The A to Z Explanation About Phantom Stocks
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.
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.
|Private and public companies are both eligible for phantom stocks, which are highly flexible.||Stocks issued as “appreciation only” are subject to gain only if the share price increases.|
|Phantom stock is much cheaper to set up and saves more money than ESOPs.||In case of a decrease in share price, the employer can terminate the deal or offer only a small amount of the total valuation.|
|Within the vesting period, there is no tax levied on the employee.||After the vesting period is over, taxes are levied as ordinary income.|
|Even with no voting rights, the employee stays invested in the company’s revenue and share price.||The employer must have cash on hand at the time of payout to pay the employees.|
|The plan is based on cash rather than the actual stock. If an employee retires, the company will have no issue handling half of the vested equity.||If the company is publicly traded, employers must declare the status of the phantom stock program to all participants annually.|
|A phantom stock program has fewer complications, as the employees are paid only if they meet all the conditions.||The employer has to pay an extra amount if a third party does the stock valuation.|
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.