What Happens to Phantom Equity When an Employee Leaves?

What Decides Whether a Departing Employee Keeps Phantom Equity?

The plan document and the award agreement decide, because phantom equity is a contract right to be paid rather than ownership. Minnesota courts can treat an employer’s written compensation terms as a unilateral contract: the employer states its terms, and the employee accepts by working. Under that doctrine, as Hall restated it, the offer “must be definite in form and must be communicated to the offeree.” In Hall v. City of Plainview, 954 N.W.2d 254 (Minn. 2021), the Minnesota Supreme Court said that “once an employee performs work in accordance with the unilateral offer of the employer, the employee earns his compensation,” and for that period of work “the employer cannot refuse to pay that compensation.”

The same terms can attach conditions to the pay. In Lee v. Fresenius Medical Care, Inc., 741 N.W.2d 117 (Minn. 2007), an employee handbook denied payment for unused paid time off to employees terminated for misconduct. The court enforced that condition, holding that employers and employees may agree to “a contract provision that attaches conditions to the right to accrued vacation” pay. Both cases involved paid time off, not equity. Lee rested on paid time off being “entirely a creature of contract,” and it approved “reasonable conditions on benefits at the time those benefits are earned.” Hall states the general rule: an employee who performs under the employer’s terms earns the compensation those terms promise.

Hall also shows the cost of general language. The handbook said its policies “should not be construed as contract terms,” and the court held that this general disclaimer did not unambiguously override a specific payout term. It said an employer that wanted to withhold earned pay “should have been more precise and clear about that intent.” I suggest writing each departure outcome into the plan in specific terms, because in Hall a general disclaimer did not, as a matter of law, defeat a specific payout provision.

How Do Vesting and the Reason for Leaving Change the Payout?

A phantom plan can treat a departure differently depending on whether units have vested and why the employee left, and a court reads those categories as the plan defines them. Unvested units are units the employee has not yet earned under the vesting schedule. Vested units are units the plan treats as earned, subject to any forfeiture terms the plan also states.

The plan in Emmenegger v. Bull Moose Tube Co., 197 F.3d 929 (8th Cir. 1999) shows the structure. Vested shares paid a higher redemption value tied to earnings on events such as termination without cause. “If a participant were to be terminated for cause or to resign voluntarily,” the court explained, the shares were redeemed only for book value, a lower figure. Terms like these are known as good leaver and bad leaver terms; see my page on bad leaver clauses in equity agreements.

The cause decision is where these plans are tested. In the same case’s later appeal, Emmenegger v. Bull Moose Tube Co., 324 F.3d 616 (8th Cir. 2003), the company’s board found two executives were terminated with cause, which cut their payout to book value. The plan let the board act “in the reasonable exercise of its discretion in good faith.” The Eighth Circuit affirmed a jury’s finding that “the board did not act reasonably or in good faith when it decided that Emmenegger and Ritzie were terminated with cause,” citing evidence of “the Company’s financial incentive to avoid paying the men redemption value for their PSP shares.” That plan belonged to a Missouri company, and the claims were tried as state-law contract claims in federal court.

Ambiguous terms carry their own risk for the company that drafted them. Staffing Specifix, Inc. v. TempWorks Management Services, Inc., 913 N.W.2d 687 (Minn. 2018) was a dispute between two businesses with no claim of unequal bargaining power. The court stated its approach for cases “involving parties of relatively equal sophistication and bargaining power.” The Minnesota Supreme Court held: “Only if a preponderance of the evidence does not prove the parties’ intent should the jury construe ambiguous terms against the drafter.” I suggest defining cause by listing specific acts and naming who decides, because under that holding, between equally matched parties, a vague term can be construed against the drafter when the evidence does not prove intent. Phantom units differ from real shares, which raise separate repurchase rights for actual shares after termination.

When Does Minnesota’s Final-Pay Law Reach a Phantom Payout?

Minnesota’s final-pay statutes decide when earned pay must be paid; the plan decides whether a phantom payout has been earned. Under Minn. Stat. § 181.13, “When any employer employing labor within this state discharges an employee, the wages or commissions actually earned and unpaid at the time of the discharge are immediately due and payable upon demand of the employee.” If those amounts “are not paid within 24 hours after demand,” the employee may collect “a penalty equal to the amount of the employee’s average daily earnings at the employee’s regular rate of pay or the rate required by law, whichever rate is greater, for each day up to 15 days, that the employer is in default, until full payment or other settlement, satisfactory to the discharged employee, is made.”

The demand has one formal requirement. It “must be in writing but need not state the precise amount of unpaid wages or commissions,” so a short written note from a departing manager can start the clock for amounts that are earned and unpaid.

The Minnesota Supreme Court limits what the statute does. Lee held that “section 181.13(a) is a timing statute, mandating not what an employer must pay a discharged employee, but when an employer must pay a discharged employee.” Hall confirmed after the statute’s 2013 amendments that it remains “a timing statute that does not create a substantive right to recover compensation independent of a contract or some other applicable legal authority providing for such compensation.” Lee treated paid time off as wages under the statute, but my research did not identify a Minnesota appellate decision deciding whether a phantom equity payout is “wages or commissions” under it. I suggest stating in the plan when units are earned and when payment is due, because those terms are what Lee and Hall look to in deciding what was owed at discharge.

An employee who resigns is covered by Minn. Stat. § 181.14, subd. 1, under which “the wages or commissions earned and unpaid at the time the employee quits or resigns shall be paid in full not later than the first regularly scheduled payday following the employee’s final day of employment, unless an employee is subject to a collective bargaining agreement with a different provision.” The same subdivision lets payment wait when the last day falls shortly before a payday: “If the first regularly scheduled payday is less than five calendar days following the employee’s final day of employment, full payment may be delayed until the second regularly scheduled payday but shall not exceed a total of 20 calendar days following the employee’s final day of employment.” Under subdivision 2, “Wages or commissions not paid within the required time period shall become immediately payable upon the demand of the employee,” and a penalty follows “If the employee’s earned wages or commissions are not paid within 24 hours after the demand,” as with a discharge.

An employee who handled company money gets a different clock. For an employee who was “entrusted with the collection, disbursement, or handling of money or property,” subdivision 4 gives the employer time to audit, whether the employee was discharged or quit. It provides that “the employer shall have ten calendar days after the termination of the employment to audit and adjust the accounts of the employee before the employee’s wages or commissions shall be paid as provided in this section,” and that “the penalty herein provided shall apply in such case only from the date of demand made after the expiration of the period allowed for payment of the employee’s wages or commissions.”

A good-faith tender limits a disputed claim. When the employer disputes the amount and tenders what it in good faith believes is due, subdivision 3 provides that “the employer shall not be liable for any sum greater than the amount so tendered and interest thereon at the legal rate.” That protection ends “unless, in an action brought in a court having jurisdiction, the employee recovers a greater sum than the amount so tendered with interest thereon.”

How Does Section 409A Limit When a Departure Payout Can Be Made?

A phantom payout made on or after a departure can be deferred compensation under Section 409A of the Internal Revenue Code, which limits payment to events the statute lists and the plan fixes in advance. Under the Treasury regulation, 26 C.F.R. § 1.409A-1(b)(4), “A payment is a deferred payment if it is made pursuant to a provision of a plan that provides for the payment to be made or completed on or after any date, or upon or after the occurrence of any event, that will or may occur later than the end of the applicable” short-term deferral period that follows vesting. The regulation also lets certain delayed payments keep short-term deferral treatment, and a payment that is deferred compensation must follow the timing rules below.

26 U.S.C. § 409A then sets three rules that matter at a departure:

1. Permitted events. Deferred amounts may be paid no earlier than events the statute lists, starting with “(i) separation from service as determined by the Secretary,” along with disability, death, a fixed time or schedule, a change in control as the regulations allow, and an unforeseeable emergency.
2. No acceleration. The plan must provide that it “does not permit the acceleration of the time or schedule of any payment under the plan, except as provided in regulations by the Secretary.”
3. The employee bears the cost of a failure. If the plan fails these rules, “all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in gross income for the taxable year to the extent not subject to a substantial risk of forfeiture and not previously included in gross income,” with interest and “an amount equal to 20 percent of the compensation which is required to be included in gross income.”

The regulation defines the departure event. Under 26 C.F.R. § 1.409A-1(h)(1), “An employee separates from service with the employer if the employee dies, retires, or otherwise has a termination of employment with the employer.” That definition has limits: “the employment relationship is treated as continuing intact while the individual is on military leave, sick leave, or other bona fide leave of absence” within the periods the regulation sets. A termination also turns on facts, because “Whether a termination of employment has occurred is determined based on whether the facts and circumstances indicate that the employer and employee reasonably anticipated that no further services would be performed after a certain date,” or that services would permanently drop below the level the regulation sets. The statute’s added delay for “specified employees” reaches “a key employee (as defined in section 416(i) without regard to paragraph (5) thereof) of a corporation any stock in which is publicly traded on an established securities market or otherwise.” I suggest naming the payment event and schedule in each award, because the statute bars the plan from allowing early payment and the tax cost falls on the employee. A sale of the company raises its own payout terms, covered in my page on phantom equity payouts on a change in control.

When Is a Phantom Equity Plan Governed by ERISA?

A phantom plan can be an ERISA pension plan if its payments are systematically deferred until employment ends, and it falls outside ERISA if it works as a bonus program. ERISA’s definition in 29 U.S.C. § 1002(2)(A) reaches a plan that “results in a deferral of income by employees for periods extending to the termination of covered employment or beyond.” The Department of Labor’s regulation, 29 C.F.R. § 2510.3-2(c), says the term “shall not include payments made by an employer to some or all of its employees as bonuses for work performed, unless such payments are systematically deferred to the termination of covered employment or beyond, or so as to provide retirement income to employees.”

The Eighth Circuit, the federal appeals court for Minnesota, applied that test to a phantom stock plan in Emmenegger (1999). Pointing out that “the PSP has allowed vested participants, such as the plaintiffs, at their option, to redeem their shares” while still employed, the court held “that the PSP is not a pension plan within the meaning of ERISA, but an excepted bonus program.” It explained that “The purpose of the vesting provision is to strengthen the connection between service and reward.” A plan that pays only after employment ends has the feature the definition names, so the answer turns on each plan’s terms and how it operates.

The classification decides which law governs a dispute. In Emmenegger, the district court first dismissed the executives’ state-law contract claims as preempted by ERISA. The claims returned as contract claims only after the Eighth Circuit held: “Since the PSP is not an ERISA plan, there is no ERISA preemption of state-law claims relating to that plan.” The classification can also decide whether units may be forfeited. ERISA’s participation and vesting part, 29 U.S.C. § 1051, does not apply to “a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees” or to the other plans it lists. For a plan it covers, 29 U.S.C. § 1053(a) provides that “Each pension plan shall provide that an employee’s right to his normal retirement benefit is nonforfeitable upon the attainment of normal retirement age and in addition shall satisfy the requirements of paragraphs (1) and (2) of this subsection,” and paragraph (2) is met when, after the years of service it sets, an employee “has a nonforfeitable right to 100 percent of the employee’s accrued benefit derived from employer contributions,” or holds the percentage its graded table sets.

A phantom plan that is an ERISA plan has a reporting option written for executive plans. 29 C.F.R. § 2520.104-23 covers a plan maintained “primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees” whose benefits “are paid as needed solely from the general assets of the employer,” or through employer-paid insurance. Such a plan meets ERISA’s reporting rules by “Filing a statement with the Secretary of Labor that includes the name and address of the employer,” within the period that regulation sets, and by “Providing plan documents, if any, to the Secretary upon request as required by section 104(a)(6) of the Act.” “Only one statement need be filed for each employer maintaining one or more of the plans described in paragraph (d) of this section.” Securities questions in these plans are covered in my page on securities law traps in executive phantom equity plans.

How Do Courts Treat Forfeiture for Misconduct or a Broken Promise After Departure?

A Minnesota court can enforce a clearly stated condition on pay, as in Lee, but it may excuse a condition that was not a material part of the deal when enforcing it would cause a disproportionate forfeiture. In Capistrant v. Lifetouch National School Studios, Inc., 916 N.W.2d 23 (Minn. 2018), a retiring territory manager’s contract made a post-employment residual commission depend on promises in a restriction-against-competition paragraph, including returning company property immediately. He returned it about three months late, and the employer refused to pay.

The Minnesota Supreme Court wrote, “We look with disfavor on forfeitures of all kinds,” and it drew guidance from the Restatement of Contracts. Under that rule, “To the extent that the non-occurrence of a condition would cause disproportionate forfeiture, a court may excuse the non-occurrence of that condition unless it was a material part of the agreed exchange,” as the court quoted it. The test has a limit that protects employers: “if the occurrence of the condition is a material part of the agreement, then the proportionality analysis is not applied and the forfeiture cannot be prevented,” the court explained. The court found the contract supported conflicting inferences about materiality, partly because “the amount of the residual commission is determined based on Capistrant’s sales during his last year with Lifetouch,” and sent the case back for the trial court to decide.

Capistrant involved a 28-year contract and millions in commissions, and the court said it did not need to decide whether to adopt the Restatement rule for all purposes. Lee shows the other side: a condition written plainly into the compensation terms was enforced. I suggest stating in the plan which post-departure promises are conditions of payment and why each matters to the company, because Capistrant turned on whether the condition was a material part of the exchange.

How Does Minnesota Treat Forfeiture When a Former Employee Competes?

The Minnesota Supreme Court has treated a clause that cancels deferred pay when a former employee competes as a restraint on competition. In Harris v. Bolin, 247 N.W.2d 600 (Minn. 1976), a profit-sharing plan let its trustee forfeit an employee’s vested account when he left to work for a competing advertising firm. The Minnesota Supreme Court reasoned that the employer’s contributions were “not a gratuity but constitute deferred compensation for services rendered,” and that for a noncompete and a forfeiture for competing, “the purpose of both arrangements is the same.” It held: “The forfeiture clause of the profit sharing plan and trust agreement constitutes an unlawful restraint of trade because it is not limited as to time, harm to the employer, or geographical area.”

Minnesota’s noncompete statute now sits on top of that rule. Minn. Stat. § 181.988, subd. 2, provides that “(a) Any covenant not to compete contained in a contract or agreement is void and unenforceable,” and the 2023 session law that enacted it applies it to contracts and agreements entered into on or after July 1, 2023. Subdivision 1 defines the term as an agreement that “restricts the employee, after termination of the employment, from performing” listed kinds of work, including “(1) work for another employer for a specified period of time.” The statute does not mention forfeiture by name, and my research did not identify a Minnesota appellate decision deciding whether it reaches a clause that cancels pay rather than barring the work.

Two other parts of the statute matter to a plan. Subdivision 2(c) keeps the rest of the agreement in force: “(c) Nothing in this subdivision shall be construed to render void or unenforceable any other provisions in a contract or agreement containing a void or unenforceable covenant not to compete.” Subdivision 2(d) adds that “a court may award an employee who is enforcing rights under this section reasonable attorney fees.” I suggest leaving competition out of a Minnesota employee’s forfeiture triggers, because Harris treated that forfeiture as a restraint on competition and the statute now voids covenants not to compete. Subdivision 1 provides that “A covenant not to compete does not include a nonsolicitation agreement, or agreement restricting the ability to use client or contact lists, or solicit customers of the employer,” and it also excludes “a nondisclosure agreement, or agreement designed to protect trade secrets or confidential information”; my page on protections that survive Minnesota’s noncompete ban explains those tools. A forfeiture tied to a nonsolicitation promise can still face the Capistrant review above.

What Release Rules Apply When a Payout Is Tied to a Separation Agreement?

When a company asks a departing employee to sign a release in exchange for a phantom payout, federal and Minnesota release rules decide whether the release holds. The federal age-discrimination statute’s waiver rules in 29 U.S.C. § 626(f) apply to an employer “who has twenty or more employees for each working day in each of twenty or more calendar weeks in the current or preceding calendar year,” under 29 U.S.C. § 630(b), and protect workers covered by 29 U.S.C. § 631(a): “The prohibitions in this chapter shall be limited to individuals who are at least 40 years of age.”

For those workers, a waiver of age claims is valid only if, among other requirements:

• New consideration. “the individual waives rights or claims only in exchange for consideration in addition to anything of value to which the individual already is entitled”
• Time to consider. “the individual is given a period of at least 21 days within which to consider the agreement,” or, “if a waiver is requested in connection with an exit incentive or other employment termination program offered to a group or class of employees, the individual is given a period of at least 45 days within which to consider the agreement”
• Time to revoke. “the agreement provides that for a period of at least 7 days following the execution of such agreement, the individual may revoke the agreement, and the agreement shall not become effective or enforceable until the revocation period has expired”

The consideration rule bears directly on phantom equity. If the plan already entitles the employee to a vested payout, that payout cannot be the consideration for the age waiver, so the release needs something more.

A release of Minnesota Human Rights Act claims adds a state rule. Under Minn. Stat. § 363A.31, subd. 2, a release of claims for past acts “may be rescinded within 15 calendar days of its execution,” in the statute’s words. The statute adds that “A waiving or releasing party shall be informed in writing of the right to rescind the waiver or release,” so the release itself should give that notice. The employee’s side has a form requirement too: “To be effective, the rescission must be in writing and delivered to the waived or released party by hand, electronically with the receiving party’s consent, or by mail within the 15-day period,” the statute provides. The statute excepts “a waiver or release given in settlement of a claim filed with the department or with another administrative agency or judicial body,” which is “valid and final upon execution” instead. My page on Minnesota severance agreement drafting covers the rest of the agreement.

What Should a Phantom Equity Plan Say About Termination?

A phantom equity plan should answer each departure question in its own text, so the company and the employee read the same terms when employment ends. One arrangement a prospective client described to me began as a few sentences from the owner: a share of the sale proceeds if the business was ever sold, described as long-term upside. The description said nothing about what happens to that share if employment ends before a sale, which is the question this page answers.

These terms each rest on a rule above:

1. Leaver categories. I suggest naming the outcome for unvested and vested units on resignation, termination without cause, termination for cause, death, and disability, because Lee and Hall look to the written terms to decide what was earned.
2. A defined cause standard. I suggest listing the acts that count as cause and naming who decides, because a cause term with no stated meaning leaves the dispute to evidence of intent and to the Staffing Specifix sequence. In Emmenegger, a plan that listed the acts and named the board still went to a jury, which found the board “did not act reasonably or in good faith when it decided” cause.
3. The value date and formula. I suggest fixing the valuation date and method for a departure payout, because Staffing Specifix, a dispute between parties of “relatively equal sophistication and bargaining power,” held that a jury may construe ambiguous terms against the drafter only if the evidence does not prove the parties’ intent.
4. The payment event and schedule. I suggest stating when a departure payout is earned and when it is paid, because § 181.13 turns on what is earned and Section 409A bars accelerating a deferred payment.
5. The ERISA position. I suggest deciding whether the plan is a bonus program, an unfunded deferred compensation plan for a select group of managers, or another ERISA pension plan, because the answer decides whether ERISA governs a dispute, whether ERISA’s vesting rules apply, and whether a statement must be filed.
6. Material conditions. I suggest stating which post-departure promises are conditions of payment and why, because Capistrant excuses only conditions that are not a material part of the exchange.
7. No competition trigger. I suggest relying on confidentiality and nonsolicitation terms rather than a forfeiture for competing, for the reasons in Harris and § 181.988.
8. A separate release payment. I suggest paying for any release with something beyond the vested payout, because the federal waiver rules require consideration beyond what the employee already is entitled to receive.

For the unvested side of the same question, see my page on forfeiture terms for unvested equity.

Planning Phantom Equity Departures Before They Happen

A Minnesota company decides what happens to phantom equity at a departure when it writes the plan, before any employee leaves. The plan’s terms define what was earned, and Minnesota courts disfavor forfeitures and review a forfeiture for competing as a restraint on competition. Sections 181.13 and 181.14 govern when earned pay is due. Section 409A fixes when a deferred payout may be made, and ERISA can apply if payment waits until employment ends. For related topics, see my Minnesota employment law page for employers. If you are preparing for a departure under a phantom equity plan, or drafting one, you can email me at [email protected] with a brief description of the plan and the departure, and I can start an intake and conflict check before you send any confidential documents.