Red Flags – Phantom Stock

January 19, 2022

In this episode, Michael and Brad spot the red flags in a dental phantom equity deal. We discuss key considerations for this model and share how to avoid massive tax and legal issues down the road.

Listen to the full episode using the player below, or by visiting one of the links below. Below is the episode’s transcript which has been edited for readability. If you have any questions or would like to learn more, email us at info@byrdadatto.com.

Transcript

Intro: [00:00:00] Welcome to Legal 123s with ByrdAdatto. Legal issues, simplified through real client stories and real world experiences. Creating simplicity in three, two, one.

Brad: Welcome back to another episode of Legal 123s with ByrdAdatto. I’m your host, Brad Adatto with my cohost Michael Byrd.

Michael: As a business and healthcare law firm we are sometimes triggered by certain buzzwords our clients will say in conversation. We know that there is a potential disaster when we hear these words and are immediately on high alert. This season’s theme is red flags.

Brad: Michael, before we get on with today’s show, those watching us on the video platforms like YouTube may have noticed that it looks like we’re in a new podcast room. Actually believe it or not, this is the same room that we’ve been recording all our episodes to date, but thanks to our awesome team led by Riley who’s off camera, they have really gussied up to our podcast room for audio and video recording, and [00:01:00] hopefully those listening to us on the podcast platforms, you’ll have a chance to stop by our YouTube page and see how good the room looks and then be reminded why we have faces for radio.

Michael: Yeah, maybe next season hair and makeup, Brad,

Brad: Maybe. Um, well I…

Michael: Ding!

Brad: Michael, not everyone listened to the first episode. Do you want to tell the audience what you just did?

Michael: Yeah, I was paying you back for episode one.

Brad: All right. Tell the audience why you just dinged me.

Michael: Oh, this season we’re allowed to say ding when we hear a red flag. You said I, and I instinctively said, ding. My bad.

Brad: I forgot what I was about to say.

Michael: No worries. Okay what we have to do, and we talked about this off air before is we have to share our recent experience of flying on a private jet.

Brad: [00:02:00] Michael, what is the opposite of ding?

Michael: I know. This is not normal life of ByrdAdatto and we got to see a different lifestyle for a few hours.

Brad: Yeah. I had to admit, I could really get used to flying private. It felt like we were imposters who actually stepped into some alternative world.

Michael: Yeah and we probably need to clarify, we did not do anything illegal to get on this private jet. We were actually invited and we were invited by a very generous friend to go on a quick getaway trip.

Brad: Yeah true. Do you think everyone who saw us boarding or getting off that plane that day, they turned to their friends when they saw us and said, ding.

Michael: Yeah, I do recall you having a Saints shirt on and so you were definitely a red flag. You were a walking red flag. I feel like we should however, share with the audience some important lessons he learned about the private jet world because I know it was very [00:03:00] eye opening and we have some different kind of wisdom.

Brad: We do, yeah. So number one, I’ll go first, it is cool you don’t go through security. You actually get in your car and you drive right up to the plane and unload from your car directly into the plane or right up against it in the hangar.

Michael: It’s pretty amazing. And thankfully, and somewhat, surprisingly, we did not run into the plane with our car when we were dropping off our luggage. That seems like something that we would do. And we didn’t. Number two, the real cost to having a private jet is not the actual buying of said plane, but the annual operating costs like fuel and maintenance and the pilot.

Brad: Ding, ding, ding! You make it sound like the cost of a plane is actually affordable to most humans. That is not exactly like going out and buying a whole set of new razors that cost a dollar and then you go broke buying all the replacement [00:04:00] blades.

Michael: Well, actually it is kind of like that, Brad, except in the case of a private jet, we can’t afford the razor or the blades.

Brad: It’s true. All right number three. I learned what it means to be F-you rich.

Michael: Sounds like a term of art, but maybe it’s instinctive and people don’t need a vocabulary definition of what F-you rich is. But I would think the audience is thinking that owning a private jet in of itself qualifies you as being F-you rich.

Brad: No, no, no Michael, that’s just being wealthy. There’s a difference, that’s a lower level of being. Most private jets require you to crouch when you’re boarding because you can’t stand and lucky for someone like me, who’s tall for a Hobbit, I don’t really have to crouch as much as someone like you. But if you can stand up on your plane upright, you’re F-you rich.

Michael: I still can’t wrap my arms around that one so let’s move on to number four.

Brad: And this is not Michael [00:05:00] and I, this is the people that we spoke with and they explained to us the world of jets, private jets.

Michael: Number four, Brad. Go to the bathroom before you board private jet, or at least the non F-you rich private jets do not have an easy to use bathroom option on board. I think technically there’s a toilet that can be used on one of the seats and maybe even a curtain you can kind of pull to give you some level of privacy, but don’t be fooled. That person is still just a mirror inches away from you. You cannot be shy if you go this route because you were there with the entire plane

Brad: True. So number five, and this will be our last one to wrap up. Private jets have amazing snacks on them.

Michael: Ding!

Brad: They do!

Michael: Those animal cookies you helped yourself to was the stash for the four year old son of our host.

Brad: First off. And let me rebut that. Number one, animal cook cookies [00:06:00] are awesome and he said to help ourselves. And secondly, I get a little cranky, you know, if I need a snack. So I think that was okay and I did leave a bag for that four year old.

Michael: Well I may have eaten that bag. Ding?

Brad: I don’t think you’re allowed to ding yourself, Michael. Well, I doubt we’re getting invited back anytime soon, so I hope everyone learned all that we can learn about teaching you about private jets. In fact, for those listening to us on this podcast, please go to our YouTube channel and you get to see a picture of us standing in front of this private plane with our friend. And in this picture, you’ll see a very cool private jet and that it was crazy windy that day. You will also note the awesome beard I was sporting that day, but Michael what does private jet talk have to do with our show today?

Michael: Well, I’m glad you asked. As part of our client’s story today, the story centers around the fact that he is successful, not F-you rich successful, but successful [00:07:00] enough to have a private plane that he runs through his dental practice.

Brad: Ding!

Michael: What red flag did you spot?

Brad: Running the plane through the business for context, that’s a layman’s way of saying that he deducts the expenses for operating his plane as a business expense of his practice. So the practices profits and loss statement. I hit the red flag button because whenever we hear about quasi personal expenses and can I use personal, I’m using air quotes for the listeners. Personal expenses being run as business expenses, we know that there can be issues with this.

Michael: We see this in expensive cars it can be run though, country club memberships, artwork…

Brad: Ding! This is not in itself wrong. I’m dinging this for a reason, but we’re spotting the red flags as a part of this season. A client usually works with their CPA on the deductible issues from an IRS perspective. We see trouble on the business side, particularly when [00:08:00] partners are involved in the ownership.

Michael: Exactly. So today Brad, let’s call our client Dr. Pig.

Brad: Ding! Uh, I’m not sure. So you said dentists and you said airplane, what does that have to do with Dr. Pig?

Michael: I had to keep things fresh, Brad. Okay this is not our first season, we have got to keep you on your toes here. So go with me on this and I’ll explain why we’re calling him Dr. Pig later in the episode.

Brad: All right. I’ll allow it for now. Let’s keep going.

Michael: Well, Dr. Pig actually reached out to me because he wanted to sell a small portion of his dental practice to a star employed dentist.

Brad: Very common, we see that all the time.

Michael: Dr. Pig wanted to spend more time with family. Let’s call his associate Dr. Fake

Brad: Ding, ding! Uh, you’re kind of out of control today.

Michael: Hey man, we’re having fun here. So let’s dial it down, we’re okay. Dr. [00:09:00] Fake is not a reflection of his personality or his teeth.

Brad: I’ll give you a very short leash here, Michael.

Michael: Okay. Well, thanks judge Brad. That’s right. Let’s continue. Dr. Pig and Dr. Fake have worked together for eight years and are close friends. They even share the same CPA, which was theoretically going to make this a smooth transaction.

Brad: That’s pretty common too. So what were the terms of the sale?

Michael: Dr. Fake would buy $700,000 of stock from Dr. Pig in return for 15% of the company. We had a whiteboard meeting. In fact, we had multiple whiteboard meetings to build out the structure. The CPA was not on these whiteboard meetings.

Brad: Ding!

Michael: Yeah. It was a good use of the button, Brad. The practice didn’t want to bring the CPA on because they had already worked through those issues and they had an agreed value already. They had agreed to this 15% [00:10:00] percentage to be sold.

Brad: Pause. Was the airplane an issue?

Michael: Great question. Yes. We’re going to give you an animal cookie. We’re going to have each of the owners be entity that owned the practice, so let me dial it back for context. I know everyone likes to have context, or at least I do. So I’ll please myself with explaining this. The dental practice was a professional corporation and when this person Dr. Fake was going to buy in the way to navigate having Dr. Fake not navigate around the airplane issue was going to be to form two professional entities, one for Dr. Pig and one for Dr. Fake so that these two entities would own the practice entity. And then the airplane could still be run through Dr. Pig’s entity and Dr. Fake wouldn’t be [00:11:00] impacted.

Brad: It’s a great solution, we also referred to this as the quasi personal expenses and direct expenses and a lot of times their expenses attributed to one another.

Michael: Well, this was all great until we received an email from the CPA that he wanted to have a conversation about the structure.

Brad: Ding!

Michael: Ding, ding! He shared two pieces of news that changed everything. First, he told us that the practice entity was actually an S corporation instead of a C corporation.

Brad: Ding! This is a legitimate issue to the model.

Michael: Yes, our client had insisted not in the first white board, but in the first white board and the second whiteboard that the practice entity was a C corporation. And for sure it’s a legitimate issue and it’s something we should talk a little bit about when we come back from commercial on the analysis side, but I don’t want to distract too much from the [00:12:00] second piece of news.

Brad: Should I just have the red flag ready to be thrown or my ding button?

Michael: Yeah. Could you just get it out there you’d be correct to do so. Dr. Fake is so named because he was going to have the chance via the suggestion of the CPA to buy some Phantom stock.

Brad: Ding! Let’s pause here again, we hear the use of phantom stock or Phantom equity all the time, and you should just pause and I think Michael, this is our first vocabulary word the day, except for F-you rich. Phantom stock is a term of art used to pay someone like an owner, even though they don’t have actual ownership, actual stock, or shares of the entity. We use that sometimes as a bonus compensation agreement that would pay a key employee, a bonus based on the profits of a sale or potential distributions or other things of that sort.

Michael: The key is that it is [00:13:00] bonus compensation that actually is designed in a way to mirror ownership. If a distribution is made to the owners, then a Phantom equity owner will get a bonus for a similar amount.

Brad: Yes. So now that we understand what Phantom stock or equity means, so what was the problem?

Michael: Well, remember our client was planning to sell and had an agreement already before he even got to whiteboard number one with us to sell actual equity, 15% of his practice for $700,000. You don’t typically sell Phantom equity because it’s fake. It’s a bonus agreement designed to mimic ownership of equity. It’s just a contract for a bonus. And so I explained to the CPA that yeah, we could do a Phantom stock agreement. We’ve done them plenty of times, but we would need to check with the client because the client had an expectation of getting a [00:14:00] $700,000 check in return for selling ownership.

Brad: Yeah, that is going to be a shift in the overall sale issue. So how did Dr. Pig react to the Phantom stock idea?

Michael: Well, I don’t know if this is good or bad, Brad, we didn’t have to actually go to Dr. Pig because the CPA, and again, I don’t know exactly how to call it this the best or worst part of it, the CPA said that he still wanted Dr. Fake to write a $700,000 check

Brad: Ding!

Michael: And for Dr. Pig to still realize a long-term capital gain sale but Dr. Fake would just have it be Phantom equity instead of real equity

Brad: Ding again, audience. Or perhaps that should be saying WTF since that seems to be something, maybe we should call the CPA the Phantom menace as this proposed model is [00:15:00] extremely problematic.

Michael: Ding to you for bringing Star Wars in so early this season. I know though, you are not incorrect. I’m thinking how in the world do you sell nothing for $700,000 and get a capital gain?

Brad: Yeah. And that’s the very point of a long-term capital gain is the sale of stock

Michael: I know, it was like the CPA wanted to solve all the problems by having a stock sale and then just magically labeling it a Phantom stock.

Brad: It reminds me of Michael that old expression comes to mind, put lipstick on a pig.

Michael: And there you have it, Brad. That’s why we call him Dr. Pig.

Brad: My mind is spinning a little bit. Let’s go to commercial and on the other side, talk more about Phantom equity from a legal perspective and why we hit the ding button so many times in this first part of the episode. [00:16:00]

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Brad: Welcome back to Legal 123s with ByrdAdatto. I’m your host Brad Adatto with my cohost Michael Byrd. Now Michael, this season’s theme is red flags. We’ve had a lot to unpack here in this first half of the show and we had two primary legal issues that we wanted to discuss and the impact of the practice, the dental practice being an S Corp, and then the CPA’s desired phantom stock. Let’s start by [00:17:00] resettling a little. What was the CPA’s goal with calling it phantom stock?

Michael: So the problem he was trying to solve was worth solving. He was concerned about Dr. Pig being able to deduct his plane expenses and other similar type expenses without having to answer to Dr. Fake. He didn’t want Dr. Fake to be impacted negatively by these deductions and so If Dr. Fake paid $700,000 to own equity in this company, Dr. Fake would have a voice in those types of expenditures. And so the CPA figured that we could basically just do the deal in a way that took away Dr. Fakes voice, he thought Phantom equity was the route to go.

Brad: And because Phantom equity is a term of art, it does unfortunately get misused. [00:18:00] It’s not a magic solution that fixes everything, which is why often we hear that term being used we hit the ding button because we want to make sure again, that it’s properly applied to whatever the situation.

Michael: Yeah exactly. And as we discussed earlier, Phantom equity is really just a compensation arrangement. There are no elements of equity when a Phantom equity holder is paid. It’s characterized for IRS purposes as a W2 payment, or possibly a 1099 independent contractor payment.

Brad: Yeah. So why is this so important for our audience to understand?

Michael: Well, so a distribution made to an owner is characterized differently. It shows up in the case of an S-Corp on their K-1. This is actually why the term of art is Phantom equity. It’s fake equity.

Brad: Yeah. And this is why it was ridiculous to suggest that someone pay $700,000 in return, they essentially get a contract [00:19:00] and a bonus, and it was impossible to have the $700,000 payment be characterized as long-term gain since the long-term capital gain relates to actual, not the Phantom, actual real equity.

Michael: Yeah. And there’s a sister concept we talk about in business arrangements every once in a while, where an individual will hold what’s called a profits interest in a company.

Brad: Yeah. And Michael thinking through this entire plan, could that have worked in this situation?

Michael: Theoretically, yes with a couple of caveats. An S-corporation cannot grant a profits interest to someone or it’ll blow the S election. So I’m sure the CPA did not want to go the route of a profits interest because he did not want to impact Dr. Pig’s ability to deduct the airplane expenses. In fact that’s the whole reason we’re having this exercise so he could continue to make these deductions. There are some alternative models that theoretically could have been explored, but we [00:20:00] would arrive at another problem. A profits interest would not be worth $700,000.

Brad: So tell our audience, what do you mean by that?

Michael: Okay. I’m going to take us back to law school for a minute. And did you ever learn about the bundle of sticks and law school? Well, we learned about this when we were learning about real estate, just this idea that if you fully own a piece of real estate, they call it fee simple. Right? If you remember, then you have the entire bundle of sticks. If you grant or someone has some smaller interest in real estate, so an easement to the property that’s a couple of the sticks from the bundle, but obviously not the full bundle. So if you own the property, and then you grant an easement, then you have, you know, not the full bundle, you have the full bundle, less the sticks that would represent the easement. Same thing for leasing a piece of property, that’s a [00:21:00] different few sticks that would go away from your bundle.

Brad: Okay. So how does stick talk have to do with applying it to business ownership situation?

Michael: So if we use this principal as an illustration and Dr. Pig owns 100% of his business, he has the whole bundle of sticks. So if he sold as the original plan, if he sold Dr. Fake 15% of the company for $700,000 Dr. Fake would now own 15% of the bundle of sticks. Well, if we figured out a way to sell Dr. Fake a profits interest, Dr. Fake would receive sticks, but he would receive less sticks. So an actual ownership interest has voting rights with it and other rights that are superior than just a profits interest. So then if you struck a deal to sell 15% of ownership for [00:22:00] 700 K why would someone then still pay 700 K for A lesser interest, a profits interest?

Brad: That makes total sense because they’re not really getting as much. So all very good fair points. Thanks for taking me back to law school. Let’s keep talking about other issues we identify and the other one was the S-Corp issue. I know that we’ve discussed in past shows, but explain what you mean by an S-Corp.

Michael: So setting the stage or resetting the stage when you form a business in any state, there’s two primary filings that go with it. There’s the steps you have to take to register with the state that you’re in. And then there’s the registration to get a tax ID with the IRS. In California, the state filing is a professional corporation for a dental practice, and then you still have the IRS filing. And when you’re a professional corporation, your choices with the IRS are to be [00:23:00] taxed as a C corporation or to make an election to be taxed as an S-Corp.

Brad: Yeah. And what is important to understand here is that an S-Corp is popular with small closely held businesses as allows that the taxes of the corporation to be reported on the personal tax return of the actual owners of that small business.

Michael: So if theoretically someone had a deduction for, I don’t know, an airplane, it shows up on their personal tax return.

Brad: Exactly. And while a C corporation that the professional entity files its own tax return. The downside to being a C corporation is often referred to as a double taxation. It can occur when the entity itself is going to pay taxes and whenever there’s a distribution of profits, then the owners of that corporation within also pay taxes. So understand that’s [00:24:00] where the double tax comes in. So again, the mind distributed shareholder that’s when taxes are paid or the entity itself has to pay its taxes.

Michael: So it posed a serious dilemma for the CPA because the whole point of this entire exercise was to take advantage of the plane deduction and to sell an interest to Dr. Fake. So let’s explore the original idea for how to do this. The news of the fact that the practice was an S-Corp instead of a C-Corp actually impacted the original idea. Let’s talk about that.

Brad: The original plan was for Dr. Fake to form an S-Corp to own the practice. Another pesky rule to qualify for an S election, is that the owners have to be individuals. So in this case, because as an S-Corp, they would have to be owners as individuals. And if we would make a change, the ownership, the S selection would be blown if an entity would come in, it would have to be a [00:25:00] secret.

Michael: So what could have been done?

Brad: There would have to have been a decent amount of structure planning from a tax advisor on the two ideas that could be explored would be to operate the practice as a C-Corp and move the airplane expenses to Dr. Pig’s new entity. I think you said that was part of the original idea, right? But now we need it to the tax advisor to explain the impact it’s going to be from doing, which is also referred to as an S inversion where you’re going from an S-Corp to a C-Corp.

Michael: Yeah. We would have to make sure we do not solve one problem and create other problems.

Brad: Perfect. Yeah. And that’s often the cases you’re solving for something and it causes another problem. And another concept to explore when you’re converting from an S-Corp to a partner tax model, are the limitations, because in this case, you said that they were in California and with the types of partnerships that can be formed for a practice of dentistry is going to be limited. Although we do know a general partnership would work.

Michael: Yeah. And there are planning issues as to the tax [00:26:00] impact of converting and to set up an asset protection friendly model with a general partnership. I know we’ve talked about that actually in California, a few seasons ago, so we could do an entire episode on some of these modeling ideas.

Brad: Yeah. So Michael, let’s get back to our story. What happened to our friendly Dr. Pig and Dr. Fake?

Michael: Well, the good news is that they’re still together and they’re still besties. Yes, the bad news is they did not end up doing anything to bring Dr. Fake on as an owner. I’m just thankful that the CPA backed off of the Phantom equity deal. You have any final thoughts?

Brad: Yeah, I think for our audience to understand, just because we dinged the red flag when we heard the term Phantom equity or Phantom stock that doesn’t mean it’s illegal or even wrong, but it’s important to understand why would a company or corporation uses option and if [00:27:00] so, if you are using it, understand the why because otherwise, as we were talking about it can cause massive tax or legal structure issues down the road., Michael, how about you? Some final thoughts?

Michael: Well, I take these special deductions that we talk about that, you know, give the ding button in this case today, an airplane. So whether you’re F-you rich and can stand up in the plane or not, you’re just regular rich. If you want to try to take advantage of deducting those expenses, you have to be careful first and foremost, with your tax advisor to make sure that the way that the plane in this case is being utilized, qualifies as a business deduction, and then understand especially in this professional services world that when you have partners and you’re wanting to deduct things, it’s not [00:28:00] just the cost of the airplane. It’s the risk you’re taking with how aggressive you may or may not be being with making the deduction in the first place. So if the IRS came in and said you can’t be deducting the way you’re flying that plane around, the partner or co-owner, or the business would be impacted.

Brad: All good points. Michael we will continue with the season next Wednesday. Wednesday’s show we will be discussing Red Flags – Non Binding Letter Of Intent.

Outro: Thanks again for joining us today. And remember, if you liked this episode, please subscribe. Make sure to give us a five- star rating and share with your friends. You can also sign up for the ByrdAdatto newsletter by going to our website at byrdadatto.com. ByrdAdatto is providing this podcast as a public service. This podcast is for educational purposes only. This podcast does not constitute legal advice, nor does it establish an attorney-client relationship. Reference to any specific product or entity does not constitute an endorsement or recommendation by ByrdAdatto. The views expressed by guests are their own and their appearance on the program does not imply an endorsement of them or any entity they represent. [00:29:00] Please consult with an attorney on your legal issues.

ByrdAdatto founding partner Brad Adatto

Bradford E. Adatto

ByrdAdatto founding partner Michael Byrd

Michael S. Byrd