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The October 2026 Executive Benefits Brief: projected 2027 tax schedules and retirement limits, what changed in deductibility, and what business owners should do before and after year-end.

This article is general information, not tax advice. Schiff Executive Benefits does not provide tax or legal advice. The treatment of any specific plan depends on its terms and on your circumstances — work through it with your CPA and counsel.

The tax treatment of phantom stock is simpler than most people expect and lands harder than most people expect. Simpler, because there is essentially one answer: ordinary income when paid. Harder, because that one answer eliminates the capital gains outcome executives usually have in mind when they hear the word "stock," and because the employer's book expense arrives years before the cash does.

Here is the full picture, for both sides of the table.

The short answer

Phantom stock payouts are generally taxed to the employee as ordinary income — reported as W-2 wages, subject to income tax withholding — in the year the payment is received. There is no capital gains treatment, because the employee never held a capital asset. The employer generally receives a compensation deduction in the same year the employee includes the amount in income.

Everything below is detail on that sentence, plus the two places it gets more complicated: FICA, and book accounting.

This article deals only with the tax treatment. For how a plan is designed, valued, and administered, start with our main guide to phantom stock plans.

Employee tax treatment

Income tax: ordinary rates, at payout

When a phantom stock award pays out, the amount is compensation. It goes on the W-2, it is subject to federal income tax withholding at supplemental wage rates, and it is subject to state income tax where applicable. If the plan is 409A-compliant, the employee is generally not taxed at grant or at vesting — only when the amount is actually or constructively received.

Two practical consequences executives should understand before they sign:

• A large lump sum can push you into a higher marginal bracket for one year. A $400,000 payout on top of a $300,000 salary is taxed very differently than the same amount spread over five years. This is a design question, not just a tax question — which is why installment payouts are common.


• State tax follows a different set of rules than you may expect. An executive who retires to a no-income-tax state and receives installment payments over ten years or more may be able to avoid source-state taxation under federal law governing state taxation of retirement income; a lump sum generally does not get that treatment. This is worth modeling before the payment schedule is fixed, because 409A will not let you change it later.

FICA: the special timing rule catches people out

FICA does not follow income tax here. Under the special timing rule for nonqualified deferred compensation, amounts are generally taken into account for Social Security and Medicare purposes in the later of the year the services are performed or the year the amount is no longer subject to a substantial risk of forfeiture — in other words, at vesting, which is often years before payment.

Why that is usually good news for the employee: if the executive's wages already exceed the Social Security wage base in the vesting year, the OASDI portion is effectively already covered, and only Medicare applies to the phantom amount. Then, under the non-duplication rule, the amount and its subsequent earnings are generally not hit with FICA again at payout.

Why it can be bad news: FICA is owed at vesting on an amount the employee has not received in cash. Plans usually solve this by withholding from other current wages. It has to be planned for, and it routinely is not.

What phantom stock is not

It is not capital gains. It is not eligible for an 83(b) election, because there is no property transferred to make an election on. It is not eligible for rollover into an IRA or a qualified plan. It is not protected by ERISA's funding rules — participants in a properly structured top-hat plan are general unsecured creditors of the company, which matters if the company fails before the payout.

[IMAGE 1 — suggested: tax documents and a calculator on a desk. Alt: "Calculating phantom stock tax treatment for an executive payout"]

Employer tax treatment

The deduction

The company generally takes a compensation deduction equal to the payout, in the taxable year in which the amount is includible in the employee's income. This is the matching principle at work: no deduction while the liability is accruing, then a full deduction when the cash goes out.

For a profitable company, this is a meaningful part of the economics. A $500,000 payout at a 21% federal corporate rate is a $105,000 deduction; for a pass-through owner in a high bracket, the after-tax cost of the plan is lower still. But the deduction only helps in the year taken, and only to the extent of income.

Payroll tax and reporting

The employer withholds and remits income tax and the employer share of FICA, and reports the payment on the W-2 (Form 1099 treatment applies for non-employee directors, which is a different analysis). The FICA timing follows the special timing rule described above, so the employer's payroll obligation may arise at vesting rather than payment — a reporting step that gets missed in plans administered informally.

The book expense, which is not a tax issue but feels like one

This is the item that surprises owners most. Phantom stock is a liability-classified award for financial reporting purposes. The liability is generally re-measured at each reporting date, so as company value rises, compensation expense rises with it — hitting the income statement years before any cash moves, and reversing in ways that can make earnings look volatile.

If your credit facility has EBITDA or fixed-charge covenants, model this before adopting the plan and talk to your lender. A company that grows quickly can generate a phantom stock expense large enough to matter to a covenant calculation, and explaining a non-cash charge after the fact is a worse conversation than explaining it in advance.

How pass-through entities are treated

All of the above applies substantially the same way to S corporations, partnerships, and LLCs, and this is one of phantom stock's real advantages for those entities.

• S corporation. Phantom stock is compensation, not equity, so it does not create a second class of stock and does not implicate shareholder eligibility rules. The deduction flows through to the shareholders.


• Partnership / LLC. A phantom unit plan is a cash-settled compensation arrangement, so the participant is a W-2 employee rather than a partner. No K-1, no self-employment tax analysis, no capital account. Compare that to a profits interest, where the executive may owe tax on allocated income they never received.


• C corporation. Straightforward compensation deduction against corporate income.

409A: the rule that determines whether any of this holds

All of the treatment described above assumes the plan complies with Internal Revenue Code Section 409A. If it does not, the analysis changes entirely and badly.

On a 409A failure, the employee generally must include all vested deferred amounts in income immediately — not at payout, but in the year of the failure and for every year the defect persists — plus an additional 20% federal tax on those amounts, plus a premium interest charge. Some states impose their own additional tax on top. The company's deduction timing follows the inclusion, so the employer is not penalized directly, but it has just handed a very large, very unexpected tax bill to the executive it was trying to retain.

The common defects are all design defects, not accidents: discretionary payment timing, informal acceleration, an undefined change-of-control trigger, or amending the payment schedule without following the subsequent-deferral rules.

If you think an existing plan has a problem, the IRS maintains correction programs and the cost of fixing a defect rises the longer it sits. See 409A Corrections and our complete IRC 409A compliance guide.

Phantom stock vs. real equity: the tax trade-off, stated honestly

	Phantom Stock	Real Equity (restricted stock)
Employee rate at payout	Ordinary income	Potential long-term capital gains on appreciation after grant/vesting
Taxed at grant?	No	At vesting, unless an 83(b) election is made
83(b) election available	No	Yes
Employer deduction	Yes, when paid	Generally limited to the amount included at vesting
Cash required from the employee	None	Possibly tax on value never received
Dilution	None	Yes

Read that table from the executive's side and real equity looks better on tax. Read it from the owner's side and phantom stock looks better on control and reversibility. Both readings are correct, and a plan sold without acknowledging the first one tends to produce a disappointed executive at exactly the moment the retention was supposed to pay off.

Full comparison: Phantom Stock vs. Stock Options vs. Real Equity.

Frequently asked questions

Is phantom stock taxed as capital gains?

No. Phantom stock payouts are ordinary compensation income. No capital asset is held, so no capital gains treatment is available.

When is phantom stock taxed — at grant, at vesting, or at payout?

For income tax, generally at payout, provided the plan complies with 409A. For FICA, generally at vesting, under the special timing rule. Not at grant.

Can an employee make an 83(b) election on phantom stock?

No. An 83(b) election applies to a transfer of property. Phantom stock transfers no property — it is an unfunded contractual promise.

Is phantom stock reported on a W-2 or a 1099?

W-2 for employees. Payments to non-employee directors or independent contractors are generally reported on Form 1099-NEC, and the underlying analysis differs.

Does the company get a tax deduction for phantom stock?

Generally yes — a compensation deduction in the year the amount is includible in the employee's income, which is normally the year of payment.

How is phantom stock taxed in an LLC?

The same way as in a corporation. Because the plan is cash-settled compensation rather than an equity interest, the participant remains a W-2 employee and does not receive a K-1 or take on partner-level tax complications.

Get the tax and the design decided together

Tax treatment is not something to check after the plan is drafted. Payment timing drives the employee's bracket, the FICA year, the state-sourcing analysis, and the company's deduction year — and 409A means those choices are largely locked once made.

Talk to Schiff Executive Benefits before the document is drafted →

This material is for general informational purposes only and does not constitute tax, legal, or investment advice. Schiff Executive Benefits does not provide tax or legal advice. Consult your own tax and legal advisors regarding your specific circumstances.

Phantom stock plans for small and mid-sized companies: how owners retain key people without giving up equity, plus sizing, valuation, 409A and funding.

A phantom stock plan example for a $20M company: 200 units, three payout scenarios, the P&L accrual, tax treatment and funding, with the numbers worked out.

A business is only as strong as the people who help build it. That truth is simple, but its consequences are not.

The best way to retain key employees is to combine meaningful leadership, competitive total compensation, visible career opportunity, and a carefully designed executive benefits strategy that connects the employee’s future to the company’s future.

That does not mean offering every possible perk. It means understanding what your most valuable people need, identifying what keeps them committed, and building a plan around the goals of your business.

Why does this matter? Because your best employees are usually the most recruitable. Competitors know their value. Recruiters know their names. And if one of them leaves, the cost may extend far beyond replacing a salary. You may also lose institutional knowledge, client relationships, revenue, culture, and momentum.

Here are seven practical strategies to help you retain key employees and restore alignment between your people and your business.

1. Identify Which Employees Are Truly Essential

Retention begins with clarity.

Not every employee needs an executive benefits plan. Not every high performer is a mission-critical employee. Your first step is to identify the people whose departure would materially affect your company’s value, growth, succession, or client relationships.

Ask yourself:

• Who drives a significant portion of revenue?


• Who owns important client or vendor relationships?


• Who possesses knowledge that would be difficult to replace?


• Who is being prepared for a future leadership or ownership role?


• Who would be expensive or disruptive to replace?


• Who could leave and create a succession problem?

This is where a business owner must look beyond job titles. A key employee may be a senior executive, technical specialist, physician, partner, producer, or operating leader.

Once you know who matters most, you can focus resources where they will have the greatest effect. A targeted plan is often more effective — and more cost-efficient: than adding generic benefits for everyone.

Our Executive Benefits Guide for Business Owners explains how selective benefits can be designed for owners, executives, and other key people who drive the company’s value.

2. Listen Before You Design the Benefit

Many retention efforts fail because the employer assumes it already knows what employees want.

You may believe your top executive wants a larger bonus. They may be more concerned about retirement income. You may think an equity grant is the answer. They may want family protection, liquidity, or a clearer path to future ownership.

The right question is not simply, “What can we afford to offer?”

The better question is, “What would make this person feel valued, protected, and invested in staying?”

Have direct conversations. Use stay interviews. Ask what your key employees value now and what they want their future to look like. Their priorities may include:

• Supplemental retirement income


• Life insurance for a spouse or family


• Greater protection from income disruption


• A meaningful connection to company growth


• Additional compensation beyond qualified-plan limits


• A path toward ownership or succession


• More certainty about their long-term role

This conversation creates a foundation for a benefit that feels personal rather than manufactured. It also helps you avoid spending money on an arrangement that looks impressive on paper but does not change behavior.

3. Close the Retirement Income Gap

A standard 401(k) is important, but it may not be enough for your most highly compensated employees.

Contribution limits, nondiscrimination rules, and the structure of qualified plans can create a significant gap between an executive’s current income and the income they may need in retirement. That gap can become a source of frustration: especially when the executive is contributing aggressively but still cannot maintain their intended lifestyle.

A nonqualified deferred compensation plan, or NQDC plan, can help address that problem.

Depending on the design, an NQDC arrangement may allow a select group of executives to defer compensation beyond qualified-plan limits. It can also include vesting schedules and distribution elections that support long-term retention.

Common approaches include:

• Employee-funded NQDC: Allows executives to defer additional salary or bonus.


• Employer-funded NQDC: Provides a discretionary benefit tied to service, performance, or retirement.


• 401(k) Mirror Plan: Helps restore contribution opportunity for executives who have reached qualified-plan limits.


• SERP: Provides a supplemental executive retirement benefit based on a defined formula or objective.

You can review the broader structure in this complete guide to deferred compensation and NQDC plans. For employer-funded arrangements, see our overview of Employer-Funded NQDC Plans, as well as the dedicated guide to a 401(k) Mirror Plan.

These plans must be designed carefully. Section 409A compliance is essential. Improper elections or distribution provisions can create accelerated taxation, penalties, and unnecessary risk for the executive.

This is one reason technical expertise matters.

Matt Schiff provided technical input on the laws governing these arrangements from 2003 to 2005 as a member of the AALU’s NQDC Committee, alongside Michael Goldstein. He was in the room where the rules were being shaped: not simply reading them after the fact.

You can also hear Matt discuss these issues with Dan Hogans, formerly of U.S. Treasury Department, through The Perfect Plan^® Podcast and official YouTube channel.

4. Create an Ownership Feel Without Giving Away Control

People often work harder when they feel connected to the outcome.

That does not mean every business should issue actual equity. Ownership can create dilution, governance complications, valuation questions, and future disagreements. For many business owners, the goal is to create the economic feeling of ownership while preserving control.

That is where phantom stock may be appropriate.

A phantom stock plan can provide a future cash benefit based on the value or performance of the company. The executive does not receive actual shares or voting rights, but the arrangement can help them participate in the value they help create.

This can be powerful for:

• Privately held corporations


• Partnerships


• Professional practices


• Family businesses


• Companies preparing for a future sale


• Businesses developing a future leadership team

The benefit is usually tied to specific conditions, such as continued service, performance, a change in control, retirement, or another defined event.

Read more about Phantom Stock and creating an ownership feel without giving away the farm.

5. Align Benefits With the Company’s Culture and Intent

A retention plan should feel consistent with the way your business operates.

If your culture values long-term service, the plan may use a vesting schedule. If your company emphasizes measurable performance, benefits may be connected to defined goals. If family protection is central to your values, life insurance and survivor benefits may be more important than a purely cash-based arrangement.

There is no universal best benefit. There is only the best structure for your goals, your employees, your entity type, and your culture.

Split Dollar and Restricted Executive Bonus Arrangements can sometimes help create a benefit that is personal to the executive while remaining structured for the business. These arrangements may address life insurance protection, future income, retention, and employer cost recovery — but they require careful coordination.

Our guide to The Perfect Plan^®, Split Dollar, and REBA explains the broader concept.

The plan must also account for employer-owned life insurance rules, including IRC Section 101(j), when applicable. Notice, consent, documentation, and policy design should be addressed before implementation. Your attorney, accountant, TPA, and benefits advisor should work together from the beginning.

6. Give Key Employees a Future They Can See

A talented employee may leave because they cannot see what comes next.

Retention improves when a key employee understands how their role can develop over time. That future may include increased responsibility, participation in strategic decisions, leadership development, ownership transition, or a defined retirement benefit.

This is especially important when your company is approaching a transition. What happens if a senior executive retires? What happens if the person expected to replace them is not ready? What happens if a partner dies and the business is suddenly dealing with a surviving spouse?

A benefits strategy should connect to your broader succession plan. Our guide on how executive benefit needs evolve from startup to succession explores these questions.

You should also consider a Supplemental Executive Retirement Plan when the goal is to provide a defined future benefit for a senior leader.

The message is clear: “We see your future here, and we are willing to invest in it.”

7. Review the Plan Before Circumstances Force You To

Retention plans should not be created once and forgotten.

Your business changes. Your employees change. Tax laws change. Ownership goals change. The person who was once your second-in-command may become your successor. A high performer may become a partner. A company may move from growth mode into acquisition or succession planning.

Review your arrangements regularly with your advisory team. Look at:

• Whether the key employee’s role has changed


• Whether the benefit still matches the employee’s priorities


• Whether vesting and distribution terms remain appropriate


• Whether the company can recover or fund the intended cost


• Whether the arrangement continues to support succession


• Whether compliance requirements are being met


• Whether the plan reflects current business value

For corporate entities, Corporate Owned Life Insurance may be considered as part of a broader funding and cost-recovery strategy. It should never be treated as a substitute for thoughtful plan design, proper documentation, or professional advice.



The best retention strategy is not a single product. It is a coordinated system.

The Best Retention Strategy Starts With Your Goals

So, what is the best way to retain key employees?

Start by identifying the people who are essential to your future. Listen to what they value. Build a visible path forward. Then coordinate compensation, retirement income, ownership feel, family protection, and succession planning into a structure that works for both the executive and the business.

That is the essence of The Perfect Plan^®: reverse-engineer the solution from the outcome you want.

Your goal may be to keep a top executive, prepare a successor, protect a family, fund retirement, or preserve the value you have spent decades building. The right plan can help you address more than one of those goals at the same time.

The five questions are worth asking now:

1. What if I end up in business with a widow?


2. What if I need a business buy-out?


3. What if my top talent leaves?


4. What if a senior executive retires and replacement costs are much higher?


5. What if I run out of retirement money?

Sit back, grab your coffee, and take an honest look at what keeps you up at night. Then, when you are ready, begin with a business valuation and planning assessment through RISR or schedule an initial conversation with Matt Schiff.

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If you are five years away from retiring or selling your business, you are standing in the only window that still gives you real leverage. Not the twelve months before a letter of intent — by then the buyer sets the terms, the tax structure is largely locked, and your key people have already figured out that something is happening. Five years out, almost everything is still adjustable. The exit planning checklist below is built for exactly that window.

The owners who capture the highest multiples and keep the most after tax are not the ones who negotiate hardest at the closing table. They are the ones who spent five years quietly engineering the business so the closing table was a formality. Here is what that looks like.

The Five-Year Exit Planning Checklist

Years 5 to 4: Establish a Baseline You Can Actually Defend

• Get a real valuation, not a rule of thumb. "Three times EBITDA" is not a plan. You need a defensible number built from normalized earnings — adjusted for owner compensation, personal expenses running through the company, one-time items, and related-party rent.


• Clean up the financials. Buyers pay a premium for three years of consistent, reviewed or audited statements. Start the clock now.


• Identify your value killers. Customer concentration above 20 percent, a single key supplier, expiring leases, missing contracts, deferred capital expenditures, and — the big one — owner dependency.


• Answer the honest question: can this business run for 90 days without you? If the answer is no, you do not own a business. You own a job that will be discounted at sale.


• Set the target number. Work backward from the after-tax proceeds you need to fund the rest of your life. That number, not the market, defines whether you are ready.

Years 4 to 3: Build the Retention Architecture

Nothing destroys deal value faster than a key executive walking during due diligence. Buyers pay for a management team that stays.

• Name your critical few. Usually three to six people. Not the org chart — the people whose departure would change the purchase price.


• Put a plan in place that pays for staying through the transaction. A nonqualified deferred compensation plan or SERP with vesting tied to a change in control aligns your executives' payday with yours.


• Consider equity-feel without equity. Phantom stock lets a key executive share in the growth in enterprise value — and get paid at the sale — without diluting your ownership, complicating your cap table, or handing a minority holder consent rights over your own deal.


• Or make it simple and portable. A Restricted Executive Bonus Arrangement gives the executive a benefit they can see and touch, funded with employer dollars, with a restriction that keeps them in the seat.


• Mind the 409A trap. Deferred compensation that accelerates on a sale must fit within the change-in-control rules of Section 409A. Get the definition of "change in control" and the payment triggers right in the document — not in a side letter three weeks before closing. A 20 percent penalty tax on your best executive is a terrible closing gift.


• If you fund with company-owned life insurance, satisfy 101(j) first. Employer-owned life insurance requires written notice and consent before the policy is issued. Miss it, and the death benefit that was supposed to be tax-free becomes taxable income. This is not fixable after the fact.

Years 3 to 2: Engineer the Tax Structure

• Revisit your entity choice while you still can. S corporation, C corporation, and partnership each produce a very different after-tax result on the same headline price.


• Look hard at qualified small business stock. For C corporation stock, Section 1202 can exclude a substantial share of your gain from federal tax. Under the 2025 changes, stock issued after July 4, 2025 gets a 50 percent exclusion at three years, 75 percent at four, and 100 percent at five — with a per-taxpayer cap of $15 million and a $75 million gross asset ceiling at issuance. Note the symmetry: a five-year runway is exactly the holding period for the full exclusion. Miss the window by a quarter and the cost is measured in millions.


• Front-load deductions in your highest-income years. A cash balance plan can generate six-figure annual deductions for an owner in the final high-earning years before a sale, moving money out of the corporate wrapper and into a protected retirement bucket at a discount.


• Model asset sale versus stock sale versus installment sale. Buyers want an asset sale for the step-up; you usually want stock. That gap is negotiable — but only if you know what it is worth to each side before the LOI.


• Evaluate personal goodwill. In the right facts, a portion of the purchase price allocated to personal goodwill is taxed once, not twice.

Years 2 to 1: Residency and Estate Tax Positioning

This is the step most owners skip, and it is frequently the most expensive one.

• Understand where you are domiciled — and what it costs. The federal estate tax exemption in 2026 is $15 million per person, $30 million for a married couple, at a 40 percent top rate. That leads a lot of owners to assume estate tax is someone else's problem. Then they look at the state.


• The state thresholds are dramatically lower. Massachusetts starts at $2 million. Oregon at $1 million. Illinois at $4 million. Washington near $3 million. New York sits at roughly $7.35 million with a "cliff" that eliminates the entire exemption if you exceed it by more than 5 percent.


• Inheritance taxes are a separate problem. Pennsylvania taxes transfers to adult children at 4.5 percent, siblings at 12 percent, and others at 15 percent — with no meaningful exemption. New Jersey, Kentucky, Nebraska, and Maryland have their own versions.


• If you plan to move, move early. Changing domicile is a facts-and-circumstances test, and high-tax states audit it aggressively. Establishing residency two years before a sale is a plan. Establishing it two months before is an invitation.


• Do your gifting before the business is worth what it is about to be worth. Transferring non-voting interests to a trust while the valuation is lower — and while discounts for lack of control and marketability still apply — moves future appreciation out of your estate at a fraction of the eventual cost. Once a letter of intent is signed, that window closes.


• Fund the liquidity. An irrevocable life insurance trust holding a properly structured policy keeps the death benefit outside the taxable estate and gives your heirs cash to pay the tax without a fire sale.

The Final Year: Stress-Test the "What Ifs"

Every plan above assumes the sale happens as designed, on schedule, with you alive and healthy. Run the other scenarios: you die before closing, you become disabled, your co-owner dies, your buyer walks, your key executive leaves, the multiple compresses by two turns. Confirm your buy-sell agreement is funded, current, and consistent with your estate plan. A twelve-year-old buy-sell with a fixed price on the first page is a lawsuit waiting to happen.

Where RISR Fits

Most of this work stalls at the same place: the owner does not have a current, credible number for what the business is worth today, so every downstream decision — how much to gift, whether the retention plan is sized right, whether the after-tax proceeds actually fund retirement — rests on a guess.

We use RISR to close that gap. RISR pulls directly from tax returns and accounting data, normalizes earnings for owner compensation and one-time items, and produces an equity value using capitalization of earnings, EBITDA multiples, and revenue multiples. From there it becomes a planning instrument rather than a report:

• What does this business need to be worth for me to walk away and never worry about money?


• How much of my net worth is trapped in one illiquid asset — and what happens to my family if that asset stops working?


• What is the gap between today's value and my target, and which specific levers close it in five years?


• What is at risk if I die, become disabled, or lose a partner before the exit?

That last set of questions is the whole point. Planning for all of life's "What Ifs" is not a slogan — it is the difference between a valuation that sits in a drawer and a plan that survives contact with reality. Once the number is real, the retention plan, the tax structure, the gifting strategy, and the estate liquidity all get sized correctly instead of approximately.

Start the Clock

Five years is enough time to do all of this well. Two years is enough time to do some of it badly. If you are inside that window, the most useful thing you can do this month is work through this exit planning checklist and get a defensible baseline valuation and a written list of what stands between that number and the one you need.

Schedule a five-year readiness review and we will build your RISR valuation and What-If analysis together. You can also download our executive benefits planning guides or listen to The Perfect Plan® Podcast, where we walk through how these structures get reverse-engineered for real companies.

Schiff Executive Benefits has spent nearly two decades designing nonqualified deferred compensation, SERP, split dollar, phantom stock, and COLI-funded retention structures for closely held businesses. This article is for general education and is not legal, tax, or investment advice. Consult your own advisors before acting.

All you need to know about Long Term Care Products: how traditional LTC insurance, life insurance with an LTC rider, asset-based hybrids like Nationwide CareMatters and Lincoln MoneyGuard, and annuity-based LTC each work — plus how C corporations, S corporations and individuals deduct LTC premiums, and how to set it up.

If you have already decided that giving away real equity is off the table, you are asking a different question than most articles answer. You do not need another explanation of what phantom stock is. You need to know how to build one that survives an IRS review, does not wreck your cash flow, and actually keeps your right-hand person from taking a call from your competitor.

This guide is that build. Below is the design sequence we walk business owners through when we create a phantom stock plan for business owners inside The Perfect Plan® framework — from picking the plan type, to setting the valuation formula, to funding the future liability so the payout does not come out of operating cash.

If you are still deciding between structures, start with our free Phantom Stock vs. Stock Options vs. Real Equity Checklist (free download) and come back here when you are ready to build.

This page is the step-by-step design walk-through. If you want the wider picture first — what phantom stock is, how units are valued, and how it compares with real equity — begin with our main guide to phantom stock plans.

Step 1: Pick the Plan Type — Full Value or Appreciation Only

This is the single decision that drives everything downstream, and most owners get it wrong by defaulting to whichever one their attorney drafted last.

Full-value phantom shares pay out the entire value of each unit at the triggering event. Grant an executive 1,000 units when the company is worth $500 per share, and if the company is worth $800 per share at payout, they receive $800,000. The full value transfers, including the value you already built before they arrived.

Appreciation-only units — functionally stock appreciation rights — pay only the growth above the value on the grant date. Same 1,000 units, same $500-to-$800 move, and the payout is $300,000. The executive is rewarded for the value they helped create, not the two decades of work you did before hiring them.

For most closely held companies, appreciation-only is the correct answer. It costs less, it is easier to defend to your other executives, and it aligns the incentive precisely where you want it: forward growth. Full-value grants make sense when you are recruiting against a public company that is dangling real RSUs, or when the recipient is a successor you genuinely intend to enrich.

A third option worth knowing: hybrid plans that pay appreciation on an ongoing basis and full value at a change of control. These reward year-over-year performance while reserving the life-changing number for the exit.

Step 2: Define the Valuation Formula Before Anyone Is Emotional

Here is where phantom stock plans die. The plan document says the payout is based on “fair market value of the company,” and five years later, the executive’s attorney and your CPA are $4 million apart on what that phrase means.

Your plan document must specify a repeatable, mechanical valuation method. The common approaches:

Formula valuation. A multiple of EBITDA, revenue, or book value, defined in the document. Example: 5.5x trailing twelve-month EBITDA, less funded debt, plus cash. Simple, cheap, predictable, and it lets the executive calculate their own number, which is a retention feature in itself.

Independent appraisal. A credentialed third-party valuation performed annually. More expensive, more defensible, and generally required if your plan is large enough to attract IRS attention.

Board determination with a defined methodology. Flexible, but the weakest position if it is ever challenged. If you use it, document the methodology, not just the conclusion.

Whichever you choose, address the edge cases in writing: What happens if you take on debt for an acquisition? If you sell a division? If a bad year drops the value below the grant price? A plan that does not answer these questions is a plan that will be renegotiated at the worst possible moment.

For help establishing a defensible number, see our business valuation resources.

Step 3: Build the Vesting Schedule — Your Actual Golden Handcuffs

Vesting is the retention mechanism. Everything else is compensation design; this is the part that keeps people.

Time-based (cliff or graded). Five-year cliff vesting is the most aggressive retention tool available — nothing vests until year five, and walking away in year four forfeits everything. Graded vesting, say 20% per year, is gentler and more common, but it creates a smaller reason to stay in any given year.

Performance-based. Units vest when the company hits defined milestones: a revenue threshold, an EBITDA target, a successful acquisition. This ties the reward to outcomes rather than tenure.

Rolling or evergreen grants. New units are granted each year with their own vesting clock, so the executive is always leaving something on the table. This is the design that produces the strongest long-term hold, and it is what we most often recommend for a key executive you intend to keep through your exit.

A note owners consistently underestimate: your vesting schedule needs to match your succession timeline. If you plan to sell in six years, a ten-year cliff is meaningless to a 58-year-old CFO and insulting to a 42-year-old VP of Sales. Work backward from your exit date. Our guide to how executive benefit needs evolve from startup to succession maps this out by company stage.

Step 4: Choose Your Triggering Events — Carefully, Because 409A Is Watching

A phantom stock plan is nonqualified deferred compensation, which means Internal Revenue Code Section 409A governs when payment can occur. This is not a formality. A 409A failure taxes the executive immediately on all vested amounts, adds a 20% additional federal tax, and adds premium interest — and it is the employee who gets hit, which makes it a retention catastrophe rather than a retention plan.

Under 409A, payment may generally be triggered only by a permitted event:

• Separation from service


• A specified fixed date or fixed schedule set at the time of deferral


• Change in control of the company


• Death


• Disability


• Unforeseeable emergency

Notice what is not on that list: “whenever the board decides,” “when the executive asks,” or “when cash flow allows.” Discretion is the enemy. Build the payment triggers into the document at the outset and follow them.

There is one meaningful exception worth designing around — the short-term deferral rule. If the payment is made within two and a half months after the end of the year in which it vests, it may fall outside 409A entirely. That works for annual appreciation payouts. It does not work for a plan designed to pay at a sale five years from now.

Also decide upfront how a payout is made: lump sum or installments. Installments over three to five years soften the cash flow hit and create a post-employment non-compete incentive, but the schedule must be locked in the original document.

For the full compliance picture, see our complete guide to IRC 409A compliance in 2026. If you suspect an existing plan already has a problem, we handle 409A corrections.

Step 5: Understand the Tax Treatment on Both Sides of the Table

For your executive: Phantom stock payouts are ordinary W-2 income, subject to federal, state, and payroll withholding. This is the honest trade-off you should disclose in the recruiting conversation — real equity held long enough can produce capital gains treatment, and phantom stock cannot. What phantom stock offers instead is no purchase price, no capital at risk, no personal guarantee, and no illiquid minority stake in a private company they cannot sell.

For you, the company: You receive a compensation deduction in the same year the executive recognizes the income, and in the same amount. This is a genuine structural advantage over an ESOP or a direct equity grant, and it is worth modeling. A $1 million payout at a 21% corporate rate is a $210,000 deduction landing in the same year as the expense.

Payroll tax timing deserves its own conversation with your CPA. Depending on how the plan is structured, FICA may be due at vesting rather than at payment under the special timing rule — which can produce a payroll tax bill years before any cash changes hands. Get this modeled before you sign, not after.

One item almost no one flags in advance: under ASC 718, phantom stock is a liability-classified award, remeasured at fair value every reporting period. As your company’s value rises, so does the compensation expense running through your P&L — and it moves with your valuation, not with a fixed schedule. If you have a bank covenant tied to EBITDA or net income, model this before you sign. We have seen well-designed retention plans create genuinely awkward lender conversations.

Step 6: Solve the Funding Problem Before It Becomes a Cash Flow Problem

This is the question every owner eventually asks: if this works, I will owe my executives a large pile of cash at exactly the moment I most want cash. Where does it come from?

An unfunded phantom stock plan is a promise backed by future operating cash. That is fine at a $50,000 liability and genuinely dangerous at $3 million — particularly if the trigger is a sale, because a buyer will treat that obligation as a reduction of your proceeds, dollar for dollar.

The most common institutional answer is Corporate Owned Life Insurance (COLI). The company purchases and owns policies on the covered executives, with cash value accumulating on a tax-deferred basis. When the payout comes due, the company has an asset sitting against the liability instead of a hole in the operating account. Because the company owns the policy, the death benefit can also recover the plan’s total cost over time — which is the difference between a benefit that is an expense and a benefit that is an investment. Designed well, the plan approaches full cost recovery.

Two compliance items are non-negotiable if you go this route: IRC 101(j) notice and consent requirements must be satisfied before the policy is issued, and the funding vehicle must remain a general corporate asset — informally funded, not formally set aside — or you create constructive receipt and lose the tax deferral you were trying to protect.

Learn more about how COLI works as a cost recovery vehicle.

Step 7: Get the Documentation and Filings Right

The plan document is the whole plan. Verbal understandings and term sheets are how disputes start. At minimum, your document needs:

• Number of units granted and the grant date value


• Full-value or appreciation-only designation


• The valuation methodology, stated with enough specificity to be replicated


• Vesting schedule and forfeiture conditions


• Permitted payment triggers and the payment form


• Treatment on death, disability, termination for cause, and voluntary resignation


• Anti-dilution and adjustment provisions for recapitalizations or distributions


• Amendment and termination authority — and its limits

Do not skip the ERISA analysis. Depending on structure, a phantom stock plan may be treated as a top-hat plan that primarily benefits a select group of management or highly compensated employees, which carries a Department of Labor filing obligation within 120 days of adoption. It is a short filing. Missing it is an unforced error with real consequences. See our guide to the top hat plan filing deadline.

The Five Mistakes We See Most Often

1. Vague valuation language. “Fair market value as determined by the board” is not a formula. It is a future lawsuit.


2. Granting too widely. Phantom stock is a top-hat tool for a select group. Extending it broadly can jeopardize the ERISA exemption and dilute the psychological value for the people who actually matter.


3. No funding plan. The liability grows precisely as fast as your success does. That is the design working, and it needs an asset behind it.


4. Ignoring the P&L impact. Liability-classified awards create earnings volatility. Your lender and your CFO should both see the model before adoption.


5. Treating it as a document instead of a conversation. An executive who does not understand the plan is not retained by it. Research on executive benefits consistently shows a wide comprehension gap — a benefit your key people cannot explain is a benefit that is not doing its job. Build an annual statement that shows each participant their current unit value.

Is a Phantom Stock Plan Right for Your Company?

The profile that fits: a privately held company with meaningful enterprise value, one to five genuinely key executives whose departure would materially damage the business, an owner who wants to retain full voting control, and a succession or sale horizon within roughly three to ten years.

The profile that does not fit: companies looking to reward broad-based employee populations, businesses with no reliable way to establish enterprise value, or owners who are actually ready to transfer real ownership — in which case you should be evaluating an ESOP or a direct equity sale.

Phantom stock also does not have to stand alone. It sits well alongside a SERP for retirement security, a Section 162 bonus plan for portable death benefit, or a REBA when you want golden handcuffs with a personally owned asset attached. Most of the plans we design are combinations, because most retention problems have more than one moving part. Our executive benefits guide for business owners covers how the pieces fit together.

Frequently Asked Questions

How much does it cost to set up a phantom stock plan?

Design and documentation costs vary with complexity, but the meaningful cost is the future payout itself — which is why the funding conversation matters more than the setup fee. A well-designed plan using COLI as a cost recovery vehicle can approach full cost recovery over the life of the arrangement.

Does phantom stock dilute my ownership?

No. No shares are issued, your cap table is unchanged, and participants receive no voting rights, no board seats, no inspection rights, and no claim on ownership. You retain complete control.

How is phantom stock taxed?

Payouts are ordinary income to the executive, subject to normal withholding. The company takes a compensation deduction in the same year and the same amount. There is no capital gains treatment, because no capital asset is transferred. Payroll tax timing depends on plan structure and should be modeled in advance.

What happens to phantom stock if I sell the company?

That depends entirely on how you drafted it. Most plans define a change of control as a triggering event, accelerating vesting and paying participants out of the transaction proceeds. Buyers will treat this as a reduction in what you receive, so the number belongs in your exit model years before the letter of intent.

Can an S corporation offer phantom stock?

Yes — and it is one of the strongest arguments for the structure. Because no second class of stock is created and no additional shareholder is added, phantom stock lets an S corp reward key people without threatening its S election or its shareholder limit.

What is the difference between phantom stock and stock appreciation rights?

The terms overlap heavily in practice. Phantom stock most often refers to full-value units, while SARs pay only appreciation above the grant date value. Many advisors, including us, use “phantom stock” as the umbrella term and specify full-value or appreciation-only in the document.

Do I have to give participants access to my financial statements?

No. This is one of the quieter advantages. Because participants are not shareholders, they have no statutory inspection rights. You control exactly what you disclose — though we recommend an annual unit statement, because a benefit no one can see is a benefit that is not retaining anyone.

Build It Right the First Time

A phantom stock plan is not a form you download. It is a valuation methodology, a vesting strategy, a 409A compliance structure, a funding vehicle, and a communication plan — and getting any one of them wrong turns a retention tool into a liability.

At Schiff Executive Benefits, we have spent nearly 65 combined years designing these plans for privately held companies and banks. We start with your goal, then reverse engineer the structure, then make sure the “feel” of the plan matches your culture and your intent. And we work alongside your CPA and attorney rather than replacing them.

Take the next step:

Schedule your Perfect Plan® initial meeting — a straightforward conversation about your key people, your timeline, and what a plan would actually cost.

Call (610) 292-9330 or email info@schiffbenefits.com

Free download: Phantom Stock vs. Stock Options vs. Real Equity — Comparison Checklist (PDF). Eighteen design questions answered side by side, plus a decision checklist you can work through with your CPA and attorney.

You built the company. Let’s make sure the people who help you run it have a very good reason to stay — without giving away a single share.

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Matt Schiff is President of Schiff Executive Benefits and host of The Perfect Plan® Podcast. He specializes in helping business owners navigate executive retention, nonqualified deferred compensation, and benefit security.

This article is for informational purposes only and does not constitute tax or legal advice. Plan design should be reviewed with your CPA and attorney. Securities offered through The Leaders Group, Inc. Member FINRA/SIPC.

Every business owner I sit down with eventually asks some version of the same question: "How do I make my best people think like owners without actually making them owners?" For most closely held companies, it comes down to phantom stock vs stock options vs real equity.

That question has more than one answer. And most of the confusion I see in the market comes from owners who have heard four different terms — stock options, restricted stock, SARs, phantom stock — used almost interchangeably by four different advisors. They are not the same thing. They do not carry the same risks. And picking the wrong one is expensive to unwind.

So let's put them side by side.

Start with the real question

Before weighing phantom stock vs stock options (or anything else), get clear on what you are actually trying to solve. In my experience it is almost always one of three things:

1. Retention. You have one to three people whose departure would genuinely hurt, and you want a reason for them to stay.


2. Alignment. You want their financial outcome tied to enterprise value, not to this year's revenue number.


3. Succession. You are building toward an exit and you need a management team that survives the transaction.

The instrument you choose should follow from the answer. If you're not sure which of these is driving you, my pillar piece on creating an ownership feel without giving away the farm walks through that diagnostic in more depth.

The four main options

Real equity (restricted stock or direct grants)

The executive becomes an actual shareholder. They get a certificate, a seat at the cap table, and, depending on your governance documents, voting rights. Could be done through Restricted Stock Units.  For more information on RSU's: Click Here

Upside: Nothing signals commitment like the real thing. It's also the cleanest story to tell a recruit.

Downside: Dilution is permanent. You inherit minority shareholder obligations, information rights, and fiduciary duties. Every strategic decision now has an audience. And if that person leaves — or divorces, or dies — you are living inside your buy-sell agreement, hoping you drafted it well.

Best fit: True partnership tracks in professional firms, or a co-founder who was always going to be a co-founder.

Stock options

The executive gets the right to buy shares later at today's price.

Upside: No cash outlay for the company at grant. Genuine upside participation.

Downside: In a closely held company, options are often a promise the executive can't cash. There's no market for the shares. Exercising means writing a check for stock they cannot sell. Meanwhile you still face eventual dilution, and you carry the valuation and administrative burden the whole time.

Best fit: Companies with a realistic liquidity path — a planned sale, a strategic buyer, or a market for the shares.

Stock appreciation rights (SARs)

A cash (or stock) payment equal to the growth in share value from grant to exercise. No purchase required.

Upside: Pure upside participation with no check to write and no cap table change.

Downside: SARs reward appreciation only. If your company is a stable, profitable, slow-growth enterprise, a SAR may pay very little even though the executive is doing exactly what you hired them to do.

Best fit: Growth-stage companies where enterprise value is the scoreboard.

Phantom stock

A contractual promise to pay cash in the future, tied to the value of a notional number of shares. No stock is issued. No dilution. No voting rights.

Upside: You keep 100% of control while the executive's economics move with yours. The plan is private — you are not publishing your cap table to your management team. Design is flexible: full value or appreciation only, vesting on time or performance, payment at a liquidity event or on a schedule.

Downside: It is a company liability, not a share of the company. That liability needs funding (more on that below), and the payout is ordinary income to the employee rather than capital gain.

Best fit: Closely held businesses where the owner is not ready — and may never be ready — to share the cap table. This is the category most of my clients land in, which is why I wrote the full phantom stock overview as a standing resource.

Phantom stock vs stock options vs real equity at a glance

	Real equity	Stock options	SARs	Phantom stock
Dilutes ownership	Yes	Yes, at exercise	No	No
Voting rights	Usually	At exercise	No	No
Employee cash required	Sometimes	Yes	No	No
Company cash required	No	No	At payout	At payout
Rewards total value	Yes	Appreciation only	Appreciation only	Your choice
Employee tax treatment	Often capital gain	Varies	Ordinary income	Ordinary income
Governed by IRC 409A	Generally no	Often exempt if structured properly	Often, depending on design	Yes
Reversible if it isn't working	Difficult	Difficult	Moderate	Easiest

That last row deserves more attention than it usually gets. Equity is close to permanent. A phantom plan is a contract you designed, and the next plan can be designed differently.

Two things owners underestimate

The funding problem. A phantom stock plan creates a future obligation — one of the biggest practical differences in phantom stock vs stock options, where the employee, not the company, puts up cash at exercise. If the company doubles, so does what you owe. Owners who ignore this end up successful and cash-poor at the same time. Properly structured corporate owned life insurance can pre-fund the liability and, in many designs, deliver full cost recovery over the life of the plan.

IRC 409A. Phantom stock is deferred compensation, and the IRS treats it accordingly. Vague valuation methods, flexible payment timing, or informal amendments can trigger immediate taxation to the employee plus a 20% penalty — a spectacular way to turn a retention tool into a resentment tool. Our 2026 guide to 409A compliance covers what the rules actually require.

Phantom stock vs stock options: how to choose

Ask three questions, in order:

1. Am I willing to have this person as a legal co-owner ten years from now? If no, you are choosing among SARs and phantom stock, and the conversation gets much simpler.


2. Do I want to reward total company value, or only the growth from here? Full-value phantom units reward the former. SARs and appreciation-only phantom units reward the latter.


3. How will I pay for it? If you don't have an answer, you don't have a plan yet — you have an intention.

Most closely held business owners who work through those three questions honestly arrive in the same place. They want the alignment without the entanglement. That is precisely what phantom stock was built to do, and it's the core of what we call The Perfect Plan®.

Ready to compare these against your actual numbers?

A side-by-side chart is useful. A design built around your valuation, your key people, and your exit timeline is better. If you'd like to see how each of these would look inside your business, schedule a conversation — bring your coffee and your questions.

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Matt Schiff is the President of Schiff Executive Benefits and the host of The Perfect Plan® Podcast. He specializes in helping business owners navigate the complex world of executive retention and benefit security.

Related Resources

• Phantom Stock: Creating an Ownership Feel Without Giving Away the Farm


• Phantom Stock: Technical Deep Dive into 409A and COLI Funding


• Supplemental Executive Retirement Plans (SERP)


• ESOP – Employee Stock Ownership Plan

The only certainty in business is change, and for the American executive the most daunting change is often the shifting sand of tax law. Nowhere is that more true than with 409A deferred compensation plans, where the rules governing how you reward your top performers matter as much as the rewards themselves. In a world where talent is the ultimate currency, a reward that triggers a massive tax penalty is not a reward. It is a liability.

This guide covers what Section 409A is, which arrangements it reaches, what a failure actually costs, how the funding and ERISA rules fit around it, and what changed for 2026. It is the technical companion to our complete guide to NQDC executive benefits, which covers plan design and selection rather than compliance. If you are earlier in the process and weighing whether an executive benefit plan is the right move at all, start with our executive benefits guide for business owners.

What Is IRC Section 409A?

At its simplest, IRC Section 409A is the set of federal tax rules governing nonqualified deferred compensation.

Before 2004, the rules around when an executive could defer pay — and when they had to take it — were comparatively loose. Following the corporate scandals of the early 2000s, Congress enacted Section 409A as part of the American Jobs Creation Act of 2004. The intent was to stop executives from manipulating the timing of income to avoid tax, or pulling money out of a plan just before a company hit trouble.

Section 409A dictates three things:

1. When you must decide to defer. Generally the election must be made in the year before the compensation is earned. For a new participant there is a narrow 30‑day window, and for certain performance‑based compensation a six‑month window.


2. When the money can be paid. The plan must fix a payment schedule or a permissible triggering event — separation from service, a specified date, death, disability, change in control, or unforeseeable emergency — at the outset.


3. No acceleration and no “haircuts.” An executive cannot simply change their mind and take the cash early, and the old practice of forfeiting a percentage in exchange for early access is not permitted.

Everything else in 409A practice follows from those three ideas. Most failures we see are not exotic. They are a missed election deadline, a payment trigger that was never defined precisely, or a plan document that says one thing while the payroll system does another.

What Types of Plans Does 409A Impact?

The reach of 409A is longer than most owners expect. It is not limited to retirement plans. It applies to almost any arrangement in which an employee has a legally binding right in one year to compensation payable in a later year.

Nonqualified deferred compensation and SERPs

Whether it is a 401(k) mirror plan or a supplemental executive retirement plan, if income is being deferred to a later date you are in 409A territory. This is the core of executive benefits, and it demands strict adherence to election timing, whether the deferral is the executive’s own or an employer‑funded discretionary credit. Mirror plans are especially relevant now that the 2026 401(k) elective deferral limit is $24,500, with an $8,000 catch‑up at age 50 and up. For an executive earning $400,000, a qualified plan alone barely moves the needle.

Phantom stock and stock appreciation rights

If you are giving key people the ownership feel without actual equity, through phantom stock or SARs, those plans have to be structured carefully. If the payout does not align with a 409A‑permissible trigger, the tax consequence lands on the executive you were trying to reward.

Severance agreements

Many owners are surprised that severance can trigger 409A. If the payout extends beyond the short‑term deferral window — generally two and a half months after the end of the year in which the right vests — the arrangement can be treated as deferred compensation. Separation agreements negotiated quickly, under pressure, are a common source of accidental exposure.

Bonuses and commissions

A bonus earned in one year but paid more than two and a half months into the next can inadvertently become a 409A arrangement. Without the right documentation, that accidental deferral becomes a compliance problem nobody intended to create.

The Cost of Getting It Wrong

In most tax scenarios, if the company makes a mistake, the company pays. Section 409A is the rare rule where the penalty falls almost entirely on the employee.

If the IRS determines a plan has failed — either a documentary failure in how it was drafted or an operational failure in how it was administered — the consequences compound:

• Immediate taxation. All amounts deferred under the plan, and under all similar plans of the same employer, become taxable at once, whether or not the executive has the cash in hand.


• A 20% additional tax. On top of ordinary income tax, the executive owes an additional 20% federal tax on the included amount.


• Premium interest. Interest is charged at the underpayment rate plus one percentage point, calculated from the year the amount first vested.


• State penalties. Several states add their own layer. California has historically imposed an additional state‑level penalty on 409A failures.

Consider what that means in practice. Telling your most valuable vice president that they owe a six‑figure tax bill today, on money they were not supposed to touch for another decade, is a retention event in the wrong direction. It is the precise opposite of what the plan was built to accomplish.

If a plan has already failed

A failure is not always fatal. The IRS maintains correction programs that can reduce or eliminate the penalty if the problem is caught and fixed in time — Notice 2008‑113 for operational failures and Notice 2010‑6 for document failures. Both are unforgiving about timing, which is why an annual review matters more than a perfect document. We cover the mechanics in detail in 409A corrections: fixing document and operational errors.

Split Dollar and REBA: Are They in 409A Scope?

One of the strategies we use most often is the restricted executive bonus arrangement, frequently built with a split dollar structure. Owners reasonably ask whether 409A applies.

The answer depends on how the arrangement is built. Loan regime split dollar, where the company lends the executive the premium for a life insurance policy, is generally outside 409A because the advances are treated as loans rather than deferred compensation. But if the arrangement includes a promise to forgive the loan later, or provides a fixed payout that functions like a pension, it can cross into 409A jurisdiction.

This is why a cookie‑cutter template is a poor idea here. If a split dollar program has never been reviewed for 409A exposure, the golden handcuffs can become a liability for the executive they were meant to retain.

IRC 101(j): Keeping the Funding Tax‑Free

Many companies fund deferred compensation liabilities with corporate‑owned life insurance. COLI is efficient: cash value grows tax‑deferred, and the death benefit can eventually recover the company’s cost. To keep that death benefit tax‑free, the employer has to satisfy IRC §101(j).

Compliance is simple in theory and missed often in practice. It requires all of the following, before the policy is issued:

• Notice. The employee must be notified in writing that the employer intends to insure their life, and of the maximum face amount for which they could be insured.


• Consent. The employee must consent in writing to being insured, and acknowledge that coverage may continue after employment ends.


• Timing. Notice and consent must both be completed before issue. This cannot be cured afterward.

Failure to satisfy §101(j) converts a tax‑free death benefit into taxable income to the employer. When we review an existing COLI portfolio, the notice and consent file is the first thing we ask for, because it is the one defect that cannot be fixed retroactively. Our COLI FAQs cover the funding side in more depth.

ERISA and the “Top‑Hat” Lane

Although NQDC plans are nonqualified, they remain subject to parts of the Employee Retirement Income Security Act. To avoid ERISA’s funding, vesting and participation requirements, an NQDC plan must qualify as a top‑hat plan.

A top‑hat plan is maintained primarily to provide deferred compensation for a select group of management or highly compensated employees. To hold that status, the sponsor should:

• Limit participation to employees who genuinely have the position and bargaining power to influence the design of their own arrangement.


• File a top‑hat statement with the Department of Labor within 120 days of adopting the plan.


• Keep the group small as the company grows. Eligibility that drifts downward over time is one of the more common ways this exemption is quietly lost.

Staying in the top‑hat lane preserves the flexibility that makes NQDC attractive in the first place. Without the exemption, your executive plan would have to follow the same rigid rules as your broad‑based 401(k).

What the One Big Beautiful Bill Act Changed for 2026

The landscape shifted with the One Big Beautiful Bill Act, signed in July 2025. Two changes matter directly for deferred compensation, and both apply to tax years beginning after December 31, 2025.

Public companies: the aggregated group under §162(m)

Section 162(m) caps a publicly held corporation’s compensation deduction at $1 million per covered employee. The Act replaced the prior affiliated‑group approach with a statutory aggregated group definition, and added rules allocating that single $1 million limit among members of the group based on what each paid the employee.

The practical effect is that compensation can no longer be spread across related entities to multiply deductions. For organizations that relied on that structure, the loss of deduction on cash compensation makes properly designed deferred compensation more valuable, not less.

Tax‑exempt organizations: the broader §4960 excise tax

The effect on tax‑exempt employers is more significant. Section 4960 imposes a 21% excise tax on remuneration over $1 million. Previously it reached only the five highest‑paid employees. Under the Act, it now reaches compensation paid to any employee or former employee who was employed in a tax year beginning after December 31, 2016 — whether or not that person would have been a covered employee under the old rule.

For a nonprofit, this turns a deferred compensation distribution into a potential excise tax event years after the executive has left. Because deferred amounts are often paid in a single year, a distribution can push an individual over $1 million in a year when their cash salary was modest. We work through the nonprofit case specifically in 457(b) vs 457(f): nonprofit deferred compensation.

Understanding what counts as recognized compensation is the key to both. For public companies it is about managing the corporate deduction. For tax‑exempt organizations it is about avoiding an excise tax bill that would otherwise have funded the mission.

Where Our Technical Perspective Comes From

I am Matt Schiff, and for over two decades I have worked on these structures. In 2003 and 2005 I served as a member of the AALU’s NQDC Committee alongside Michael Goldstein. In that role I was part of the industry dialogue with the IRS and Treasury while the regulations governing 409A and 101(j) were being written, and I contributed technical input during that process.

That matters because it is the difference between reading a regulation and understanding what it was trying to accomplish. The gray areas in 409A are where plans succeed or fail, and intent is often the only guide.

On The Perfect Plan® Podcast I sat down with Dan Hogans, who was at the U.S. Treasury Department and worked on the 409A regulations, to talk through the regulatory history and how these rules interact with split dollar and corporate structures. You can watch that conversation here. If you want the reasoning behind the rules rather than a restatement of them, it is the best hour we have recorded.

The Five “What Ifs”

Compliance is the floor, not the goal. When we sit down with an owner, we start with the questions that actually define what happens to the business:

1. Succession. Are you prepared to be in business with a widow?


2. Buy‑out. Is there a clear, funded plan for a business buy‑out?


3. Retention. What happens if your top talent leaves for a competitor?


4. Efficiency. Can you replace a senior executive at a cost you have actually budgeted for?


5. Security. Is your team — or are you — at risk of running out of money in retirement?

A plan that answers those five questions and also complies with 409A is worth building. A plan that complies with 409A and answers none of them is just paperwork.

How We Build It

We do not sell products off a shelf. We reverse‑engineer the solution from the goal backward, and we do it alongside the advisors you already trust — your accountant, your attorney and your TPA. Our role is the technical bridge between what you want the plan to do and what the code allows it to do.

That collaboration is deliberate. An executive benefit plan that conflicts with your existing tax position or your buy‑sell agreement is not a benefit. It is a future problem with a funding schedule. We would rather spend an hour with your CPA at the design stage than explain a correction filing later.

Compliance is also not a one‑time event. Plans drift. Eligibility expands, payroll systems get replaced, a payment gets made a quarter early because someone was trying to be helpful. An annual review is the least expensive part of this entire exercise.

Frequently Asked Questions About 409A

What happens if a 409A plan fails?

All deferred amounts under that plan and similar plans become immediately taxable to the executive, who also owes an additional 20% federal tax plus premium interest at the underpayment rate plus one percentage point. Some states add their own penalty. The employer’s exposure is generally limited to reporting and withholding obligations, which is why 409A is unusual among tax rules.

Who does Section 409A apply to?

It applies to service providers with a legally binding right to compensation payable in a later year. That includes employees, and also directors and certain independent contractors. It is not limited to the five highest‑paid people or to public companies.

Is a 401(k) subject to 409A?

No. Qualified plans, including 401(k) and 403(b) plans, are excluded from 409A. The rule exists for nonqualified arrangements. A 401(k) mirror plan, despite the name, is nonqualified and is fully subject to 409A.

When must a deferral election be made?

Generally by December 31 of the year before the year in which the compensation is earned. Newly eligible participants have 30 days from first becoming eligible. Certain performance‑based compensation can be deferred up to six months before the end of the performance period.

Does 409A apply to severance pay?

It can. Severance paid within the short‑term deferral window, generally two and a half months after the end of the year in which the right to it vests, is usually outside 409A. There are also separation‑pay exceptions tied to a multiple of compensation. Severance that is paid out over a longer period often is subject to 409A, and the agreement needs to be drafted accordingly.

Can a 409A failure be corrected?

Sometimes. IRS Notice 2008‑113 addresses operational failures and Notice 2010‑6 addresses document failures. Both impose strict deadlines, and relief generally shrinks the longer the problem goes undetected. Correction in the same year as the error is far cheaper than correction two years later.

Is deferred compensation protected if the company goes bankrupt?

No. An NQDC plan is an unsecured promise to pay, and that is a structural requirement rather than an oversight. If the assets were formally set aside for the executive’s benefit, the deferral would not work for tax purposes. Participants are general creditors. This is the single most important thing an executive should understand before deferring a large share of their pay.

What is the difference between 409A and a 409A valuation?

They are related but distinct. This article concerns deferred compensation timing rules. A “409A valuation” is the independent appraisal a private company obtains to set the fair market value of its common stock, so that stock options are not granted below fair market value and do not create a 409A problem. Same statute, different application.

Next Steps

If you want to know how your current program holds up against the 2026 landscape, or you are designing one from scratch, there are three useful places to start:

• Understand what is at stake. Use our RISR valuation tool to establish what the business is actually worth before deciding what to protect.


• Review the design options. Our guide to NQDC executive benefits covers plan types, funding and selection. If you are choosing between structures, SERP vs NQDC is the shorter read.


• Have the conversation. Book a meeting and we will walk your existing documents with you.

Sit back, grab your coffee, and let’s plan for the future together. Let’s make sure your plan is more than a promise — let’s make it The Perfect Plan®.