Despite the mysterious name, phantom stock will be familiar to business owners using stock incentives or advisory shares to compensate employees and stakeholders.
In short, it’s a way of mirroring the incentives offered by more popular arrangements without the necessity of exchanging ownership and voting rights in a company.
In this article, we’ll touch on the benefits of equity-sharing agreements and the advantages of phantom stock plans and associated tax treatments.
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For help with phantom stock plans, or other business needs, indinero’s outsourced accounting services provide expert help at a more affordable rate than in-house help.
Benefits of Traditional Equity-Sharing Agreements
Today’s job market is highly competitive, particularly for companies hiring employees with specific skills and experience.
Stock options allow companies to compete for talent without committing limited cash resources.
Other benefits include:
- Motivation – Incentive stock options encourage employees to work towards the company’s success because they have a stake in its growth.
- Retention – By offering an attractive long-term incentive that vests over time, employees are encouraged to remain committed to the company.
- Tax Advantages – Both employees and employers can strategically time the exercise of stock options to minimize tax burdens.
- Flexibility – The grant date, exercise price, vesting date, and expiration date can be tailored to fit the particular circumstances of a given company.
What Is a Phantom Stock?
Phantom stock is an employee benefit that affords staff the financial benefits of stock ownership without owning shares.
Employees receive ‘phantom’ shares that track the market value of the company’s actual stock. When a triggering event occurs, “phantom shareholders” receive a payout.
Why Use Phantom Stock Instead of Traditional Equity Sharing Agreements?
In addition to the benefits of traditional arrangements, phantom stock offers a variety of benefits for both employees and employers:
- No Ownership Transfer – Since phantom stock doesn’t transfer actual equities, shareholders don’t need to be concerned about stock dilution or reductions in voting power.
- Simplified Administration – Equity sharing agreements are complex. In comparison, phantom stock plans are simpler to administer.
- Additional Flexibility – Cash is usually exchanged when phantom stock is exercised, but such agreements can also include provisions for bestowing actual stock instead. Circumstances change, and phantom stock offers versatility.
- Reduced Risk for Employees – Unlike traditional stock options, which may become worthless if the company’s stock price declines below the exercise price, phantom stock can be structured to guarantee employees a payout based on a predetermined value of phantom shares.
Types of Phantom Stock Agreements
The greatest benefit of phantom stock plans is their added flexibility. They usually compensate employees with cash instead of equity, and employers can also include a clause allowing each party to opt in to exchange equities. Predicting the future is impossible, and keeping one’s options open is valuable.
Here are some potential phantom stock agreements, each of which can be incorporated into your custom-tailored plan:
- Appreciation Only – Employees receive the cash equivalent of increases in a company’s stock value over time.
- Full Value – This version grants employees rights to the full value of a company’s stock upon vesting, regardless of whether it has increased or decreased in value.
- Performance Based – Payouts are tied to specific employee or company performance metrics,
- Tenure Based – This type vests over a predetermined period where employees receive cash upon completing the vesting period, regardless of other performance criteria.
- Change in Control – Company acquisition, merger, or sale can be included as a triggering event.
Phantom Stock Tax Treatment
Being granted phantom shares typically has no financial consequences for either employee or employer because it is only a contractual right to payment, not a payment itself.
In other words, phantom shares are taxed when exercised, not granted.
The second thing to note is that since they are deferred compensation plans, phantom stock agreements must adhere to IRS section 409A. This subject is too complex to cover in this blog post, so consider consulting indinero’s business tax services team for help.
Tax Impact on the Company
The employer is eligible for a tax deduction when an employee is paid. When the stock vests, the value of the phantom stock is included as wages taxable under the Federal Insurance Contributions Act (FICA).
Tax Impact on the Employee
When an employee receives compensation for their phantom stock, it is considered regular income and taxed at ordinary income tax rates.
Phantom Stock Plan Example
Let’s take a look at a fictional agreement between Acme Incorporated and Jon Doe:
- Acme grants Mr. Doe 100 units of phantom stock.
- The units vest over three years, with one-third vesting on the anniversary of the grant date.
- The value of the units is equivalent to the value of Acme stock on the vesting date.
- Upon vesting, Mr. Doe is entitled to receive cash or, with the consent of Acme, stock equivalent to the value of the units.
- The payout is subject to achieving certain performance metrics as detailed elsewhere.
- If Mr. Doe’s employment is terminated before the vesting date, any unvested units shall be forfeited.
- If Acme is merged, acquired, or sold, the Units shall fully vest, and Mr. Doe is entitled to receive their full value.
Practical Tips for Implementing a Phantom Stock Plan
There are many reasons to implement an equity compensation plan. It’s important to be clear on the goals you’re trying to accomplish, as well as communicate them with employees before it’s time to sign a contract.
Establishing Goals
Any time you offer stock options, you should have clear goals and intentions to measure these programs’ success.
Here are a few questions to consider before putting down your goals:
- Are you trying to reward key employees?
- Are you hoping to promote long-term retention?
- Are you trying to align interests with shareholders, employees, or both?
Structuring the Plan
Depending on your stated goals, your phantom stock plan will vary considerably.
A plan that seeks to reward key employees might be a generous one with short vesting terms. Conversely, one trying to promote long-term retention will include longer time horizons.
Communication
The best way to ensure your company, its employees, and shareholders are aligned is to communicate with them while writing a plan. It’s entirely possible to erroneously assume a stakeholder wants one thing while they actually want another, so be clear and proactive with your communication.
Conclusion
As the job market tightens, phantom stock is a flexible solution that combines the incentive-aligning power of equity compensation without the downside of ownership or voting right dilution for existing shareholders.
For help developing a phantom stock plan for your company, contact indinero’s outsourced accounting team today.
