Phantom Stock: What is it? The good, the bad, and the ugly
Phantom stock is a form of incentive compensation (similar to stock options) that enables the employee to benefit from the growth of the company and allows the employer to align the employee’s interests with the company’s growth.
Tell me more! How is it used?
Phantom stock is a contractual agreement with benefits similar to stock options. Recipients typically don’t pay for phantom stock and the value tracks the value of the stock in the company over time. An employee might receive an annual grant of shares in their phantom stock plan account.
Presumably, the value of the company will soar because of all the amazing employees and the value of the company’s shares will go up over time.
At some point in the future (typically upon departure from the company), the phantom stock account is paid out to the departing employee. This gives them a chance to participate in the equity value they create during their tenure.
Why is it used?
High-performance companies often want their employees to think like owners. One way to encourage ownership thinking is to compensate at least some, if not all employees with equity. There are an array of methods for transferring equity to employees, and your counsel can help you select one. One popular option is to use phantom equity or phantom stock.
What is the value? Are there tax consequences?
Phantom stock has no “exercise” point like stock options. When an employee exercises stock options, which typically must be done within 10 years of the grant, the options must be valued and the strike price must be paid by the employee. If the value is substantially higher than the strike price, taxes may even be imposed. If none of the stock is being liquidated at that time the employee can be put into a cash squeeze while paying for options and the taxes due!
The advantage is, if managed correctly, stock options create long-term capital gains for the employee, which is taxed at the lowest rate available, possibly even tax-free if it’s QSB (Qualified Small Business) stock!
Which is better: stock options or phantom stock?
Stock options are not always effective. If the timeframe to company exit is long, the vision is not believed by the employees or they’ve had other stock options that “aren’t worth the paper they’re printed on”, they may not be motivating. Stock options also create administrative overhead, a more complicated and dynamic capitalization structure, and foster ownership with people who may become disgruntled in the future.
In contrast, phantom stock is a contract with employees so it is more flexible, always results in regular compensation, and is always treated as regular income by the tax authorities.
It’s far more tangible to most employees, though, and allows you to structure payments to participants in a clear and manageable fashion.
The agreement, account value, and clear opportunities to benefit from the value created can make phantom stock much more compelling to employees and is less overhead for management. Phantom stock can be adjusted more easily from year-to-year and, with fewer shareholders, reduces the risk of “shareholder” lawsuits.
Consider phantom stock next time you’re looking for ways to share equity value with your employees. Don’t overlook stock options and restricted stock, which both offer better potential tax treatment, but phantom stock is often the simplest way to go.