If your business is looking for a way to incentivize employees’ performance and allow them to share in the company’s success, issuing phantom stocks (aka phantom stock plans) could be right for you.
With a phantom stock plan, your company can grant key employees, or all employees, a right to share in the company’s value without granting the rights that normally come with the ownership of stock (e.g., management and voting rights).
Phantom Stock: Appreciation-Only vs. Full Value
There are two types of phantom stock plans: appreciation-only and full-value.
- Appreciation-Only Plan: Under this plan, employees only receive the difference between the phantom stock’s initial value and its increased value at the payout date.
- Full-Value Plan: This type of plan pays out both the appreciation and the value of the underlying stock over time.
For example, let’s say ABC Inc. grants Megan 100 phantom stocks initially valued at $10 each (total $1,000) and five years later the value is $30 per share. Under an appreciation-only plan, Megan receives $2,000. With a full-value plan, she would receive $3,000.
Phantom Stock vs. Equity
Unlike actual equity, phantom stock does not confer any ownership rights. This makes it an appealing choice for companies seeking to offer employees financial incentives tied to performance without diluting ownership.
Phantom Stock vs. Stock Appreciation Rights (SARs)
Phantom stock and Stock Appreciation Rights (SARs) share similarities, as both provide payouts tied to company value. However, SARs generally offer employees the appreciation in stock value only, without the option for full value, while phantom stock plans may include either appreciation-only or full-value payouts.
Phantom stock Taxation
- Phantom stock plans are treated as deferred compensation. Employees are not taxed on phantom stock income until the payout, with the income then taxed as ordinary income.
- For the company, payouts may be tax-deductible if the plan aligns with 26 U.S. Code § 409A regulations.
- Unlike actual stock, the value of phantom stock is taxed as ordinary income.
Accounting for Phantom Stock Plans
Accounting for phantom stock plans requires recognizing a liability for the payouts at fair value, adjusted over time as the company’s stock value changes. Proper accounting is essential for managing cash flow impacts and ensuring compliance with tax regulations.
Benefits and Drawbacks of a Phantom Stock Plan
Phantom stock plans can be a powerful tool for aligning employee incentives with company success, but they come with a few considerations to weigh.
Benefits of a Phantom Stock Plan
- Flexibility with Structure: Unlike traditional stock options, phantom stock plans offer freedom in design. Companies can decide how and when employees can cash out, customizing terms to fit both business goals and employee incentives.
- Stronger Employee Motivation: Employees can share in the company’s growth, boosting morale and loyalty without giving up any actual ownership.
- No Dilution of Control: For owners, one of the biggest perks is maintaining full control over the company’s shares and decision-making, while still rewarding employees financially.
Potential Drawbacks
- Tax Implications: Phantom stock payouts are taxed as ordinary income, which can lead to higher taxes for employees compared to capital gains.
- Cash Flow Pressure: The company needs to have cash available to fund payouts when employees redeem their shares, which can be a strain if not planned carefully.
- Setup Complexity: Crafting a phantom stock plan involves legal and financial intricacies that can make setup a bit more involved than other incentive programs.
What Should Go in a Phantom Stock Agreement?
A well-crafted phantom stock agreement ensures clarity and alignment for both the company and employees. Key elements to include are:
- Type of Plan: Specify whether the plan is appreciation-only or full-value, as this determines the potential payout.
- Vesting Schedule: Outline the timing for when employees earn the right to the phantom stock, such as over several years or based on performance milestones.
- Payout Terms: Define how and when payouts will be made—whether upon termination, retirement, or another triggering event.
- Valuation Method: Clarify how the company will determine the stock’s value, especially if it’s a privately held business.
- Conditions for Payout: Detail any contingencies, like continued employment, that must be met before employees can receive payouts.
- Forfeiture Provisions: Include terms on forfeiture, which specify under what conditions employees may lose their rights to the phantom stock (e.g., if they leave the company early).
- Tax and Compliance Considerations: Ensure the agreement aligns with tax regulations, particularly 26 U.S. Code § 409A, to avoid unforeseen tax liabilities.
By addressing these points, the agreement can set clear expectations for both parties, making the plan smoother to administer and understand. It’s wise to have a contract attorney draft and negotiate this agreement for you.
Need Help Creating Phantom Stock Plans?
If your company is interested in incentivizing employee performance, consider implementing a phantom stock plan. Offering shadow stock or phantom equity to employees can motivate your team and align their interests with the company’s success.
Contact Gordon Law today to schedule a consultation and discuss how a phantom stock plan can support your business goals!
