare.

The Alternative: Phantom Stock

Despite the spooky name, “Phantom Stock” is a straightforward concept. It is a form of non-qualified deferred compensation (NQDC).

Think of it as “shadow equity.” You grant the employee “units” that track the value of actual company shares. If the company’s value goes up, the value of their phantom units goes up. When a triggering event occurs—such as a future date, the employee’s retirement, or the sale of the company—the employee is paid a cash bonus equal to the value of their units.

The Crucial Difference: At no point does the employee own actual stock. They have a contract right to a future payment, not an ownership stake.

The Showdown: Comparing Key Factors

For the business owner whose primary goal is retaining talent without diluting control, the comparison is stark.

1. Governance and Control

• Actual Equity: You are diluting your ownership. You now have a new partner with legal rights to information and, potentially, decision-making power.
• Phantom Stock: Zero dilution. You retain 100% control. The employee has no voting rights and no inherent right to inspect the company books.

2. The Tax Treatment (Employer Side)

This is often the deciding factor for the business owner.

• Actual Equity: Generally, when you grant stock to an employee, the business gets no tax deduction for the value of that equity.
• Phantom Stock: When you eventually pay out the cash value of the phantom units, that payment is treated as compensation. This means it is a tax-deductible expense for the business at that time.

3. The Tax Treatment (Employee Side)

This is where Phantom Stock is less advantageous for the employee, and it’s important to be transparent about it.

• Actual Equity: The opportunity for capital gains treatment (lower tax rates) upon exit.
• Phantom Stock: The payout is taxed as ordinary W-2 income. It is subject to regular income tax and payroll taxes at the time of payment.

Why Phantom Stock Often Wins for Private Owners

If your goal is a true succession plan—where you are actively grooming someone to take over and buy you out—actual equity makes sense. You want them to begin assuming the mantle of ownership.

But if your goal is simply to place “golden handcuffs” on a key manager and align their incentives with yours, actual equity is often using a sledgehammer to crack a nut.

Phantom stock allows you to say to a key employee: “I value you, and I want you to share in the wealth you help create. If we grow this company from $10 million to $20 million over the next five years, you will receive a check for $500,000.”

It achieves the goal—incentivizing growth and retention—without requiring you to rewrite your operating agreement or worry about a minority shareholder vetoing your next big strategic move.

The Need for a Strategic Approach

Implementing a Phantom Stock plan is not a DIY project. Because it is a form of deferred compensation, it must comply with strict IRS rules (specifically Section 409A). A poorly designed plan can lead to severe tax penalties for the employee you are trying to reward.

You also need a clear, objective mechanism for valuing the business. If the plan pays out based on the company’s increased value, how is that value determined? A vague valuation formula is a recipe for a future lawsuit.

At Suttle & Crossland, we help business owners navigate these complex compensation strategies. We look at the full picture: your long-term exit strategy, your cash flow needs, and the tax implications for both the business and the employee.

Before you offer a piece of your business to anyone, let’s have a conversation about how to achieve your retention goals while protecting what you’ve built.