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Phantom Stock Plan: What It Is, How It Works, 2 Types

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

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What Is a Phantom Stock Plan?

A phantom stock plan is an employee benefit plan that gives selected employees (senior management) many of the benefits of stock ownership without actually giving them any company stock. This type of plan is sometimes referred to as shadow stock.

Rather than getting physical stock, the employee receives mock stock. Even though it's not real, the phantom stock follows the price movement of the company's actual stock, paying out any resulting profits.

Key Takeaways

  • A phantom stock plan, or 'shadow stock' is a form of compensation offered to upper management that confers the benefits of owning company stock without the actual ownership or transfer of any shares.
  • By simulating stock ownership, without actually providing it, management ensures that equity does not become diluted for other shareholders.
  • Large cash payments to employees, however, must be taxed as ordinary income rather than capital gains to the recipient and may disrupt the firm's cash flow in some cases. 

How Phantom Stock Plans Work

There are two main types of phantom stock plans. "Appreciation only" plans do not include the value of the actual underlying shares themselves, and may only pay out the value of any increase in the company stock price over a certain period of time that begins on the date the plan is granted. "Full value" plans pay both the value of the underlying stock as well as any appreciation.

Both types of plans resemble traditional nonqualified plans in many respects, as they can be discriminatory in nature and are also typically subject to a substantial risk of  forfeiture  that ends when the benefit is actually paid to the employee, at which time the employee recognizes income for the amount paid and the employer can take a  deduction .

Phantom stock may be hypothetical, however, it still can pay out dividends and it experiences price changes just like its real counterpart. After a period of time, the cash value of the phantom stock is distributed to the participating employees.

Phantom stock , also known as synthetic equity, has no inherent requirements or restrictions regarding its use, allowing the organization to use it however it chooses. Phantom stock can also be changed at the leadership's discretion.

Phantom stock qualifies as a deferred compensation plan. A phantom stock program must meet the requirements set forth by the Internal Revenue Service (IRS) code 409(a). The plan must be properly vetted by an attorney, with all of the pertinent details specified in writing.

Phantom stock plans have a lot in common with traditional nonqualified stock plans.

Using Phantom Stock as an Organizational Benefit

Some organizations may use phantom stock as an incentive to upper management. Phantom stock ties a financial gain directly to a company performance metric. It can also be used selectively as a reward or a bonus to employees who meet certain criteria. Phantom stock can be provided to every employee, either across the board or distributed variably depending on performance, seniority, or other factors.

Phantom stock also provides organizations with certain restrictions in place to provide incentives tied to stock value. This can apply to a limited liability corporation (LLC) , a sole proprietor or S-companies restricted by the 100-owner rule.

The two types of phantom stock plans are "appreciation only," which doesn't include the value of the underlying shares, just the increase in stock over the amount of time the shares are held; and "full value," which pays the underlying value and the amount the stock increased while it was held.

Stock Appreciation Rights

Stock appreciation rights (SARs) are similar to a phantom stock-based program. SARs are a form of bonus compensation given to employees that is equal to the appreciation of company stock over an established time period. Similar to  employee stock options (ESO) , SARs are beneficial to the employee when company stock prices rise; the difference with SARs is that employees do not have to pay the  exercise price , but receive the sum of the increase in stock or cash.

Most commonly made available to upper management, SARs can function as part of a retirement plan. It provides increased incentives as the value of the company increases. This can also help ensure employee retention, especially in times of internal volatility, such as an ownership change or a personal emergency.

It provides a level of reassurance to employees since phantom stock programs are generally backed in cash. This can, in turn, result in higher selling prices for a business if a prospective buyer perceives the upper management team as being stable.

Internal Revenue Service. " Publication 5528 (6-2021): Nonqualified Deferred Compensation Audit Technique Guide ."

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9 frequently asked questions about phantom stock plans

How to pay incentive compensation based on company value.

This article was originally published on Oct. 12, 2020 and has been updated

Phantom stock plans can be a valuable method for companies that seek to tie incentive compensation to increases or decreases in company value without awarding actual shares of company stock.  Here are answers to nine frequently asked questions about phantom stock plans and what they could mean for your company.

1. What is a phantom stock plan?

A phantom stock plan is a deferred compensation plan that awards the employee a unit measured by the value of a share of a company’s common stock, or, in the case of a limited liability company, by the value of an LLC unit.

However, unlike actual stock, the award does not confer equity ownership in the company. In other words, no actual stock is ever awarded to the employee under a phantom stock plan. Instead, the employee is granted a number of phantom stock units, and the plan provides that each phantom stock unit is equal in value to one share of common stock.

2. Why might a company want to issue phantom equity instead of actual equity?

Phantom equity does not have some of the drawbacks associated with providing actual equity. Situations in which a company may not want to issue  actual equity  include:

  • A foreign parent may wish to award phantom stock units to executive employees of a U.S. subsidiary to avoid the complications of selling stock on a foreign exchange.
  • A U.S. parent may wish to incentivize executive employees of a subsidiary without awarding shares of parent stock to tie their incentive to the subsidiary level value rather than the parent level.
  • Equity grants may give rise to voting rights or unforeseen minority rights under state law.
  • Additional legal documents and agreements, such as a shareholder’s agreement, may have to be amended or drafted, increasing complexity and legal fees.
  • A company may wish that former employees do not own company stock after they separate from service.

3. How does a phantom stock plan work?

A company can grant an employee a designated number of phantom stock units or a percentage interest in the company’s value pursuant to a prescribed valuation method; this can be done once or multiple times. The phantom stock plan should indicate the number of phantom stock units or the participation percentage interest to be granted to the employee.

For example, the company could grant the employee a 5% interest initially and increase the interest to 10% after the employee completes five years of service.

Whether granted up front or over a period of years, the phantom stock units may either be immediately vested or subject to any vesting schedule determined by the company. For example, vesting may be cliff or graded, time-based, or based on the achievement of specified financial performance goals. 

In addition, special forfeiture provisions can be included in the phantom stock plan to eliminate the company’s obligation to make payments to an executive upon specified events (e.g., if the employee breaches non-compete restrictions in the plan or the employee’s employment is terminated for cause). 

4. How is the value of a phantom stock unit determined?

The value of a phantom stock unit may be measured by the value of a full share of company stock, or it may be based just on the appreciation in value during a specified time frame. (If based only on the appreciation, this is commonly referred to as a stock appreciation right.) The value may be a specified value, determined by an express written formula or determined by a third-party appraisal.

The method used for valuation should take into account adjustments that the parties agree are appropriate. For example, a company could exclude gain or loss attributable to operations or sales of certain divisions of the company. Other adjustments that might be considered include subtractions for capital investments made by the shareholders during the course of the plan, additions for any dividends paid to shareholders during this period, and the amount of accrued deferred compensation attributable to the phantom stock units themselves.

It should be noted that the value of the phantom stock units fluctuates from year to year as the value of the company changes. For example, if the company has a bad year and the value of its stock decreases, the value of the phantom stock also decreases. Thus, regardless of any vesting schedule, there is no locked-in value inherent in the phantom stock. 

In addition, companies should be aware that events outside the company’s control also affect its value if a third-party appraisal is used. For example, legislative increases or decreases in corporate tax rates may result in companies having more or less cash flow, accordingly (with all else being equal). Similarly, a major event like the coronavirus pandemic affects market values for many companies. Companies should consider the possibility of such unexpected fluctuations in value, regardless of whether it relies on a third-party valuation.

The phantom stock plan should specify what events should trigger, or give rise to, a valuation (i.e., what events should entitle the employee to receive benefits under the plan) and at what precise point the value of the phantom stock units should be determined.

Typically, the valuation will follow an event that triggers phantom stock unit payouts so that the amount of such payouts can be determined. Companies can choose what the triggers are—examples include a separation from service, a change in control, or a specified future date or fixed payment schedule. In most cases, a valuation is required upon the employee’s termination, death, or disability. In other cases, valuation may be required periodically, such as annually, or on a specific future date.

To the extent possible, any date specified for measuring the value at a triggering event should be based on practicalities consistent with the company’s business practices. For example, once a triggering event has been identified, the company should consider whether the value should be determined on the exact date of the triggering event; or whether it makes more sense to look forward or back to the nearest quarter or year-end, depending on what financial information may be needed to calculate value.

5. How does the executive receive value from the phantom stock?

The number of phantom stock units, vesting schedule, form of payment (i.e., lump sum or installments over a period of years), and triggering payment events are typically set forth in individual grant agreements. Actual payouts of the phantom stock units are usually deferred until a predetermined future date or until the employment relationship is terminated due to retirement, death, or disability.

The phantom stock plan must specify when the phantom stock unit payments should commence and at what point a valuation of the units is generally required, as described above. If payments are to be made in installments, the phantom stock unit plan or grant agreement should also specify whether interest will accrue on the unpaid installments.

When designing these provisions, the company should take into account possible phantom stock valuations and company cash flow. It should be noted that even if payments are made after the grantee terminates service, the nature of the payment is generally still treated as compensation for tax purposes and reported on Form W-2.

6. How is phantom stock treated for income tax purposes?

Phantom stock plans are deferred compensation plans and, as such, must be designed and documented to conform to the requirements of section 409A. For income tax purposes, if the plan is compliant with section 409A, the deferred compensation attributable to the phantom stock will not be subject to income taxation to the employee until it is actually paid to and received by, the employee.

At the time the payment becomes taxable, the company is entitled to a deduction in a corresponding amount (subject to general limitations under section 162 with respect to the amount being reasonable and not excessive). However, unlike actual stock for which the increase in value on a disposition may be eligible for favorable capital gains tax rates, phantom stock unit payouts are taxable to the employee at ordinary income tax rates.

To ensure these tax results occur, companies should ensure that the terms of the phantom stock plan are in compliance with section 409A prior to the plan becoming effective. A violation of the section 409A rules could cause immediate taxation, plus an additional 20% tax, as well as the assessment of penalties all prior to any actual receipt by the employee.

7. What are the payroll tax consequences of phantom stock?

For the Federal Insurance Contributions Act (FICA), deferred compensation is includible as wages in the later of either the year in which the related services are performed, or the year in which the deferred compensation becomes vested.

The vesting and forfeiture provisions contained in the phantom stock plan or individual grant agreement determine whether and when the executive’s rights are vested. As the phantom stock units become vested, the value of the phantom stock units is includible as wages subject to FICA taxes. This is the case even though the amounts are not subject to income tax until actually paid to the employee.

If the employee’s base pay (before adding in the phantom stock unit payment) exceeds the Social Security wage base, no additional Social Security tax would be assessed on the phantom stock payments. However, the company and the employee would each be subject to Medicare payroll tax since the Medicare tax is imposed on total wages, without any wage cap.

8. Can entities taxed as partnerships use phantom stock?

Although partnerships do not have common stock, as noted above, entities taxed as partnerships, including LLCs, can implement plans very similar to phantom stock plans. In the case of a partnership, however, the value of a phantom stock unit is tied to partnership equity value rather than common stock value. All other aspects of the plan would be the same. Because the phantom stock units are not actual equity in the partnership, such a plan should not raise any concerns over partners being considered employees.

9. What should a company consider when designing a phantom stock plan?

Because a phantom stock plan is a nonqualified deferred compensation plan, companies have a lot of flexibility in plan design as long as that flexibility is exercised before the plan becomes effective.

Companies should address the following when formulating aspects of the written plan:

  • What are the objectives of the plan?
  • What behavior or performance levels is the company trying to incentivize?
  • Who will be allowed to participate? (Consider current and future positions)
  • What percentage of the company’s value should be dedicated or reserved for this plan?
  • Should participants receive the base value of the phantom stock units, or only participate in growth over and above the base value?
  • Is the potential payment opportunity under the phantom stock plan in line with the company’s compensation and business objectives in three, five, 10, or 15 years given certain performance assumptions?
  • How frequently will phantom stock units be granted (e.g., a single upfront grant or annual grants)?
  • When will phantom stock units vest? If phantom stock units are awarded annually, will each new grant be subject to a fresh vesting schedule?
  • How will the phantom stock units be valued (i.e., based on a formula or an appraisal)?
  • How will the phantom stock units be valued in the event of a merger, consolidation, or a change in control of the company? How should a change in control be defined?
  • Will special vesting rules apply in the case of death, disability, or attainment of specified normal retirement age?
  • Will any funding mechanism be used to help the company meet “fund” its future obligations to pay the amount owed to recipients?
  • Should forfeiture provisions apply if the employee enters into competition with the company or is terminated for cause? How broadly or narrowly should the plan define what qualifies as cause for termination?
  • When should the value of the phantom stock units be paid out in cash (e.g., periodically every three to five years, upon termination of employment, only upon a future change in control, or, perhaps, other events)?
  • Should the payment be made in a lump sum or in installments over a period of years? If payments should be made in installments, over how many years?
  • During the installment payout period, should earnings be credited on the balance at a specified interest rate? If so, at what rate? Should the phantom stock units pending payment continue to participate in the growth in value of the company?
  • Does the phantom stock plan comply with section 409A?  The plan must be designed and documented to conform to section 409A. This may restrict some of the flexibility of the plan design.

Various equity compensation methods, including phantom stock units, can provide great incentive to the employees receiving them and the employer providing them by cultivating increased engagement that can boost company performance. The attributes of phantom stock units should be carefully considered to determine whether it is the  right incentive plan  to meet a company’s needs.

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phantom option plan

Phantom stock, explained

Phantom stock

In today's competitive job market, startups are constantly looking for ways to attract and retain top talent. One way to do this is by offering equity compensation, which can give employees a stake in the company's success. In some cases, traditional equity compensation plans, such as stock options or restricted stock, aren't possible (in particular when trying to issue to non-employees in certain countries, like India), may clash with company strategy, or too complex, especially if you want to issue equity across borders .

Enter phantom stock, a type of equity-based compensation plan that can be offered to employees, senior management, and service providers, instead of actual equity.

Phantom stock plans are a relatively new concept but they are quickly gaining popularity as a cost-effective and flexible alternative to traditional equity compensation.

In this guide, we will deep dive into the world of phantom equity, how they work, its advantages and disadvantages. We will also provide answers to some frequently asked questions about phantom stock plans and some best practices for startups who are considering using them.

Understanding phantom stock

What is phantom stock.

Phantom stocks are also referred to as phantom shares , phantom stock options , phantom equity , ghost shares , virtual shares , or shadow stock . Don't be confused when they're used interchangeably! There isn't a universal definition that applies to all cases. In general, as the terms suggest, the concept of phantom stock is simply a ghost or virtual stock that may appreciate (or depreciate) over time.

The concept is fairly straightforward: A phantom stock plan is a contractual agreement between the company and the employee or service provider, where the company promises to reward the phantom stockholder with the equivalent cash value of the company's actual stock at a future date.

Unlike traditional options or stock grants, phantom stock does not equate to actual ownership of company stock. Instead, they offer employees a hypothetical stake in the company's value, which is tied to the company stock's performance.

How does a phantom stock plan work

A phantom stock plan is less complex than traditional stocks precisely because it does not involve actual stock ownership. Instead, they create outcomes similar to stock option plans by incorporating a deferred cash bonus program. The agreement provides the employee with virtual shares which hold the right to a cash payment at a future event designated by the employer.

Let's break this down:

  • The company creates a pool of phantom stock that is tied to the value of the company's real shares.
  • The company then sets a vesting schedule, which is the time period during which the employees must remain with the company in order to receive the bonus. The company can also set a trigger event, like a milestone or a liquidity event.
  • When the vesting schedule is satisfied (including any trigger events being met), the company will pay the employees a cash bonus equal to the value of the phantom shares, based on the performance of the company's stock price.
  • If the company's stock price goes up during the vesting period, the value of the phantom shares also goes up, resulting in a larger cash bonus for the employees. If the stock price goes down, the value of the phantom shares decreases, resulting in a smaller bonus.

Phantom stock example

For example, if a company grants an employee 100 phantom stocks with a value of $10 per share, then the employee's total bonus would be $1,000 (100 shares x $10 per share). If the company's actual share price increases to $15 per share when the phantom shares are settled, then the employee would receive a payout of $1,500 (100 shares x $15 per share).

Now, this example changes depending on the types of phantom stock being used.

Two types of phantom stock plans

There are two types of phantom stock:

Appreciation only

Simply put, employees receive payouts based only on the increase in the value of the company stock. Or if the stock price goes down, employees do not receive anything.

Employees receive a cash bonus based on the full value of the company stock, including any appreciation in value. This type of phantom stock plan is less common than appreciation-only phantom stock.

It’s also worth noting here, that under this type of phantom plan, the employee will end up receiving money even if the company's share price goes down.

Appreciation only vs. full value, example

Assume an employee receives 200 phantom stocks with a starting price of $15. At a predetermined future date, the company will calculate the value of the company stock and pay the employee any positive difference.

Let's say the share price grows to $18.

In an "Appreciate Only" plan, the company will pay the employee the difference between the starting price and the new price ($18-$15) which is $3 (the 'Spread'). With 200 phantom stocks, the employee receives 200 x $3 = $600.

In a "Full Value" plan, the employee receives the value of the underlying shares as well as any appreciation that has occurred. Thus, referring to the above example, the employee would receive 200 (phantom stock) x $18 (appreciated value) = $3,600.

In contrast, let's say the share price goes down to $10.

In an "Appreciate Only" plan, the employee will not receive any compensation.

In a "Full Value" plan, however, the employee still receives the full value of the underlying shares. So, the employee would receive 200 (phantom stock) x $10 (depreciated value) = $2,000.

Still here? Let's keep going!

Who qualifies for phantom stock plans

Generally speaking, employees are the main recipients of phantom stocks. However, phantom stock can be issued to anyone that your company has a direct relationship with, such as directors and other third-party recipients (including contractors, service providers, or consultants).

As a phantom stock plan is simply a deferred cash incentive plan, it typically requires liquidity and your company to have accessible cash when the trigger event occurs. Due to this requirement, phantom stock is often considered for senior, top-performing, or key employees.

It is important to consider the cash-heavy venture of a phantom stock program and what works best for your company.

phantom option plan

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Equity incentive plans are crucial to the startup ecosystem but can be an overwhelming process for startup founders. Cake removes the complexity out of granting, vesting, and exercising equity compensation. Whether you're looking to issue stock options or phantom shares, Cake makes equity management simple, efficient, and globally possible.

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Drawbacks of phantom stocks.

There are potential drawbacks to consider when implementing a phantom stock plan.

  • Lack of ownership. Phantom equity does not give employees actual company stock ownership, which can be a disadvantage for some employees. Employees who are looking to invest in the company may prefer traditional equity compensation plans, such as actual stock through an ESPP, stock options, or RSUs, where they have actual ownership and decision-making influence (e.g. gain voting rights when the stocks vest).
  • Lack of liquidity. Unlike actual shares, phantom shares cannot be sold or transferred, so employees have to wait until there's sufficient liquidity at a future payment date or event to receive their reward.
  • Uncertainty. Since phantom shares are based on the performance of the company, employees may be unsure of the actual value of their shares until the actual payment date.
  • Taxes may be higher for employees. Much like a bonus, the cash received from phantom stock is taxed as ordinary income. These rates are generally higher than the long-term capital gains rates that employees typically qualify for under other traditional equity schemes.

Benefits of phantom stocks

In spite of its drawbacks, phantom stock plans are still widely popular in the startup world as both an alternative and supplement to, traditional equity compensation. Some key benefits include:

  • Increased productivity. Because the value of phantom stocks is directly tied to performance, employees are motivated to contribute to the company's growth, be more efficient, and work harder.
  • Low barriers to participation. Unlike stock options which involve the actual buying/selling of stock, employees don't have to fork out any cash to participate in these schemes.
  • Cap table bloat (non-dilutive). As a founder, you're probably concerned about the effects of dilution on the cap table and other shareholders/investors. Phantom shares are a great way to give employees exposure to the increases in your company's share price, without granting them equity that dilutes the value of your shares.
  • Cost-effective. Due to their low cost of implementation, employers can use Phantom Plans to hire, attract, and retain top talent while managing capital outflows, and focusing on developing their product.
  • Flexibility. Companies have a lot of flexibility when it comes to designing phantom stock plans. They can choose to offer appreciation-only or full-value phantom stock and can set time-based or performance-based vesting conditions as they see fit.
  • Tax benefits. Phantom stock can offer tax benefits for both the company and the employee. If structured properly, phantom stock payouts may be tax deductible for the company, while employees can defer taxes until they actually receive payment.

As always, it is best to seek advice from experts when you're thinking about implementing a phantom stock plan and whether or not this fits your growth requirements and strategy.

How are phantom stocks taxed

The beauty of a phantom stock plan is that they are not taxed on grant or vesting! Simply put, the payment is taxed as ordinary income (W-2) and is deductible to the employer at the time of payment.

Since phantom stock is a form of deferred compensation, for the taxable event to be deferred until payment, your plan will need to be compliant with Section 409A . In order to be exempt from Section 409A, we see most phantom plans structured so that payments are made no later than March 15th of the year following the year of vesting; allowing the phantom plan to be exempt from Section 409A under the short-term deferral exception.

Liquidity events

Establishing this form of equity is often quite straightforward given the employees are not offered actual shares in the company. Most payment triggers for these plans are usually tied to a specific liquidity event (think asset or share sale, or a big funding round/capital raise).

These events can be few and far between, so it's important to structure your phantom stock plan in a way that ties it to company performance, and when your company will have sufficient liquidity to make the cash payments.

Start your phantom stock plan in 3 steps

Step 1: Develop a phantom stock plan

The Plan Rules will outline the terms and conditions of the plan, including eligibility, vesting schedules, payout calculations, and termination provisions.

Step 2: Obtain a 409A

When issuing phantom shares to US-based stakeholders, you will need to conduct a 409A valuation to determine the fair market value of the phantom stock.

Step 3: Issue the phantom stock awards

Note here, before issuing phantom shares to non-US recipients, be aware of variations in terminology and legal hurdles. Some phantom stock equivalents include:

  • Australia: Virtual Stock Option Plans
  • UK: Phantom Share Scheme
  • Canada: Restricted Stock Unit Plans, Deferred Stock Unit Plans

Interested to set up a phantom stock plan and integrate phantom shares into your equity program? Reach out to our team of equity experts and let us help you get started for free .

Whether you're looking to attract or retain key employees, use alternative employee compensation to increase cash flow, or simply want an easy-to-use employee benefits program, shadow stock can help!

Giving your teams a stake in the company's future will reward employees with a cash payout that could mean the world to someone. While they do have some potential drawbacks, phantom stocks offer many benefits, including flexibility, cost savings, and most of all, more company owners! (which we love to see at Cake).

As always, be sure to consult with a qualified professional to determine whether they are the right fit for your company's needs. With the right strategy in place, phantom stocks can be a valuable addition to your company's employee benefit plan.

Quick-fire Q&A

Faqs on phantom stocks, are phantom stocks the same as stock options or rsus.

No, phantom stocks are a different type of equity compensation that does not require the company to issue actual shares of stock.

What's the difference between phantom stock and stock appreciation rights?

Stock appreciation rights (SARs), like phantom stock, offer the advantage of potential stock appreciation to employees without granting them actual stock ownership. However, SARs are more akin to stock options, allowing employees to exercise them at their discretion within the specified timeframe of vesting and expiration.

Can phantom stocks be used for startups?

Yes! phantom stocks can be a great fit for startups and other fast-growing companies that are looking for a flexible and cost-effective way to offer equity compensation to their employees.

How are the payouts for phantom stocks calculated?

The cash payment for fully vested and exercisable phantom stock units are typically calculated by multiplying the number of phantom stock units the employee has by the increase in value of the company shares.

This article is designed and intended to provide general information in summary form on general topics. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice. The contents is not intended to be a substitute for such advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.

phantom option plan

Alex Kazovsky is a seasoned leader with a track record of driving business growth and operational excellence. Currently, Alex serves as Global Equity Lead here at Cake Equity. In this role, Alex is responsible for the overall equity management strategy, including equity compensation plans, local compliance, and long-term incentive structures. Alex brings a data-driven and analytical approach to equity management, aimed at maximizing the impact and effectiveness of global equity.

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  • Phantom Stock Plans

phantom option plan

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on July 14, 2023

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Table of contents, what are phantom stock plans.

Phantom stock plans are employee compensation plans that provide the benefits of owning company stock without transferring shares. These plans grant employees the right to receive a cash payment or equivalent shares based on the value of company stock at a future date.

The main purpose of phantom stock plans is to incentivize and retain key employees by aligning their interests with those of shareholders.

These plans provide employees with the potential for financial gain as the company's stock value increases without diluting ownership or incurring the same costs as traditional equity awards.

Phantom stock plans differ from traditional stock options and restricted stock units (RSUs) in several ways.

Stock options give employees the right to purchase shares at a predetermined price, while RSUs are grants of actual shares. Phantom stock plans provide only the economic benefit of owning shares without transferring ownership.

Types of Phantom Stock Plans

Appreciation-only phantom stock plans.

Appreciation-only phantom stock plans are designed to reward employees based on the company's stock value increase over time.

Participants receive a cash payment or equivalent shares equal to the difference between the stock's value at grant and its value at vesting or payout.

Full-Value Phantom Stock Plans

Full-value phantom stock plans provide employees with the entire value of the underlying company stock at the time of payout.

This includes both the initial stock value at the grant and any appreciation that occurs during the vesting period, resulting in a potentially larger payout for participants.

Performance-Based Phantom Stock Plans

Performance-based phantom stock plans tie payouts to the achievement of specific company performance goals or metrics.

These plans can help align employee efforts with strategic objectives and ensure that rewards are tied to the overall success of the company.

Hybrid Phantom Stock Plans

Hybrid phantom stock plans combine elements of both appreciation-only and full-value plans or incorporate performance-based features. These plans offer greater flexibility in structuring employee rewards and can be tailored to meet the unique needs of individual companies.

Types of Phantom Stock Plans

Features of Phantom Stock Plans

Granting and vesting schedules.

Phantom stock plans typically include granting and vesting schedules, which determine when employees receive their awards and when they become eligible to receive payouts.

These schedules can be based on time, performance, or a combination of factors, allowing companies to customize their plans to meet specific objectives.

Dividend Equivalent Rights

Dividend equivalent rights (DERs) allow participants in phantom stock plans to receive additional compensation based on the dividends paid on the underlying company stock .

This feature helps to further align employee interests with those of shareholders and can increase the overall value of the phantom stock awards.

Settlement Methods

Phantom stock plans can use various settlement methods to distribute payouts to participants, including cash settlement and stock settlement.

Cash Settlement

Cash settlement involves paying employees the value of their phantom stock awards in cash, typically based on the company's stock value at the time of payout. This method does not require the issuance of actual shares, thereby avoiding dilution of ownership.

Stock Settlement

Stock settlement involves issuing actual shares of company stock to participants in lieu of cash payments . This method can provide employees with the potential for further gains if the stock value continues to increase but may result in a dilution of ownership for existing shareholders.

Tax Implications for Participants and Companies

Phantom stock plans have different tax implications for participants and companies than traditional equity awards.

Generally, phantom stock payouts are treated as ordinary income for employees, while companies can often claim tax deductions for the payouts made under these plans.

Features of Phantom Stock Plans

Designing and Implementing Phantom Stock Plans

Identify plan objectives.

The first step in designing and implementing a phantom stock plan is to identify the company's objectives for the plan. This could include incentivizing and retaining key employees, aligning employee interests with shareholder interests, or managing ownership dilution concerns.

Select Eligible Participants

Determining which employees will be eligible to participate in the phantom stock plan is a crucial decision. Companies should consider factors such as the employee's role, performance, and potential impact on the company's success when selecting participants.

Determine Plan Type and Features

Companies must decide on the type of phantom stock plan that best suits their needs and any additional features they wish to include.

This may involve selecting between appreciation-only, full-value, performance-based, or hybrid plans and incorporating features such as dividend equivalent rights or specific settlement methods.

Establish Grant and Vesting Schedules

Establishing grant and vesting schedules is essential to designing a phantom stock plan.

These schedules determine when employees receive their awards and when they become eligible to receive payouts and can be based on factors such as time, performance, or a combination of both.

Communicate the Plan to Participants

Effectively communicating the phantom stock plan to participants is critical to its success.

Companies should provide clear and transparent information on the plan's features, benefits, and potential risks and ensure that employees understand how the plan aligns with the company's overall objectives.

Manage Ongoing Plan Administration and Compliance

Once a phantom stock plan is implemented, companies must manage ongoing administration and ensure compliance with relevant laws and regulations.

This may involve tracking grant and vesting schedules, calculating payouts, managing tax and accounting implications, and conducting regular plan audits.

Designing and Implementing Phantom Stock Plans

Legal and Regulatory Considerations of Phantom Stock Plans

Securities laws and regulations.

Phantom stock plans may be subject to securities laws and regulations, depending on the plan's structure and the company's jurisdiction. Companies should consult with legal counsel to ensure their plan complies with applicable securities regulations and any required disclosures or filings.

Tax Regulations

Phantom stock plans have unique tax implications for both participants and companies, which must be considered during plan design and ongoing administration.

Companies should consult with tax professionals to ensure their plan complies with relevant tax regulations and to minimize any adverse tax consequences for participants.

Accounting Standards

Companies implementing phantom stock plans must comply with applicable accounting standards, such as recognizing the plan as a liability on their financial statements .

Consulting with an accounting professional can help ensure that the plan is properly accounted for and complies with relevant accounting standards.

Employment Laws

Phantom stock plans may also be subject to employment laws, particularly in regard to anti-discrimination and equal pay requirements.

Companies should consult with legal counsel to ensure their plan complies with applicable employment laws and does not inadvertently create disparities or discrimination among employees.

Advantages of Phantom Stock Plans

Incentivizing and retaining key employees.

Phantom stock plans are an effective tool for incentivizing and retaining key employees, as they offer the potential for financial gain based on the company's stock performance.

This aligns employee interests with those of shareholders and encourages long-term commitment to the company.

Alignment of Employee and Shareholder Interests

By tying employee rewards to the company's stock value, phantom stock plans help align employees' interests with those of shareholders. This can lead to increased employee motivation, as they share in the company's financial success.

No Dilution of Ownership

One advantage of phantom stock plans over traditional equity awards is that they do not result in dilution of ownership for existing shareholders. This can be particularly attractive to closely-held or family-owned businesses, where maintaining control of ownership is a priority.

Flexibility in Plan Design

Phantom stock plans offer a high degree of flexibility in their design, allowing companies to tailor the plans to meet their specific needs and objectives. This can include customizing grant and vesting schedules, incorporating performance-based features, or creating hybrid plans.

Lower Administration Costs

Compared to traditional equity awards, phantom stock plans can have lower administration costs as they do not require the issuance of actual shares. This can result in cost savings for the company while providing a valuable employee incentive.

Disadvantages and Challenges of Phantom Stock Plans

Accounting and tax complexities.

Phantom stock plans can present accounting and tax complexities for both companies and participants.

Companies must account for phantom stock awards as a liability on their financial statements. At the same time, participants may face ordinary income tax on payouts rather than the more favorable capital gains tax treatment available with traditional equity awards.

Potential for Increased Cash Flow Requirements

Phantom stock plans can increase companies' cash flow requirements, particularly if cash settlements are used for payouts.

This can be a challenge for companies with limited cash reserves and may require careful planning and management to ensure sufficient funds are available when payouts are due.

Perception of Lesser Value Compared to Traditional Equity Awards

Some employees may perceive phantom stock plans as having lesser value compared to traditional equity awards , such as stock options or RSUs.

This perception can be due to the lack of actual share ownership and the different tax treatment of payouts, which may affect employee satisfaction and engagement with the plan.

Possible Negative Impact on Company Culture

If not carefully designed and communicated, phantom stock plans can have a negative impact on company culture.

Employees may view these plans as favoring certain individuals or groups, leading to feelings of inequality or resentment among the workforce.

It is crucial for companies to ensure transparency and fairness in the implementation of phantom stock plans to avoid such issues.

Pros and Cons of Phantom Stock Plans

Phantom Stock Plans in Various Industries

Start-ups and small businesses.

Start-ups and small businesses can benefit from implementing phantom stock plans to attract and retain talent while managing ownership dilution concerns.

These plans can be particularly appealing to early-stage employees, as they offer the potential for financial gains as the company grows and succeeds.

Family-Owned Businesses

Family-owned businesses often use phantom stock plans to incentivize and retain key non-family employees without diluting family ownership.

This approach allows the company to align the interests of employees with those of family shareholders while preserving control of the business within the family.

Non-profit Organizations

Non-profit organizations can use phantom stock plans as a tool to incentivize and retain key employees in the absence of traditional equity compensation.

These plans can be structured to reward employees based on the organization's financial or performance metrics, helping to align employee interests with the organization's mission and goals.

Publicly Traded Companies

Publicly traded companies may also utilize phantom stock plans to incentivize and retain key employees while managing ownership dilution concerns.

These plans can offer a flexible and cost-effective alternative to traditional equity compensation while still aligning employee interests with shareholder value.

Final Thoughts

Phantom stock plans can be an effective employee compensation strategy, but understanding their benefits and drawbacks is crucial for companies.

By evaluating their features, advantages, and challenges, companies can make informed decisions about whether to implement such a plan.

Factors such as their objectives, employee demographics, industry, and legal and regulatory requirements should be considered to ensure the chosen plan meets the company's needs and complies with relevant laws.

As companies seek innovative ways to attract and retain top talent, phantom stock plans and other equity compensation strategies will likely continue to evolve and gain popularity.

However, due to their complexities, companies should seek the guidance of financial advisors , legal counsel, and tax professionals to ensure compliance with all regulations and meet their objectives.

Phantom Stock Plans FAQs

What are phantom stock plans, and how do they differ from traditional stock options.

Phantom stock plans are a form of employee compensation that provide the financial benefits of stock ownership without actually granting shares. They are based on the value of a company's stock and typically pay out in cash or actual shares upon meeting certain conditions. Unlike traditional stock options, phantom stock plans do not involve the issuance of real shares, so they do not result in ownership dilution.

What are the different types of phantom stock plans available to companies?

There are four main types of phantom stock plans: appreciation-only, full-value, performance-based, and hybrid plans. Appreciation-only plans provide gains based on the increase in the stock value, while full-value plans payout based on the entire value of the stock. Performance-based plans link payouts to specific performance metrics, and hybrid plans combine features of the other types to create a customized plan.

What are some advantages of implementing phantom stock plans as part of an employee compensation strategy?

Phantom stock plans offer several advantages, including incentivizing and retaining key employees, aligning employee and shareholder interests, preventing dilution of ownership, providing flexibility in plan design, and potentially lower administration costs compared to traditional equity awards.

What are the potential disadvantages and challenges associated with phantom stock plans?

Some potential disadvantages and challenges of phantom stock plans include accounting and tax complexities, increased cash flow requirements for companies, the perception of lesser value compared to traditional equity awards, and possible negative impacts on company culture if the plan is not carefully designed and communicated.

What legal and regulatory considerations should be taken into account when implementing phantom stock plans?

Companies implementing phantom stock plans must consider various legal and regulatory requirements, including securities laws and regulations, tax regulations, accounting standards, and employment laws.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website , view his author profile on Amazon , or check out his speaker profile on the CFA Institute website .

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Phantom Stock Plan

Refers to a type of employee incentive plan that allows participants to earn benefits that are based on the value of the company's stock

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What Is A Phantom Stock Plan?

  • What Are Phantom Shares And The Benefits They Offer?
  • Who Is Using A Phantom Stock Plan?
  • Why Would You Adopt A Phantom Stock Plan?
  • The Key Difference Between A Phantom Stock Plan Vs. A Stock Option Plan

Key Considerations

A phantom stock plan is a type of  employee incentive plan  that allows participants to earn benefits based on the value of the company's stock. These employee incentive plans are often used in addition to other employee benefits, such as stock option plans.

A phantom stock plan is an employee perk that grants senior management and other chosen employees all of the advantages of stock ownership without actually transferring any firm stock to them. The term "shadow stock" is occasionally used to describe this kind of arrangement.

Under this plan, employees are not given any shares of the company's stock. However, they are given the right to receive benefits based on the value of the company's stock.

These benefits may include the right to purchase shares at a discounted price or the right to receive cash payments based on the value of the company's stock.

This particular employee incentive plan is often criticized for being too complex and providing employees with benefits that are not directly tied to their performance.

However, this can be an effective way to motivate and retain employees.

Employee incentive plans can be a great way to keep your best employees on board. However, they are not without their risks. 

If not appropriately managed, employee incentive plans can create a division between employees who receive the incentive and those who do not. Therefore, if you implement an employee incentive plan, be sure to do so fairly and transparently for all employees.

What are phantom shares and the benefits they offer?

The main benefit of a phantom shares program is that it allows the company to provide an option for employees to defer compensation to gain long-term growth. Phantom shares can be helpful when the company wants to grow and has plans for future expansion but lacks capital. 

The company can offer these benefits by issuing phantom shares without issuing new shares or generating new capital. These phantom shares are just cash deposits in a bank account with no interest.

In addition to allowing employees to defer compensation, phantom shares also give participants who leave their job in good standing additional credits they can use towards their account balance later.

Some of the benefits of phantom shares include:

  • The ability to share in the company's future growth
  • A long-term investment that can produce high returns
  • A sense of ownership and pride in the company
  • A motivator to stay with the company for the long-term

If your company is considering offering phantom shares to employees, weigh all the pros and cons before deciding.

Who is using a phantom stock plan?

Startups and private companies often use these plans to attract and retain key employees. This plan works by setting aside a certain number of shares that will be awarded to critical employees later. 

These shares do not have any actual value until they are vested, at which point they can be sold or traded.

The main benefit of this plan is that it can help to align the interests of key employees with those of the company. In addition, providing employees with a financial stake in the company is more likely to work hard to help the company succeed. 

Additionally, phantom shares can be less expensive and easier to administer than traditional stock plans. As a result, companies use this plan to attract new employees while avoiding the cost and burden of issuing company shares.

Some examples of businesses that use this type of plan are banks, insurance companies, realty companies, and nonprofits.

There are a few different ways that phantom shares can be structured. The most common type of plan is an equity incentive plan, which gives employees the right to purchase shares at a set price in the future. 

Startups and small businesses often use this plan to attract and retain talent.

Why would you adopt a phantom stock plan?

You may want to adopt a phantom stock plan if you have a sizable amount of money that can be saved. For example, if you're planning on opening your own company and don't want to give up all your equity for funding.

Phantom shares are also used in cases where the company doesn't have enough assets or cash to issue shares. This allows companies to save money while still providing benefits for their employees.

Another reason some companies may consider using phantom shares is because they offer tax savings. For example, if the shares are issued as non-voting preferred stock, the company will likely exclude these shares from employee income taxes. 

In many cases, this allows for more capital to be raised at a lower cost than issuing equity through a traditional issuance process.

It is an excellent way to incentivize employees by increasing their financial compensation. It can also help to align the interests of management and employees by increasing the value of employees' shares.

Employers, however, need to consider the administrative costs of implementing a phantom stock plan. This includes naming fees, additional internal accounting fees, and accounting fees associated with issuing phantom shares.

The main benefit is that it can be more affordable than issuing company shares, but an employer has to consider the long-term implications before doing so.  Filing requirements such as annual reports and shareholder meetings are also required for companies implementing a phantom stock plan.

The Key Difference Between a Phantom Stock Plan vs. a Stock Option Plan

As its name implies, a stock option plan is a compensation plan where company employees receive equity or ownership in the company for their work. It's an option because it gives employees the right (or "option") to buy shares at a predetermined price during a fixed period.

Stock options or annual salary increases are given out as part of an incentive program. In contrast, phantom stock plans don't need to be tied to any particular incentive or a formal way that you can earn them. 

The only requirement for participating in a phantom stock plan is that your company's board must approve it of directors and have at least five people on it who have been with the company for more than one year.

However, like other forms of deferred compensation plans, there are specific tax considerations involved with this type of plan.  Phantom stock plans are not taxed until converted into actual shares later, meaning you get the benefit of receiving some tax-free income immediately.

One of the critical factors to consider when choosing this plan is how much ownership you want your employees to have in the company. If you decide not to offer full ownership, you can still benefit your employees by issuing them phantom stock.

It would help if you also considered the tax implications of using this plan compared to an employee-owned company.

It is also important to determine the vesting schedule for the phantom shares. This will determine when and how employees can cash in on their benefits. 

The plan should include provisions for what happens to the phantom shares in the event of a change in control of the company. 

This ensures that employees can still reap the rewards of their hard work even if the company is sold or goes public. Finally, it is important to choose an experienced plan administrator to handle the plan's details. 

This will ensure that everything runs smoothly and that employees can take advantage of the benefits they are entitled to.

These plans are an excellent way for employers to save money on taxes, salaries, and benefit plans while still providing some form of deferred compensation.

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Phantom Stock Plans: How This Alternative to Real Equity Works

What’s a form of equity compensation that’s not actually equity compensation? This may seem like a riddle intended to baffle startup founders, many of whom already have a hard enough time keeping their equity terms straight. But the answer is a type of employee compensation that has become increasingly common in recent years: phantom stock. 

Phantom stock plans, otherwise known as shadow stock plans, are a creative way to compensate key employees without granting them actual shares of company stock. Just as a phantom might mirror the outline of an actual figure, phantom stock is a type of employee compensation that tracks the value of actual shares of company stock. Employees who are granted rewards of phantom stock are thus able to benefit from the rise in value of the underlying company stock, without owning any actual stock .

In this guide, we’ll cover everything you need to know about phantom stock plans—including the situations in which they might make more sense than granting actual shares of company stock.

  • What is a phantom stock plan

How phantom equity works

The main types of phantom stock, pros and cons of phantom stock plans, how to think about phantom stock as a startup founder, what is a phantom stock plan.

A phantom stock plan is an employee compensation plan in which an employee is offered “phantom shares” that track the value of the company’s actual stock. It’s important to highlight that phantom shares are not actual equity , though their value does rise and fall in accordance with the value of the company’s stock.

Phantom stock plans can be a powerful motivational tool for key employees, including those who already may be highly compensated or top performers. They also have some very attractive benefits for the employer, who typically controls the terms and structure of the plan and may include provisions that incentivize the employee to stay with the company for a longer term. Existing shareholders may also benefit from phantom stock plans, since granting shares of phantom stock does not require the issuance of new shares and thus does not result in the dilution of shareholder equity .  

The result may sound like a win-win-win situation for employees, the company, and existing shareholders—and in some cases, it is! But phantom stock has some complexities and potential downsides to understand as well. We’ll get to those in a bit. For now, let’s take a deeper look at how phantom stock works.

The basic idea behind phantom stock is simple: reward a key employee with the financial benefits of stock ownership without giving them actual shares of company stock. The specific number of shares granted to the employee may vary depending on factors like seniority and performance, and in some cases, additional shares may be granted if certain performance goals are met.

Phantom stocks aren’t technically equity, but they do share a few things in common with traditional forms of equity compensation. For example, a 409a valuation may be required to determine the fair market value (FMV) of a share of phantom stock—just as it would be required to determine the price of stock options offered to employees.

As with other types of equity compensation , phantom stock programs also usually include a vesting schedule to encourage employee retention.

How phantom stocks vest

“Vesting” means that the employee doesn’t get all of the phantom stock upfront. Instead, they earn the cash value of their phantom stocks based on a specific delay mechanism—such as time requirement or performance milestone—that’s specified in the terms of the grant. 

The full value of the phantom stocks may not vest until the full vesting period is up. In some cases, the employee may see their shares partially vest over the course of the vesting schedule. In other cases, the employee won’t see any cash payment until they’re fully vested—a period that may be up to three, four, or five years.

How company performance affects the value of phantom stocks

Assuming the company is successful and continues to grow, the employee stands to benefit from the appreciation in the company’s stock price. 

But here’s a wild thought: what if the company stock price doesn’t appreciate over the full course of the vesting period? What if it actually declines ? Does the employee get anything in this case?

Well, it depends on the terms of the grant and the type of phantom stock the employee is granted. Different types of phantom stock can result in different reward valuations at the end of the vesting period. To illustrate this point, let’s take a look at the two main types of phantom stock.

The two main types of phantom stock are full-value phantom stock and appreciation-only phantom stock. 

Full-value phantom stock

As its name indicates, full-value phantom stock grants the full value of the underlying share of stock. At the end of the vesting period, the employee receives not only the value of how much their stock appreciated since the time of the grant, but the full value of the stock.

Here’s an example to make this more clear:

  • An employee named Sally is granted 100 shares of full-value phantom stock. At the time of the grant, each of these shares is worth $100.
  • Sally’s phantom stocks vest over a period of five years. In the course of that time, the value of one share of company stock rises from $100 to $150.
  • When she is fully vested, Sally receives a cash bonus of $15,000 (100 shares x $150). 

It’s worth noting that, with full-value phantom stock, the employee will end up with some money even if the price goes down . Let’s look at the example above. If the value of one share of company stock goes down from $100 to $50 in the same time period, Sally will receive a cash bonus of $5,000 (100 shares x $50) when she is fully vested. That’s a lot less than what she’d earn if the value of the stock rises, but it’s still something.

Appreciation-only phantom stock

Unlike full-value phantom stocks, appreciation-only phantom stocks only have value if the underlying stock’s price increases over the term of the vesting period. The employee typically receives a cash payout equal to the appreciation in the stock price from the time of the grant to the end of the vesting period. 

If there’s no appreciation in the stock price, it’s possible that the employee won’t receive any cash bonus at all. This is obviously not a great outcome for the employee! If it does end up being the case, the company may provide some other type of cash bonus or incentive as consolation—but this is not guaranteed if it’s not spelled out in the terms of the grant. 

Let’s look at an example of how appreciation-only phantom stock works:

  • An employee named Steven is granted 100 shares of appreciation-only phantom stock. At the time of the grant, each of these shares is worth $100.
  • Steven’s phantom stocks vest over a period of five years. In the course of that time, the value of one share of company stock rises from $100 to $150.
  • When he is fully vested, Steven receives a cash bonus of $5,000 (100 shares x $50).

Phantom stock awards can be a solid basis for an employee benefit plan, but they don’t always make the most sense. Before you determine whether a phantom stock program makes sense for your company, here are some advantages and disadvantages to consider. 

Advantages of phantom stock plans

  • Phantom stock doesn’t dilute shareholder equity. If you’re a founder, you probably care about limiting the dilution of equity ownership across your cap table . Your company’s other shareholders probably care about this a lot, too! Phantom stock can be a great way to give employees exposure to the rise in your stock’s price without granting them equity that would dilute the value of your shares. 
  • It can help your employees feel bought-in to company success. At many public companies, an employee who wants to own stock must purchase that stock on the open market or in an employee stock purchase plan (ESPP). In the absence of other equity compensation, phantom stock is a way to give employees a “stake” in your company’s future without requiring them to buy their own shares.
  • It can supplement other, more restrictive types of equity . It’s not always easy to grant additional equity incentives to top-performing employees. Sometimes the shares just aren’t there, or the regulatory requirements are too onerous. Phantom stocks may offer a more flexible, less restrictive way to reward employees with something close to equity.

Disadvantages of phantom stock plans

  • Phantom stock may create outstanding liabilities that affect the value of your company. While phantom stock doesn’t dilute shareholder equity, it can still create outstanding liabilities that decrease the value of your company. This is assuming that the payout is in cash and not shares.
  • Taxes may be a pain for employees. The cash payout on a phantom stock plan is taxed at ordinary income tax rates in the year in which the phantom shares vest. Ordinary income rates are typically higher than the long-term capital gains rates an employee might qualify for with other types of equity, so they may be giving up more to the IRS than they otherwise would.
  • Less appreciation in the share value means less of a payout. This is basically true with any type of equity, including ordinary stock options. Still, employees with appreciation-only phantom stocks may be extra-bummed if they make it to the end of their vesting period and end up with no reward because the stock’s price didn’t rise. On the other hand, at least the employee doesn’t stand to lose any money from the transaction.

In the right scenario, a phantom stock incentive plan can benefit both the company and the employee. But there are other types of employee compensation you may want to consider as well, whether it’s traditional equity or something like Stock Appreciation Rights (SARs), which work similarly to appreciation-only phantom stock.

How much (and what type) of equity to offer can be a fine line to walk. You need to think about your company’s financials as well as your employees’ motivation and wellbeing. If you’re interested in learning more about equity and your options as a startup founder, schedule a call with a Pulley expert today.

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Phantom Stock: Everything You Need to Know

Phantom stock is an employee benefit where selected employees receive the benefits of stock ownership without the company giving them actual stock. 8 min read

What is Phantom Stock?

Phantom shares (phantom stock agreements) are an employee benefit where selected employees receive the benefits of stock ownership without receiving actual stock from the company . While not stock in the company, phantom stock is worth money just like real stock— its value rises and falls with the company's actual stock (or what the company is valued at, if it's not a publicly traded company). Employees are paid out profits at the end of a pre-determined length of time.

Also known as  ghost shares , shadow stock ,  simulated stock , or  phantom shares , phantom stock is often provided as a bonus for employees’ hard work and longevity. One form of phantom stock is Stock Appreciation Rights.

There isn't one exact one-size-fits-all definition of what phantom stock is or how companies use it. The term “phantom stock” can apply to any reward that takes time to mature . Usually, the award is for a specific number of units, or phantom shares, that follow the price of the company's actual shares — going up as the company is worth more and down as it's worth less.

Each phantom stock plan has a plan charter. This charter dictates the  vesting  schedule. If there are goals or tasks that participants must accomplish in order to vest, the charter outlines what these are and what the participants will receive. The charter also states voting rights, if any. If the phantom stock can be converted to actual shares in the company upon payout, the charter will outline how this is done. Having a well drafted plan charter is imperative for companies. 

Why Do Companies Use Phantom Equity?

Awarding employees company stock can provide many benefits, including motivation to work harder because if the company is successful, its stock prices will go up. This system also encourages loyalty to a company: employees feel invested, which makes it less likely that they'll seek new opportunities elsewhere.

However, even with these incentives, phantom stock might be a better option for employers in certain situations:

  • When there are legal concerns.
  • When the company is unwilling to issue additional shares.
  • To prevent diluting stock by giving it to many employees, which may influence voting control.

Providing phantom stock allows the company to reward employees for their hard work without worrying about those big problems.

Phantom shares are typically used to encourage senior leadership to produce better results for the company. The number of shares awarded usually depends on the leader’s place in the organization and how well their team has performed. Though the promise of the money is given today, the benefits are long-term—paying out after two, three, or five years, depending on the term that the company sets. As previously noted, the phantom stock can also be contingent on accomplishing a specific goal or task.

Form and Structure of Phantom Stock Agreements

There are two types of phantom stock agreements that most companies use:

  • Appreciation only

Appreciation Only

When companies use appreciation-only phantom stock, recipients don't receive the current value of real stock when they cash out their phantom stock. Instead, they receive anything above and beyond what the phantom stock was worth when it was granted.

For example, let's say that Bob was granted 500 phantom shares on June 5, 2020. When the shares were granted, they were worth $60.50 each. In order to receive the benefit of these shares, Bob needs to stay with the company for five years. At that time, on June 5, 2025, the shares are worth $85.25.

For each of Bob's shares, he'll get the difference between the current value ($85.25) and the initial value ($60.50), which is $24.75 per share. Multiply that by 500 shares, and Bob's bonus ends up being $12,375.

Where appreciation-only phantom stock pays out the difference between the shares' initial value and their current value, full-value phantom stock pays out exactly what it's worth.

For example, let's say that Mary is granted 500 phantom shares on June 5, 2020, for the company she works for. Coincidentally, the stock for her company is also worth $60.50 a share, and she also has to wait five years for them to mature. Once those five years have passed, the shares are (strangely enough) also worth $85.25.

However, unlike Bob's phantom shares, Mary's are worth the full value — which means she's paid out the full $85.25 per share and gets a bonus of $42,625. Go Mary!

Why Is Phantom Equity Important?

For employees , phantom stock rewards the time and effort they have invested into their company . When the phantom stock matures, companies will typically pay employees the cash value of the shares or, in some less often circumstances, convert the phantom shares into actual stock.

For company owners , phantom stock can help grow their business offering top employees a reason to stay and help the company succeed for the long-term. Strong leadership is essential to a company's success, and replacing senior leadership can be expensive and time consuming. 

Phantom shares could be granted every year, even if they take five years to mature. This means that once leaders have been at the company for five years, they can expect to benefit from these rewards annually. On the other hand, if they leave the company before the shares mature, they will not receive any of those rewards.

Reasons to Consider Not Using Phantom Stock Plans

Phantom stock is not a good idea if the company is planning on issuing it to most or all employees, especially if the phantom shares will be paid out when the employee leaves the company or retires. In that case, phantom shares may be ruled illegal because of the  Employee Retirement Income and Security Act  ( ERISA ). Employee stock ownership plans (ESOP) and 401(k) plans are qualified plans that are considered legal under ERISA. However, ERISA prevents non-qualified plans from acting like qualified plans. Sometimes awarding phantom stock, especially if given to a large percentage of employees, may be seen as a non-qualified plan under ERISA.

Companies should also make sure they're in compliance with  Internal Revenue Code Section 409A . This addresses executives that might be tempted to accelerate distributions because of knowledge that the company is nearing financial collapse. When setting up a phantom stock plan , Section 409A must be followed, which includes the guidelines for distributions and terms of the plan.

Phantom stock might not always be your best option. Phantom stock only benefits employees if the company grows; issuing phantom shares when you don't foresee growth in the near future could backfire and lower morale. Additionally, some employees may get more excited about having actual shares in the company, which can be kept for years to come, rather than having phantom shares. 

Reasons to Consider Using Phantom Stock Plans

Despite some of the challenges associated with phantom stock, it is important to note that phantom stock definitely has its advantages. These advantages include:

  • Little to no complications.  Phantom shares are only paid out if the employee meets certain terms. If an employee leaves the company before those terms are met, the phantom stocks disappear. If the company had used actual stock, those would have to be repurchased, which would make things more complicated and potentially, more expensive.
  • No voting rights.  Since phantom shares are not the same as real stock, you don't have to worry about employees voting down key decisions, such as selling the company or changing leadership roles.
  • Invested employees . Even without voting rights, employees will still be invested in the company because typically, when the company succeeds, stock prices (and therefore the value of phantom shares) will rise.
  • Less expensive.  Setting up a phantom stock bonus plan is much less expensive than setting up an ESOP, and when you're running a business, anything that saves you money is a good thing.
  • More flexibility.  Phantom stock plans can be used in privately held companies and public ones, in small and large companies, in  LLCs  and  C Corporations , and even in non-profit organizations to some extent.
  • No taxes are owed till the stocks mature.  When company stocks are given to an employees, even if they have to hold onto them for a specific term, it's considered taxable income. Phantom stock doesn't have this issue and is not considered income until the bonus is paid out.

As long as phantom shares are created according to the applicable laws, including ERISA and IRS Code 409A, they bring a lot of advantages with them.

Frequently Asked Questions About Phantom Stocks

  • What are the differences between phantom stocks and an ESOP?  An ESOP is a qualified retirement program, similar to a pension plan. Though stocks are involved, the employee doesn't usually gain ownership of the shares. Instead, a specific number of shares are awarded to each employee, when that employee is ready to retire, the shares are cashed out. The value of those shares increases and decreases as company stock increases and decreases, because they are actual shares. All employees in a company are eligible for this plan, similar to a 401(k). Having an ESOP in place is like having a second set of owners that need to approve key decisions, which is not the case with phantom shares. Phantom stock is only given to a small percentage of employees. Most commonly, this group is the core leadership team. Here, the employee never actually owns shares, because the shares don’t actually exist. There is also more flexibility regarding how and when phantom stock can be cashed out. Until that point, phantom stock is not actually equity.
  • SARs are for the amount of money equal to the increase in value of a specific number of shares over time.
  • They may or may not have a specific date when they pay out.
  • If they don't, employees can choose when they want to cash out once the shares vest.
  • SARs don't offer dividend-equivalent payments.
  • They are often granted along with  stock options  in order to help finance the purchase of options or to pay tax if any is due.

There's a lot of flexibility when it comes to SARs, which means that there are also a lot of decisions to make with things like vesting rules, eligibility, and who gets how much. The main difference between SARs and phantom shares is that phantom shares have the possibility of offering dividend-equivalent payments. Additionally, phantom shares can be dependent on performance criteria.

  • Does your company expect growth? The only way that this program will work is if growth is expected in the coming years.
  • If there is projected growth on the horizon, will it work to share 5 to 15 percent of that growth with employees?
  • Will the amount of money that you are able to share be enough that it is meaningful to your employees?
  • Are there key employees who are essential to the successful growth of your company?

Once you've considered the answer to these questions, you should have a better idea of whether a phantom stock program would benefit your company.

  • What happens to phantom stock if the company is sold?  If a business is sold, employees that own phantom stock receive money that is equal to the amount they would have received had they owned actual stock in the company. For that reason, it's financially beneficial to employees to own phantom stock, as they don't need to worry about dilution.
  • Do phantom stocks take dividends into account?  It depends on how the phantom stock plan is set up, but they definitely can include dividend payments to phantom shareholders, which is a great benefit to owners of said phantom stock.

If you need help with creating a phantom stock program or just have questions about how phantom shares work, post your question or concern on UpCounsel's marketplace. The lawyers at UpCounsel come from law schools that include Yale Law and Harvard Law and have an average of 14 years of legal experience. These lawyers are the top 5 percent of lawyers, and have worked with or on behalf of companies such as Menlo Ventures, Google, and Airbnb.

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The A to Z Explanation About Phantom Stocks

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Phantom stock. Unusual name isn’t it? A phantom stock, also known as “ shadow stock ” or “ ghost shares ”, gives employees the opportunity to share in the wealth and success of the company. Companies do this by providing employees with a stake in the company's stock as well as a retirement plan to ensure they have enough money later on in life.

Back in the day, public companies used phantom shares primarily to generate cash for executives who held stock options. Nowadays, it has become more popular in private companies as a substitute for actual stock grants or awards.

A software engineering firm with $28 million revenue and 85 employees carried out a case study . They wanted to implement phantom stock options as a solution to reduce turnover, increase revenue, and attract stronger talent.

At the end of the year, the company achieved 50% growth and the employee turnover problem was erased. The company also became stronger in its competition for talent.

While phantom stocks may sound good right now, there are many things you should know before you give phantom shares to your employees, including how they work and the tax implications.

In this article, I will help you understand what phantom shares are, why they're different from other types of equity, and how to set them up.

Let's get started!

What Is Phantom Stock?

The idea of phantom stock plans is to mimic the value of a share to an employee without actually handing over the shares. Phantom stock plans, also known as equity compensation plans, equity pay plans, stock bonus plans, or phantom equity plans, are a form of employee stock option plan (ESOP) .

It is an employee benefit that gives employees the opportunity to purchase company shares at a predetermined price, known as the “equity value.” Companies use phantom stock options as a part of their total reward strategy .

In most cases, phantom stock programs are a combination of employee stock options and a compensation program. That makes it an incredibly effective employee retention strategy .

In many US-based companies, phantom shares are granted as a long-term compensation incentive program to reward long-term service or as a retirement recognition.

Further Reading: The Perfect Retirement Gift Ideas For 2022

Types Of Phantom Stock

Phantom stocks are mainly categorized into two types.

Types_of_phantom_stock

Here is a phantom stock example. Let's say Albert was granted 100 phantom shares in January 2020.

At that time, the price per share was $50. Let's take the vesting period to be five years. After five years, the share price has appreciated from $50 to $60.

In the " appreciation only method ", in January 2025, Albert will receive the appreciated amount per share. That is, ($60-$50) X 100 shares = $1000.

In the " full value phantom stock ," after the vesting period of 5 years, Albert will receive the full value of the shares. That is $60 X 100 shares = $6000.

How Does A Phantom Stock Work?

As per the phantom stock agreement, an employer grants selected employees units or "phantom" shares.

The agreed-upon plan grants the employees some shares in the company or phantom units. The program should also detail the starting value, along with other conditions, such as the vesting schedule, payment dates, dividend availability, and other specifics.

The employees will receive a payment in exchange for their shares of stock according to their type of phantom stock program.

The amount is calculated based on:

  • The number of vested shares they hold.
  • The value of the shares at the time of payment.
  • Whether or not they own stock in full or just the appreciation in value since it was received.

The phantom dividends are often redeemed in cash payment, much like a employee bonus . However, should the plan agreement allow it, the payment obligation may be satisfied by distributing actual stock to the employees.

Pros And Cons Of Phantom Stock

Now, as we have a fair idea, let’s look at the advantages and disadvantages of phantom stock programs.

What To Consider When Designing A Phantom Stock Plan?

Here are the top 5 things to consider while designing a phantom stock program:

1. Decide On Your Goals And Offerings

You should consider certain factors before offering phantom equity to employees. Plan out the objectives, identify the eligible employees, and decide on the percentage of equity.

Since phantom stocks are a deferred employee compensation plan , employers can modify the plan as and when required.

Eventually, a phantom stock program should reflect the company culture you are trying to establish.

2. Establish A Proper Phantom Stock Valuation

When you're trying to value your company, you can either get a formal appraisal or set the value yourself. Most companies use a formula or use one of their key metrics ( EBITDA , for instance) to determine the value of their business.

Just make sure you don't set it too high, or your shares could be worth more than the company is worth.

3. Set Up Your Shares

Many people think phantom shares should be equal to the number of company shares. However, this is not the case.

Phantom equity is an employee incentive program tied to the valuation and long-term goals you want to accomplish. It is meant to incentivize employees by linking their performance to a successful company. Still, it is not meant to be a substitute for company shares.

You only need enough phantom shares to incentivize your employees and meet your short-term goals.

4. Decide How To Allocate The Stock

Phantom shares come in two forms, as mentioned earlier in the blog. "Appreciation only" and "Full Value."

You can now decide which type of phantom plan will meet your needs and organizational goals.

Besides the two ways, you can also grant employees to defer their income to phantom shares. In this method, the employee will invest a percentage of their annual income to the phantom stock options.

5. Plan A Payout Schedule

Most companies schedule their phantom stock payouts annually.

If you want to reward a longtime employee who is integral to your plans, an upfront one-time grant might be the way to go.

Some people worry that this might not be as good as annual rewards over a predetermined period of years. However, by giving them an equal lump sum now, you can show your appreciation for what they've done for your company.

6. Draft The Phantom Stock Agreement

Your employees need to be protected when it comes to their rights. Phantom share agreements must be designed in a way that ensures the correct tax treatment and the desired deferred compensation for employees.

If you are drafting phantom stock agreements, consider them an additional asset within your offerings intended to retain key employees .

Some Frequently Asked Questions About Phantom Stocks

1. what determines the value of phantom stock units.

Phantom stock units are set equal to the unit value of the real shares. The company uses the same formula to calculate the actual stock price as well as the phantom stock.

2. How is phantom equity taxed?

Phantom shares don't usually pay dividends. Initially, the grant had no tax implications. However, the payout is tax-deductible by the employer as regular income.

3. Can phantom shares be diluted?

Phantom equity does not dilute shareholders as actual shares are not being transferred. An employee does not become the owner of the business. They are potentially the cash beneficiaries of the company's value.

4. How do you avoid section 409A with a phantom stock plan?

Phantom stock awards are typically structured to avoid 409A limitations by making the award payable on the date of vesting.

This is to follow the short-term deferral rule, which states that the payment will be made within two and a half months after the end of the tax year in which the vesting date occurred.

5. Are phantom stock plans subject to Erisa?

Qualified plans under the 401(k) plan are subject to all rules and regulations of ERISA . A phantom stock plan is not subject to ERISA rules on participation, vesting, funding, and fiduciary responsibilities.

6. Can an S-Corp have phantom stock?

It is possible to have a phantom stock plan without terminating the S-corp status. But you must carefully structure the phantom stock plan to avoid complications:

  • Make sure the liquidation rights are limited.
  • Requests for immediate stock ownership should not be accepted.
  • Capital contributions by employees should not be accepted.

7. Can an LLC issue phantom equity?

Limited liability companies (LLC) can issue phantom stock as "phantom unit rights." Phantom Unit Rights encompasses both the past and future value of an LLC unit.

8. Phantom stocks Vs. ESPP?

A phantom stock plan is an alternative to employee stock purchase plans (ESPP). The primary difference between the two lies in the time at which you can make a return on your investment.

With an ESPP, the stock price will increase over time, but you cannot sell shares until the end of the offering period. With a phantom stock plan, you can choose to receive your payment upon vesting or to have the payout occur at the end of the life of the program.

9. Phantom stocks Vs. ESOP?

ESOP stands for Employee Stock Option Plan . Phantom stock or phantom equity is a type of ESOP. While some ESOPs might grant the employees actual stocks, phantom stock grants benefits that mimic the actual stock.

10. Phantom stocks Vs. RSU?

Phantom stock is settled as a cash bonus, while RSUs are settled in actual shares. RSUs also have the option of giving the employees voting rights, dividends, and other benefits even before the vesting period.

11. Phantom stocks Vs. SARs?

Stock appreciation rights (SAR) are similar to phantom stocks, except they provide the right to receive the monetary equivalent of increases in value over time. This is applied to a specified amount of shares. With phantom stock, the stock value is normally paid out in cash.

12. Phantom stock Vs. Profit-sharing?

Profit-sharing plans are the type of plans where a portion of the profit made by the company is distributed to the employees. It does not involve the distribution of company shares or share price. Phantom stocks are deferred employee compensation where the employees are granted the equivalent to the company share price.

13. Phantom stock Vs. Equity?

Equity comprises real stocks, subject to capital gains as per the fluctuation of the share price. Phantom stocks are also called shadow stocks is a simulating stock, subject to capital gains only after the vesting period.

14. How does an employer benefit from phantom stock?

Phantom equity program is a strategy that companies use to motivate employees and increase productivity by giving them a stake in the company. It also helps the company earn more profits by driving the company stocks higher.

When in doubt, phantom stock options are the most secure form of ESOPs. Risk is minimal, and the terms and conditions are flexible as per the employer at any time. If the value of your share price does not go up after the vesting period, there will be no payout. Further, you can use this option to mark special occasions like the Employee Appreciation Day , where you can delight your employees with phantom stocks to show your gratitude.

Thadoi Thangjam

Thadoi Thangjam is a digital marketing executive at Vantage Circle . When she’s not geeking out over content strategies, she is probably hunting for the next perfect track to add to her playlist. For any related queries, contact [email protected]

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How To Create A Phantom Stock Option Plan For Your Startup

January 5, 2015 by Willow Novell 1 Comment

In the first post,  How To Create A Stock Option Plan For Your Startup , we covered what Stock Option Plans (SOP) are, how they work, and how to use them to reward your employees and collaborators who take the leap of faith in your early stage project.

It all seemed very nice and easy, right? But what happens if we want to award SOPs to our “helping hands” but we don’t want to dilute our shareholders stock? Please allow me to introduce to you SOPs’ little cousin :

PHANTOM STOCK OPTION PLANS (Phantoms)

As well as SOPs, Phantoms are a contractual agreement between the company and the employee, advisor, mentor or whatever collaborator the company decides to reward. Phantoms grant a right to a monetary payment at an agreed future time or event as expressed in the Plan and tied to the market value of the company’s stock at the moment of vesting. The same way as it was explained for the SOPs, the payout will increase or decrease linked to the value of the companies stock, but in this case the collaborator will not receive any actual stock but the cash value of it.

shareholders agreement for startups - barcinno

Phantom stock avoids the risks inherent in having additional shareholders

How do Phantoms work?

The main principle of vesting period, cliffs, and organization of the Plan is equal to that of the SOPs. Then, why do we use Phantoms? As expressed above, is an easy way to reward those people around the company without diluting the existing shareholders. Phantoms are linked to the monetary value of the shares. Once the vesting period finishes and the options have matured , the grantee has the option to execute the Plan and exchange the options for the monetary value of the shares he had been granted in the Plan.

Let’s use a simplified example: You grant an advisor Phantom options with a standard 4-year vesting period at a value equivalent to 1000 shares . The economic value of those shares at the moment of issue is €1 each. Let’s imagine that in four years the value of those shares is €5 per share at the execution moment. Your company, rather than making him a shareholder with 1000 shares of the company, pays him the economic value of the shares, meaning €5.000. The final amount received by the collaborator would be €4.000 since he has to buy the shares in order to receive the amount. Sometimes this option is eliminated and the final reward is paid in full.

Usually companies link the cash out of the Phantoms to an exit event. Collaborators may have vested all the Options but may not be able to receive the cash. This is a way to protect the company’s cash flow. Receiving cash during an exit event prevents the company from running out of funds by collaborators cashing out. Remember to always mention the Phantoms to the potential buyer; maybe you can even have them include and increase the payout to make them take the cashing out of the collaborators.

For those receiving the Phantoms: For accounting purposes, phantom stock is treated in the same way as deferred cash compensations. Phantom stock payouts are taxable to the employee as ordinary income and deductible to the company. Please bear that in mind when accepting them as compensation and have your tax accountant make sure to include those when you talk to the IRS.

To the early stage companies out there: keep believing in these options to help you grow. Your budget may not allow for market salaries and phantom stock options are a great way to offer a high-reward compensation to attract top talent. Just remember, if you grant too many options you may find yourself without sufficient cash for your business when the vesting period ends.

Even more hot fire from Barcinno:

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Willow Novell

About Willow Novell

Willow is a native of Barcelona but raised around the world...LL.M in International Law by the Chicago-Kent College of Law, and ESADE B-school alumni, he has been a transactional and corporate lawyer for several companies and law firms in Spain, specializing in counseling startups. He sees the world as a huge opportunity to be grabbed by the horns, and Barcelona is a wild bull waiting to be tamed. You will likely find him close to the beach or just wondering between hidden wine and cheese places. You can follow him @WillowBCN

phantom option plan

November 14, 2019 at 22:50

Hi Willow. can you help answer a question? Do companies that have phantom plans create a phantom plan set of guidelines and issue shares of phantom? I am in contract phase with a startup and the phantom doc seems very sparse. It mentions no shares or triggers except that 13% of net proceeds if company is sold. This seems a bit over the top. Any help would be great.

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  • EMPLOYEE BENEFITS & PENSIONS

Issues in converting phantom stock plans to actual ownership

  • Employee Benefits
  • Types & Qualifications

Editor: Anthony S. Bakale, CPA

Private companies that hope to sell their business in the intermediate term sometimes want to incentivize key executives who are not owners to grow the business's value in exchange for a piece of the growth. This is commonly structured in one of three ways: a phantom stock plan, stock options, or stock appreciation rights (SARs). Generally, under these structures, at the time of sale the plan triggers a payout to the executive that is taxed as compensation when paid. Sometimes, after these plans are in process, the executive and company wish to change the program to allow the executive to receive long - term capital gain treatment on future growth. To accomplish this, the executive would need to have actual ownership in the business rather than a phantom interest, stock option, or SAR. If the plan is changed in exchange for actual ownership, the results under Sec. 409A are vastly different for phantom stock plans, stock options, and SARs.

Before looking into this situation, it is necessary to give a brief overview of Sec. 409A. Sec. 409A was enacted in reaction to the actions of executives of some public companies that went bankrupt during the recession and stock market crash in the early 2000s. Congress was concerned that executives who were legally deferring income taxation on deferred compensation were able to accelerate the payment of the deferred compensation in advance of a company's bankruptcy. This allowed executives with inside knowledge to get paid despite the losses suffered by creditors and shareholders.

Congress sought to eliminate this abuse with Sec. 409A. Unfortunately, the legislation was not limited to public companies; it also applied to private businesses, with no exception for small businesses. As a result, privately held businesses often find themselves trapped in the web of Sec. 409A. A nonqualified deferred compensation plan that violates Sec. 409A, either in design or operation, subjects the employee to immediate income taxation on the vested balance in the plan and a 20% excise tax on the amount included in income.

To comply with Sec. 409A, the plan must be in writing, and distributions from the plan cannot be accelerated and can be made only on account of the following events:

  • Separation from service;
  • Disability;
  • A specified future date;
  • Change of control of the employer; or
  • An unforeseeable emergency.

The conversion of a phantom stock interest to actual ownership represents one of the many Sec. 409A traps that affect private businesses. To illustrate the issue, consider the following:

Example: The value of the company allocated to the executive's program at the inception of the program is $10,000, its value at the date of conversion to actual ownership is $100,000, and the value of the ownership interest at the time of sale is $200,000. The executive is fully vested and is paid only upon a change in control of the business. In comparing the conversion of a phantom interest with that of a stock option or SAR, assume no Sec. 83(b) election has been made. The phantom values are determined based upon a formula in the plan, which happens to track closely to the actual value of the share price.

Under a stock grant or SAR, the general concept is that the executive will be rewarded by the increase in value of the ownership shares allocated at the date of the company sale over the value on the date they were issued. Sec. 83 governs the taxation of stock options and SARs. Under Sec. 83, non-publicly traded stock options are not taxed until they are exercised, unless a Sec. 83(b) election is made to tax them on the date of grant. In the example, the options or SARs will be taxable at the time of exercise as ordinary income since a Sec. 83(b) election was not made. Therefore, at the date of conversion, the executive exercises her option and recognizes $90,000 of taxable income ($100,000 value less exercise price of $10,000). When the company sells, the executive will have capital gain income of $100,000 ($200,000 less cost basis of $100,000).

If the executive was the beneficiary of a phantom stock plan rather than a holder of stock options or SARs, the results would be the same from an income tax standpoint. The executive would have taxable income of $90,000 upon the issuance of the ownership interest and the cancellation of the phantom stock plan. Upon the sale of the company, the executive would have the same $100,000 capital gain.

The three situations seem to have the same economic interests among the parties, and the ultimate payout is based upon the company's sale value, with no seeming ability of the executive to gain an advantage over creditors or other shareholders. However, Sec. 409A penalizes the phantom stock structure but does not affect a stock option or SAR structure.

Regs. Sec. 1. 409A - 1 (b)(5) exempts stock option grants and SARs from the definition of deferred compensation subject to Sec. 409A. Stock option grants are excluded, provided the exercise price at the time of grant is not less than the fair market value (FMV) and the number of shares subject to the option is fixed. Similarly, SARs are excluded if the amount of compensation awarded is not greater than the excess of the FMV on the date of exercise over the FMV on the date of the award. In the example, the conversion date is changed to a date earlier than the date set for exercise in the plan documents. This change does not violate the prohibition on acceleration of benefits in Sec. 409A because the program is not covered by that Code section.

Strangely, even though the phantom stock plan in the example looks and acts like the SAR program, it is treated differently for Sec. 409A purposes. The phantom stock plan provides a formula to value the benefit. Even if the formula provides a value identical to the stock's value, it is not considered a SAR, as its benefit is based upon the phantom stock agreement, not the stock's value. Under Regs. Sec. 1. 409A - 1 (b)(1), a plan provides deferred compensation to the extent that the employee is legally entitled to the rights under the plan. The regulation further states the fact that the rights may be reduced by operation of the plan, including formula valuation, does not create a substantial risk of forfeiture to the rights of the plan and, thus, the plan is not excluded from Sec. 409A. Therefore, phantom stock plans are subject to Sec. 409A even though SARs are not. As such, in the example, the executive would incur an excise tax of $18,000 upon the conversion.

Executives and businesses stuck with this issue may try to plan using Regs. Sec. 1. 409A - 3 (f), which says that an employee can voluntarily forfeit or relinquish his or her rights in a plan without its being deemed a payment, unless another right or payment is substituted. In the example, the issuance of ownership is includible in the executive's taxable income under Sec. 83, is deemed a payment per Regs. Sec. 1. 409A - 1 (b)(4)(i)(B), and thus is a prohibited acceleration, as a change of control has not occurred.

But what if the timing is different for the voluntary forfeiture and the issuance of ownership? For example, the voluntary forfeiture happens before or after the issuance of the ownership interest. In either case, the employee or the employer is taking a risk that the other party will take the desired action and can argue that the ownership issuance is not a substitution for the phantom stock interest. Under the step transaction doctrine, steps in a transaction are generally not collapsed if there is no binding obligation between unrelated parties. However, the IRS will likely argue that there is a quid pro quo and try to tie the transactions together. Also, under the regulation, if the ownership interest's value is materially different from the value of the phantom interest in the plan, it would not be deemed a substitution. Given the lack of guidance in this area, any dispute with the IRS will likely be a messy facts - and - circumstances argument. However, the taxpayer and business may feel it is worth the risk if they have no alternatives.

This is one of the many headaches that Sec. 409A is causing private businesses, and it seems to be far from the intent of the law.

Editor Notes

Anthony Bakale , CPA, is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at [email protected] .

Contributors are members of or associated with Cohen & Company Ltd.

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Home » Blog » Tax Accounting » Phantom Stock Options – Accounting & Tax Treatment

Tax treatment and phantom stock plans

Phantom Stock Options – Accounting & Tax Treatment

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A phantom stock option is a bonus tax treatment plan where the amount of the bonus is determined by reference to the increase in value of the shares subject to the option. Shares are not actually issued or transferred to the option- holder when an option is exercised, but rather the right to receive an award based on the value of the company’s shares. Phantom stock plans are typically used in private companies where owners wish to motivate and reward employees based on long-term value creation, and restrict the actual ownership of the company’s shares.

Accounting Treatment for Phantom Stock Plans

An annual valuation needs to be completed at the year-end to determine if there has been an increase in value in accordance with the phantom stock plan’s formula.

If the value increases then an accounting is recorded as compensation expense together with the liability for future payment. These accounting rules are under Section 3870 o]’ The CICA Handbook.

  • ABC Corp established a Phantom Stock Plan (PSP) program on January 1, 20XX
  • Plan entitles employees to receive cash at the date of exercise for the difference between the market price of the stock and the pre-established price of S20
  • 5,000 PSP shares
  • Service period required is two years
  • Market price of the stock is 522 on December 31, 20XX and ~;29 on December 31, 20xl
  • PSP option is exercised on January 1, 20×2

Compensation expense for 20xx and 20xl is computed as follows:

Analysis of compensation expense on 12/31/xx:

Analysis of compensation expense on 12/31/xl : Market price

When the PSP options are exercised on January 1, 20×2, the total payment would be $45,000 ($5,000 ÷ $40,000).

Corporate & Individual Tax Treatment

Options granted for tax purposes do not coincide with the accounting treatment.

The compensation expense recorded on the financial statements will be added back for tax purposes. The expense will only be treated as a tax deduction the year the PSP option is exercised.

If the employee chooses to cash in the $45,000 PSP shares, this amount received must be included as employment income and the company will receive a tax deduction.

For more information about phantom stock options and accounting services , contact Hogg, Shain & Scheck today. ​

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Phantom Stocks: All Pros and Cons Analyzed

Employees are the pillars of every company. And offering benefits to employees like company stocks is a great way to retain talent. Such compensation is mainly beneficial for startups that cannot offer competitive salaries to compensate for the employee’s experience and skill. This comes under the employee equity plans, which also include other schemes like ESOPs .

So if you want to retain some senior-level employees and stop them from eyeing other opportunities, it’s time to understand how you can steer away from the usual salary increment route and opt for phantom stocks.

Phantom stocks could be the bridge to establish a profitable arrangement both for your employee and your company.

What is a Phantom Stock Options Plan?

phantom-stock-plan

Phantom stocks are types of compensation that are primarily meant for senior-level employees. Under this plan, employees enjoy the benefits of stock ownership . However, these stocks are hypothetical.

Meaning, phantom stock options have the characteristics of regular stock. It’s worth money, and the price keeps fluctuating according to the market. But employees gain from the profits of the stock price change only after a fixed and agreed-upon tenure. These stocks, also known as ‘shadow stocks,’ do not give the employees voting rights or even a say in the decisions taken for and by the company. They only reap financial benefits.

Each phantom stock plan contains an agreement that outlines the plan’s vesting timeline. Each rule would be outlined in the agreement, including the goals or tasks that a participant must complete before the shares can vest.

It also describes these goals and what is delivered to participants once they have met their objectives.

What are the Different Types of Phantom Stock Options?

phantom-stock-types

There are two types of Phantom stocks: Appreciation Only and Full Value.

1. Appreciation Only

Under this type of phantom stock, the employees only get compensated with the stock’s appreciated value. This means that at the time of cash settlement, they will receive the difference between the current value and the value of the stock when it was granted.

Also read: Experts Discuss: 5 Must-Knows on Incorporating in the United States

2. Full Value

As the name suggests, employees who are given full value phantom stocks get the entire value of the stock as compensation when the cash settlement is released.

It must be noted that both types of plans are similar to traditional non-qualified plans in many ways. Vesting schedules in phantom stock plans are usually dependent on tenure or the achievement of specific goals or tasks outlined in the plan charter.

This document also specifies whether participants will receive monetary equivalents in the form of dividends or voting rights.

So far, we’ve discussed the nature and types of phantom stock options. Now, let’s dive into the pros and cons of employee stock options.

What are the Pros of Using Phantom Stocks?

There are several benefits of using phantom stocks. They are:

1. Financial Gain at Zero Debt

By transferring the value of stocks of the company, employers save a lot on their employee wages. This means they get to retain quality talent without having to drain their financial resources.

At the same time, phantom stocks do not mess with existing shareholders’ control over the company.

Also, under the phantom stock scheme, employees receive the value of the stock as compensation and not the stock itself. Hence, there are no chances of equity dilution.

2. Increased Employee Productivity

Implementing phantom stock pros the company in terms of its human resource in two ways:

  • The employees work with renewed enthusiasm which leads to an increase in overall productivity.
  • Furthermore, with better compensation, the employees stop looking for other opportunities. This is a rather significant advantage of phantom stocks.

Every company needs experienced, senior-level employees in managerial and leadership-related positions. But financing these talents and retaining them is pretty expensive, and that’s where phantom stocks step in.

The best part here is that when you transfer real stocks to an employee, they also have the right to vote in your organization’s decisions.

However, since phantom stocks aren’t real, you get to increase their productivity and loyalty without giving them the right to vote.

3. Easy Exit Mechanism

Phantom stocks provide an easy exit mechanism in comparison to ESOPs . Since they are not actual stocks, there is no hassle of repurchasing them from the employee or from the secondary market where an employee may sell the shares.

Employees cease to reap the benefits of phantom stocks once they leave. You might feel that this might bother employees, but no, their profits aren’t compromised here.

Also read: What Is the Right Time to Exercise Stock Options?

Unlike ESOPs, phantom stocks are much more flexible, and they do not have to wait till their retirement to access the cash benefits.

They can do so even while they are in the service. Here, the employees are only given financial help if they meet specific requirements. Once they leave, the economic benefits stop, simple.

4. Non-Taxable Before Maturity

When employees hold equity shares for a specific period, it comes under the company’s taxable income. However, when you issue phantom stock to your employees, it will be exempted from tax until the stock matures.

However, even when it matures and you have to release the cash settlement, the tax for the transaction will be governed by the guidelines set for the salary income head.

What are the Cons of Using Phantom Stocks?

Like every other aspect, there are certain drawbacks of using phantom stocks as well. They are:

1. You Need to Have Cash in Hand During Settlement

No matter how things are looking for your company when settling employees’ cash benefits, it would help if you had the financial means to compensate them.

Unlike real stocks, phantom stock options only benefit employees through monetary compensation. And if you fail to pay them, they have all the rights to take a legal course of action against you.

2. You Need to Pay for Third-Party Stock Valuation

In case you need to opt for a third-party stock valuation, you alone will have to bear the charges of the advisory firm. Since your company implements the phantom stock scheme, your entitled employees cannot share the cost.

3. Capital Gains Treatment Does Not Apply to Phantom Stocks

Since phantom stocks aren’t real stocks, your employees will miss out on quite a few benefits with Phantom stocks. Regular stocks undergo capital gains treatment under which you will be required to pay a tax on the profit you made from the sale of the stock.

However, phantom stocks aren’t real and they only benefit the employee financially. Hence, it gets taxed as ordinary income and your employee has to pay that.

The disadvantage here is that capital gains have lower tax rates than regular income. So although you will be saving on capital gains tax, your employee will have to pay a tax on the extra benefit. This might give them second thoughts about the arrangement and reconsider if it’s worth it.

Final Thoughts

You can see that the downsides of phantom stocks are outnumbered by the benefits they bring along. And there is no doubt that they act as an excellent tool to motivate and retain employees.

So if you want to scale your business by compensating your senior-level employees, who hold key positions in your company well, then reach out to us to request a demo and take your business to new heights.

trica equity offers all valuation services at a discount. Check out now!

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Australian Employee Share Schemes: Phantom Options Plan

Employer benefits.

  • Preservation of Equity: Phantom option plans allow employers to incentivize employees without diluting existing equity.
  • Employee Engagement: By tying rewards to company performance, phantom option plans can foster a sense of ownership and engagement among employees.
  • Performance Alignment: Phantom option plans can be structured to align with specific company performance metrics, ensuring that rewards are tied to the achievement of strategic goals.

Employee Benefits

  • Financial Upside: Phantom option plans provide employees with the opportunity to benefit from the company's success in a way that is similar to holding actual shares.
  • No Capital Gains Tax: As phantom options are not actual shares, employees are not subject to capital gains tax.
  • Cash Payout: Phantom options result in a cash payout, providing a tangible reward for employees.
  • Long-Term Incentive: Phantom options often vest over a period of time, providing a long-term incentive for employees to remain with the company and contribute to its success.

Plan Conditions

  • Non-ESS Scheme: Phantom option plans are not considered Employee Share Schemes (ESS) and are therefore not subject to ESS tax rules.

Plan Considerations

  • Phantom options represent a promise to pay a bonus equivalent to the value of a certain number of shares, but they do not involve the transfer of actual shares.
  • Phantom options can be tied to specific performance metrics, providing flexibility in how employee incentives are structured.
  • While phantom options do not dilute the equity of existing shareholders, they do represent a future cash outlay, which needs to be factored into financial planning.
  • Phantom options can be particularly useful for private companies that wish to incentivize employees without giving away equity.

The Ultimate Guide to Phantom Shares for Startups

Find out what phantom shares are, how they work, and how to create a phantom shares plan

Motivating and inspiring employees can be done in many different ways. But one strategy that is growing in popularity is the use of phantom shares. Also known as virtual stock options, phantom shares promise to deliver the same economic benefits as stock options without granting any actual stock. If you're ready to learn more about phantom shares, keep reading to discover how they work and how they can impact your startup!

What are Phantom Shares?

Phantom shares, also known as phantom stock or virtual stock options, are a popular industry trend among startups. Such a compensation asset aims to reward, keep and inspire employees . Here is how they work:

  • Those who get phantom shares do not own a stake in the company. Unlike stock options , recipients of phantom shares do not get a right to buy shares or become shareholders.
  • Instead, the idea is to link the value of phantom shares to the actual value of the company's stock. So the compensation from phantom shares is tied to the company’s stock value .
  • Phantom shares provide the team with the opportunity to benefit from company growth. It means that when a company's share value increases, the potential compensation also goes up.
  • Unlike equity compensation, there's no requirement for startups to set aside actual shares as assets when implementing a phantom stock plan.
  • Phantom shares usually get liquid when the company gets acquired or goes public or if the company decides to do a buyback.
  • Any gains from the assets must be reported to tax authorities as ordinary income upon vesting . 
  • The phantom shares plan forms part of your cap table and the vested phantom shares will dilute stakeholders when the company gets acquired or IPOes.

How are Phantom Shares Paid Out?

Phantom shares are usually paid out when the company gets acquired or IPOes . The phantom shares are paid out in cash for their corresponding value. In case of the acquisition, the acquirer must deduct from the total acquisition cost the money to be paid out to employees with phantom shares. 

Upon getting acquired, shareholders will only get diluted by the amount of vested phantom shares , also taking into account potential acceleration rights. For example, if a company has a phantom share plan with 10k shares and at the time of the acquisition, only 5k shares have been granted and vested by employees, the rest of the shareholders will only get diluted by the 5k phantom shares which were vested already.

Companies may also buy back some phantom shares from employees at a discount if it was already established in the original contract. Buybacks are an effective way of giving employees liquidity and making space in the cap table without increasing dilution.

How to Create a Phantom Shares Plan?

From the company's point of view, launching an incentive program like a phantom shares plan is usually a task that becomes more complex as the number of investors and employees grows, but the process is usually the same:

4-step process to create a phantom shares plan: Design, Approve, Launch and Manage

1. Design of the phantom shares plan

The first step is for the management and founder team to align on the essential elements of the plan, for example:

  • Size of the plan (pool size) : defining the % of shares that you want to allocate is critical. The so-called pool size ranges from 5 to 15% of the total shares available. It is usually closed just before an investment round.
  • Vesting period : the period over which the shares will be vested. Usually, the vesting period is 4 years. 
  • Vesting schedule : Simple structure is the most common (in case of 4 years of vesting, 25% of shares are vested each year). Still, it is possible to grant shares under a different schedule (20% in the first year, 25% in the second, 25% in the third, and 30% in the fourth). Phantom shares can be vested every month, quarterly, or annually.
  • Cliff : minimum period an employee needs to work for to start having access to the vested phantom shares. For example, if an employee leaves after 11 months and the cliff is 1 year, no shares will be considered vested. However, when the cliff is reached, then all the ‘vested shares’ become available at that moment (1-year cliff = one  year’s worth of phantom shares).
  • Full acceleration: when there is a trigger event, all the unvested shares are accelerated and fully vested.
  • Partial acceleration: when there is a trigger event, a specified % of unvested phantom shares is accelerated.
  • Single trigger, double trigger or x trigger acceleration: this clause specifies the number of conditions (triggers) that need to happen for any acceleration to occur.
  • Liquidity event : a triggering event specified in the agreement for the execution of the phantom shares plan. Typical triggers are the moment when the company gets acquired or IPOes. 
  • Repurchase or buyback : the company may reserve the right to repurchase phantom shares early before the liquidity event, usually at a discount based on the market valuation. This clause is used mainly in successful companies. The primary motivation for such an activity is for investors to acquire more company shares without further diluting the founders.
  • Definitions of good and bad leavers : the exit or abandonment clauses define what will happen to the phantom shares (assigned, vested and non-vested). These are determined based on the reason for the end of the employment relationship with the company. Usually, a good leaver covers death, retirement, illness, unfair dismissal and sometimes voluntary leave.

2. Approval of the plan

Once the compensation system is defined, the executive body (usually the council) approves the plan.

3. Launch of the plan 

Sending the employee invitation letters, setting up meetings and organizing an information flow to explain the conditions will be a necessary step when launching your phantom shares plan. Communication strategy around employee equity compensation will have to play a big role to ensure the success of the plan. 

4. The management of your phantom shares plan 

First, your company's lawyers will create and prepare the documents. But once the plan is approved, somebody will have to manage the employee grant letters and vesting calculations, provide ownership visibility, send letters of consolidation when employees leave the company, and keep the phantom shares plan up to date. Capboard automates all these processes and provides the tools to set up the plan, manage it efficiently and give the much-needed visibility for every party involved . Learn more about how you can automate your company's compensation plans .

Advantages of Offering Phantom Shares to Employees

Offering a phantom stock plan to employees is an effective tool startups can use to reward loyalty and incentivize the workforce. It is a good alternative to an employee stock option plan (ESOP) , and here is why. 

  • This type of incentive compensation program provides employees with a financial benefit based on the company's performance. As a result, it creates a mutually profitable dynamic. But, you don't have to give equity and dilute your stakeholders , which is the case when offering stock options. 
  • Awarding phantom shares does not require cash outflow right at the moment. That allows you to enjoy the positive impact of such a plan while your company is still developing or fundraising.
  • It encourages worker engagement and performance . At the same time, it helps startups retain talented employees that have been integral in helping grow the company. A phantom stock plan can build loyalty within the staff and support rapid expansion. It is especially relevant as the company gains more ground in competitive markets.
  • Phantom shares allow employers to align their long-term interests with their employees. It is done by setting up target vesting milestones. That means creating a performance-based compensation system using phantom shares. And such an approach can help you encourage employee performance over the long term .
  • Cap table management is easier when having a phantom stock plan and not a stock options plan as phantom shares’ beneficiaries will never become shareholders. Hence, it has no impact on the company’s governance. 

Disadvantages of Offering Phantom Shares to Employees

Offering phantom shares to employees can seem like a great idea for startup founders looking for a way to provide compensation. But it's essential to consider the potential drawbacks: 

  • Employees may not understand the implications of owning nonexistent shares. Something that can put the whole plan at risk of failing and harming the company and the team’s morale. 
  • Furthermore, real stock options may be more attractive forms of compensation due to their cost structure and increased liquidity. 
  • It's important to note that employees with phantom shares are not calling the shots . They cannot decide when they will receive the compensation. The phantom shares are redeemed when particular circumstances trigger them. For example, when the company is sold, is part of a merger or goes public. Such triggers need to be specified in the phantom shares agreement.

In the end, phantom shares are just that - phantom or virtual . That means they exist on paper only. No rights to equity are granted, so employees cannot buy any shares. However, employees can keep the vested phantom shares if they leave as good leavers. 

Phantom shares vs RSUs vs SARs

Phantom shares, RSUs (Restricted Stock Units), and SARs (Stock Appreciation Rights) are popular methods of offering employee compensation in startups. The three plans share similarities. However, there are significant differences that founders should be aware of.

Phantom shares

  • Phantom shares are a type of compensation where employees receive notional shares in the company. 
  • Unlike RSUs, they do not provide ownership rights.
  • But they do entitle employees to economic benefits since their value is tied to the company's share value.

RSUs (Restricted Stock Units) 

  • RSUs give employees a certain number of shares in the company, which they can sell once they vest. 
  • Once the shares have vested, employees may choose not to sell them at the market price and keep them for potential future profits.

SARs (Stock Appreciation Rights)

  • SARs give employees the right to receive an amount equal to the increase in the value of a set number of shares without owning them. 
  • It means that employees do not have to buy any shares. Instead, they receive a payout equal to the increase in the value of the shares. 
  • However, they can choose to get the shares for the value of the appreciation.   

Employers must be aware of the various tax consequences of each compensation strategy. It is also crucial to remember that each compensation has specific rules and regulations. It is recommended to seek advice from legal and financial professionals before deciding on a compensation strategy.

Tips for Maximizing the Benefits of Offering Phantom Shares

Phantom shares incentivize employees to stay for the long term and perform. They can also provide tangible returns on their hard work. With a well-crafted phantom stock plan, employee compensation can increase significantly. That makes it a win-win situation as the employees and your company benefit from such an arrangement! It's important to make key employees a part of the decision-making. It will allow for maximizing the benefits for both parties. Employee input plays a crucial role in developing an agreement that works for everyone. Here are 6 steps for maximizing the benefits of offering phantom shares.

6 tips to maximize the benefits of a phantom shares plan

Offer Phantom Shares at Your Startup with Capboard

Offering phantom shares can be an effective way to inspire employees and create a long-term, results-oriented culture within your startup. Considering the legal and organizational implications of such a plan is crucial before introducing it in your organization. But when done right, you and your team can be greatly rewarded.

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Phantom Stock – What exactly is it and How does it work?

Phantom stock is considered a great way to reward senior-level employees

A lot of companies offer their senior-level employees with extra company benefits along with their salaries. These benefits normally include employee compensation in the form of company stock. There are a lot of employee equity plans that are used including ESOPs , stock options , and phantom stock . Among these plans, phantom stock is considered a great way to reward senior-level employees.

Phantom Stock Plan

A phantom stock plan is employee compensation that gives selected employees, mostly in senior management, benefits of stock ownership without actually giving them company stock. This is sometimes referred to as phantom shares , simulated stock , or shadow stock . It is basically offered as a bonus for staying with the company for a long time and the hard work that employee puts in.

Just like real stock, phantom stock is worth money, and its value increases and decreases just like normal stock. Employees get profit gained from a phantom stock plan after a time period is complete . There are also multiple kinds of phantom stock plans to choose from, based on the preferences of the company, which usually varies on the vesting schedule .

Each phantom stock plan has an agreement that defines the vesting schedule of the plan. The agreement would outline each rule including the goals or tasks that a participant needs to accomplish before the shares can vest. It also defines these goals and what is given to the participants once they reach their goals. If there are any voting rights , those rights are also mentioned in the agreement It would also outline the rules of if the phantom stock can be converted to actual shares upon payout.

Why Do Companies Use Phantom Stock?

Offering employees with employee compensation in the form of equity can offer a lot of benefits. The main benefit is motivating them to work harder by aligning their interest with the company’s. It also helps create loyal employees, as they feel invested in the firm, and may stay with the company longer to receive the full amount of phantom stock. Nonetheless with such incentives, phantom stock is great for certain situations, such as:

  • When the organization is reluctant to issue additional shares .
  • When there are legal concerns .
  • To offset the effect of stock dilution

The number of shares given to an employee is usually based on how senior they are in the organization and their performance. And even though they are promised money today, their benefits are long-term . As per the phantom stock plan, the company would pay out the benefits in two, three, or even five years, with some being subject to certain milestones as well.

Types of Phantom Stock

There are two kinds of phantom stock plans that are given as employee compensation. These include either “full value” phantom stock , or “appreciation only” phantom stock . Each has been explained below:

#1 Appreciation Only Phantom Stock

The recipients of “appreciation only” phantom stock would not get the current value of the stock. Instead, they earn the stock price appreciation as profit where the stock value increases over time. For instance, let us say an employee is going to get 2,000 shares of phantom stock and each stock is worth $20 . This would mean that the current value of the company stock would be $40,000 . And in this example as per the agreement terms, the employee has to stay with the firm for at least four years before they can “sell” their shares. This requirement with a timeframe is called the “vesting” period.

Now, let us say that the vesting period has ended , and the company stock value is $50 per share . The employee would get the difference between the $20 per share value when the deal was made and the $50 per share when the vesting period is complete. This means that the appreciation is $30 per share , which would give the phantom stock shareholder a profit of $60,000 .

Here is a table that summarizes this “appreciation only” scenario:

#2 Full Value Phantom Stock

As per a “full value” phantom stock deal, the participant gets both the current value and any stock appreciation once they have fulfilled the requirements of the phantom stock plan. Taking the same example as before, we know that the employee would get the $30 per share price increase after four years . Nonetheless, they would also get the current value on the shares from the date the deal started. So, this means that the employee would get a total of $100,000 after the four-year vesting period is complete.

Here is a table that summarizes this “full value” scenario:

How does a Phantom Stock Plan work?

For companies to be able to issue phantom stock to employees , both parties need to enter into an agreement. Adhering to the terms of the plan, the company would offer an amount of phantom stock or shares to the participating employees over a specified period of time. The agreement would have all the details like the payment events , vesting schedule , and any other conditions.

Pros and Cons of Phantom Stock

Now that you know what phantom stock is and how it works, let’s take a look at the pros and cons of giving out phantom stock for your company.

Pros of the Phantom Stock Plan

The phantom stock plan has many advantages for a company. They include:

  • Phantom stock is highly flexible and they can be used by both private and public companies.
  • Setting a phantom stock plan is a lot cheaper than setting up ESOPs . It saves the employer a lot of money.
  • There are no taxes that have to be paid by the employee s getting phantom stock until the stock mature.
  • There are less complications in a phantom stock plan, where the employees are paid only if they meet the set terms. And since the plan uses cash and not actual stock, if an employee leaves, the company would not have trouble in handling half the vested stock.
  • Even though voting rights are not offered, the employees are still invested to increase the share price of the company .

Cons of the Phantom Stock Plan

Just like everything, there are cons to phantom stock as well, which include:

  • Every benefit that the employees get is taxed as ordinary income . And since the benefits are paid in cash, capital gains treatment is not available.
  • Participants who are a part of the “appreciate-only” phantom stock plan may not get a thing if the company stock doesn’t appreciate at price.
  • For employees, if the value of the shares drop, the employer can take a call in the deal by offering little control to the employee . There are also chances where they can terminate the deal.
  • When the time comes, it is important for employers to have cash in their hands to pay for the benefits.
  • For the SEC and all the true shareholders , if the company is publicly traded, employers would have to report the status of the phantom stock plan at least annually to all participants.
  • The employers would have to pay if the overview of the stock valuation has to be done by a third-party firm.

If you can handle the downsides of phantom stock plans , then this form of equity compensation may be suitable for you.

Important Legal Framework For Phantom Stock

Even though it is possible, it is tough to avoid some main parts of the federal legislation if you are going to use a phantom stock plan. The very first thing is the ERISA , which is the pension law of 1974 that looks at all the long-term deferred cash of a retirement plan. For meeting ERISA requirements , you need to include the top group of employees in the plan. You also need to give the ERISA a document with specific language. So, to be compliant for this law, you will need to have the phantom stock plan created and administered properly. 

The second federal law is the IRC 409A where there are rules in place for the definitions of triggering events , acceleration of vesting limitations , payout timing and many other things. If the company fails to comply with all these rules, the penalties are onerous. It also includes huge tax penalties for the participants of the plan. In short, if you want to avoid these two limitations, you will have to narrow the rules of your plan. And you will need the help of a professional for preparing a 409a valuation for the company.

Taxation of Phantom Stock

Regardless of how payments for a phantom stock plan is made, the gains are considered as ordinary income and taxed as such . And the tax rate is on the stock price received at the end of the deal. When this happens, the employer has the option to get a deduction in the year the employee reports income, equal to the amount of bonus given out to the employee.

This income is reported in the employee’s W-2 and is subject to withholding tax requirements . But one thing about this plan is that it does not get any special tax treatment or benefit from any deferral of tax beyond the time of payment. Based on the time of the year the phantom stock amount is paid, you may not be required to pay FICA and FUTA . This means that if the compensation was given at the end of the year, then the employee may be over the required wage base amount for FUTA and FICA taxes. But medicare tax still needs to be given as it is not subject to the wage base limit.

Recording Phantom Stock on Eqvista

Eqvista now allows you to manage your company’s phantom stock easily . With Eqvista, issuing phantom stocks to your employees can be done in minutes. Also, your phantom stocks are recorded in real-time in your company’s equity page, cap table, and reports, making it easier to keep track of them and stay up-to-date with your company’s activities.

Aside from issuing and managing your phantom stocks, you can also repurchase them on Eqvista. To learn more about Eqvista’s phantom stocks feature , you can go to our support page and read up the guides we have prepared.

Interested in using Phantom Stock for your company?

A phantom stock plan is a solid employee compensation and a great motivation technique for employees. The best part about this is that if the stock price does not appreciate, both the employee and the company lose nothing. This is a major upside that other plans don’t have. It makes phantom stock one of the best plans to implement in the company.

But while you do this, ensure that you keep track of all the shares in your company . The best way to do this is by using a cap table app such as Eqvista . It can help you keep track of all the phantom stock in your company. Check it out here and begin using it today !

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Phantom Stock Case Studies

The following examples reflect actual circumstances and plans design by VisionLink for its clients.

Objective: Increase focus on value creation, attract stronger talent, reduce turnover

Company Profile: Software Engineering Firm; $28 million in revenue; 85 employees

Growth Goals: Double revenue in 5 years via rapid geographic expansion

Growth Barriers: High cost of turnover in software industry; urgent need to retain key talent without diluting shareholder equity

Compensation Issues: Salaries and bonuses strong but some competitors offered stock options and the company didn't have a long-term value proposition that competed

Solution: Phantom Stock Option Plan . The Plan offered annual grants of stock appreciation rights to selected key employees. Awards were offered annually based on company and individual performance. Vesting was instituted over three years for each block of grants and cash redemptions were scheduled to begin in year four.

Results: The company achieved 50% growth in the first year following plan adoption due to the attraction of three large contracts. Participants saw significant growth in their share value but vesting schedule delayed redemption. Plan was integrated as a significant part of the company recruiting pitch. Employees were given online access to track their share values.

Owners report:

  • Turnover problem was eliminated
  • Inner-office discussions about value creation increased significantly
  • Attraction capability for key producers was strengthened allowing them to compete for talent

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COMMENTS

  1. Phantom Stock Plan: What It Is, How It Works, 2 Types

    A phantom stock plan is an employee benefit plan that gives selected employees (senior management) many of the benefits of stock ownership without actually giving them any company stock. This...

  2. PDF Phantom Stock Plan (Private Company)

    This form phantom stock plan is primarily designed for use by a privately held company to incentivize employee and other service provider performance by granting awards whose value is determined based on the company's stock value. It includes practical guidance, drafting notes, and optional and alternate clauses.

  3. 9 frequently asked questions about phantom stock plans

    A phantom stock plan is a deferred compensation plan that awards the employee a unit measured by the value of a share of a company's common stock, or, in the case of a limited liability company, by the value of an LLC unit. However, unlike actual stock, the award does not confer equity ownership in the company.

  4. Phantom Stock Plan

    A phantom stock plan, also called a shadow stock plan, is a type of deferred employee compensation plan where the type of shares issued to plan participants are phantom shares instead of company shares. Phantom shares provide benefits similar to stock ownership but without actually issuing company shares. Summary

  5. What Is a Phantom Stock Plan for Employees?

    A phantom stock plan pays employees through their employer's without giving ownership of actual stock. It's also called a shadow stock plan because its value mirrors a company's stock. The plan does not consist of genuine shares in the business, but it confers similar financial benefits to employees.

  6. Phantom Stock Option Plan

    A Phantom Stock Option Plan, also known as a Stock Appreciation Rights (SAR) plan, is a deferred cash bonus program that creates a similar result as a stock option plan. The sponsoring company determines a phantom stock price through an internal or external valuation of the company.

  7. Phantom Stock Plan: A Guide for Startups

    The concept is fairly straightforward: A phantom stock plan is a contractual agreement between the company and the employee or service provider, where the company promises to reward the phantom stockholder with the equivalent cash value of the company's actual stock at a future date.

  8. Phantom Stock Plans

    For companies seeking alternatives to stock options, phantom stock is a possible solution. Sometimes referred to as shadow stock and mock stock, phantom stock offers compensation that provides the key benefits of stock ownership — a stake in the company's health and growth — but there's no need to provide actual shares, which ultimately limits dilution at the company.

  9. Phantom Stock Plans

    Phantom stock plans are employee compensation plans that provide the benefits of owning company stock without transferring shares. These plans grant employees the right to receive a cash payment or equivalent shares based on the value of company stock at a future date.

  10. Phantom Stock Plan

    A phantom stock plan is a type of employee incentive plan that allows participants to earn benefits based on the value of the company's stock. These employee incentive plans are often used in addition to other employee benefits, such as stock option plans. A phantom stock plan is an employee perk that grants senior management and other chosen ...

  11. Phantom Stock Plans vs. Equity: How It Works

    Advantages of phantom stock plans. Phantom stock doesn't dilute shareholder equity. ... If you're interested in learning more about equity and your options as a startup founder, schedule a call with a Pulley expert today. Get started with Pulley. No matter where you are in your growth, Pulley simplifies equity management - Cap tables, 409a ...

  12. Phantom Stock: Everything You Need to Know

    When setting up a phantom stock plan, Section 409A must be followed, which includes the guidelines for distributions and terms of the plan. Phantom stock might not always be your best option. Phantom stock only benefits employees if the company grows; issuing phantom shares when you don't foresee growth in the near future could backfire and ...

  13. Everything You Need To Know About Phantom Stocks

    The idea of phantom stock plans is to mimic the value of a share to an employee without actually handing over the shares. Phantom stock plans, also known as equity compensation plans, equity pay plans, stock bonus plans, or phantom equity plans, are a form of employee stock option plan (ESOP). It is an employee benefit that gives employees the ...

  14. How To Create A Phantom Stock Option Plan For Your Startup

    Let's use a simplified example: You grant an advisor Phantom options with a standard 4-year vesting period at a value equivalent to 1000 shares . The economic value of those shares at the moment of issue is €1 each. Let's imagine that in four years the value of those shares is €5 per share at the execution moment.

  15. Issues in converting phantom stock plans to actual ownership

    This is commonly structured in one of three ways: a phantom stock plan, stock options, or stock appreciation rights (SARs). Generally, under these structures, at the time of sale the plan triggers a payout to the executive that is taxed as compensation when paid.

  16. Phantom Stock Options

    A phantom stock option is a bonus tax treatment plan where the amount of the bonus is determined by reference to the increase in value of the shares subject to the option. Shares are not actually issued or transferred to the option-

  17. Phantom Stocks: All Pros and Cons Analyzed

    What is a Phantom Stock Options Plan? Phantom stocks are types of compensation that are primarily meant for senior-level employees. Under this plan, employees enjoy the benefits of stock ownership. However, these stocks are hypothetical. Meaning, phantom stock options have the characteristics of regular stock.

  18. Phantom Option Plans

    Plan Considerations. Phantom options represent a promise to pay a bonus equivalent to the value of a certain number of shares, but they do not involve the transfer of actual shares. Phantom options can be tied to specific performance metrics, providing flexibility in how employee incentives are structured. While phantom options do not dilute ...

  19. The Ultimate Guide to Phantom Shares for Startups

    Acceleration clauses: accelerated vesting in a phantom shares plan implies that the phantom shares will vest immediately if a specific event occurs. For example, there could be an acceleration clause within your phantom shares plan in case of an acquisition/IPO. In that case, the unvested shares would be accelerated, becoming the employee's ...

  20. Phantom Stock Option

    A Phantom Stock Option Plan is a deferred cash bonus program that creates a similar result as a stock option plan. The sponsoring company determines a phantom stock price through an internal or external valuation of the company. Employees are awarded some number of phantom options that carry specific terms and conditions.

  21. Phantom Stock Plan

    The purpose of this 2011 Phantom Stock Option Plan (the "Plan") is to aid Fuel Systems Solutions, Inc., a Delaware corporation (the "Company"), in attracting, retaining, motivating and rewarding officers and key employees of the Company or its Subsidiaries to promote the creation of long-term value for shareholders by closely aligning the intere...

  22. Phantom Stock

    Phantom Stock Plan. A phantom stock plan is employee compensation that gives selected employees, mostly in senior management, benefits of stock ownership without actually giving them company stock. This is sometimes referred to as phantom shares, simulated stock, or shadow stock.It is basically offered as a bonus for staying with the company for a long time and the hard work that employee puts in.

  23. Phantom Stock Option Plan

    Solution: Phantom Stock Option Plan. The Plan offered annual grants of stock appreciation rights to selected key employees. Awards were offered annually based on company and individual performance. Vesting was instituted over three years for each block of grants and cash redemptions were scheduled to begin in year four. Results: