Phantom stock plans and taxation: What to know about this non-traditional equity compensation structure

This article gives you a comprehensive walkthrough of phantom stock and taxation.

Phantom stocks allow employees to participate in the company’s shares or wealth by purchasing phantom shares, commonly referred to as “shadow stocks” or “ghost shares”. In the past, public businesses primarily used phantom shares to pay out cash to executives who owned stock options. In the contemporary world, it is increasingly used in private corporations as a stand-in for actual awards or stock grants.

You should know several things before indulging in phantom stocks, including how they operate and their tax ramifications. This article gives you a comprehensive walkthrough of phantom stock and taxation.

Phantom stock plans and taxation

To understand phantom stock and taxation thoroughly, we first need to grasp some basic terms and the importance of understanding taxation.

What are phantom stock plans?

A phantom stock plan, sometimes known as a shadow stock plan, is a kind of deferred employee compensation plan in which phantom shares, rather than company shares, are granted to plan members. The advantages of phantom shares are quite similar to those of stock ownership but without the real issuance of firm shares.

The employee receives mock stock rather than actual shares. The phantom stock, despite not existing, tracks the performance of the company’s genuine shares and distributes any profits that result.

Importance of understanding taxation in phantom stock plans

Taxation is an important consideration in phantom stock plans, as how these plans are structured can have a significant impact on the amount of taxes that employees will be required to pay. Specifically, the timing and manner in which phantom stock awards are taxed can impact the amount of income taxes, payroll taxes, and capital gains taxes that employees will owe.

Tax implications in phantom stock plans need to be carefully understood such as the timing of the tax liability and the type of income subject to taxation. Understanding these tax implications is essential for companies and employees to properly structure and manage phantom stock plans. This can help ensure that the plans are tax-efficient, compliant with applicable tax laws, and provide the intended benefits to participants while minimizing unintended tax consequences.

Types of phantom stock plans

There are two types of phantom stock plans:

Appreciation Only

An ‘Appreciation Only’ phantom stock plan would mean that the plan participant is paid an amount equal to the difference between the stock price of the company at redemption and the phantom stock’s issue price.

Let’s understand this through an example. Assuming that the phantom stock’s issuing price is $20, the cost of the company’s common shares at redemption was $50. The difference here, i.e., $50 – $20= $30, would be the amount paid to the plan participant. Hence, each phantom stock would generate $30 in cash.

Full Value

A ‘Full Value’ phantom stock plan would mean that the plan participant is paid an amount equal to the value of the common stock (underlying asset) of the phantom stock at redemption.

Assume, for instance, that the phantom stock’s issuing price is $15. The cost of the company’s common shares at redemption was $40. Each phantom stock would generate $40 in cash.

Comparison with traditional stock options (phantom stock plan, SAR, ESPP, RSG)

As we have discussed above, phantom stock plans are non-traditional equity compensation plans. Let’s look at some basic differences between phantom stocks and traditional stock options to facilitate the use of what’s best for your business.

  • Stock Appreciation Rights – Similar to phantom stock, stock appreciation rights (SAR) grant the rights to the cash equivalent of the rise in the value of a specific number of shares over a specified period. This is also typically paid out in cash like phantom stocks but might also be done so in the form of shares.
  • Employee Stock Purchase Plans – Employee stock purchase plans might be substituted with phantom stock plans (ESPP). The period it takes to get a return on your investment is what distinguishes the two. An ESPP’s stock price will rise over time, but you won’t be able to sell any stock until the offering period is over. With a phantom stock plan, you can decide whether to get your reward upon vesting or when the program comes to an end.
  • Restricted Stock UnitsRestricted stock units (RSUs) are settled in genuine shares, whereas Phantom Stock is settled as a cash bonus. Dividends, voting rights, and other advantages can also be provided to employees under RSUs before the vesting period.

Taxation of Phantom Stock Plans

Phantom stock plans must adhere to IRS (Internal Revenue Service) Section 409A since they are deferred compensation plans. To follow the procedures of taxation that one should, it is important to understand the tax implications of phantom stocks on both employees and the company, along with the treatment of phantom stock plans for tax purposes.

Tax implications for the employee

If the plan complies with section 409A, the employee is only required to pay income tax on the deferred compensation related to the phantom stock once it is paid to and received by the employee. The grant of phantom shares typically has no financial repercussions for the employee because an employee is not taxed upon receiving a contractual right to payment. The sum paid to the employee at the moment of payment will result in a tax deduction for the company or the employer.

The value of the phantom stock units is includible as wages taxable under FICA (Federal Insurance Contributions Act) as soon as they become vested. No additional Social Security tax will be levied on the phantom stock payments if the employee’s basic pay (before including the phantom stock unit payment) exceeds the Social Security wage base. Medicare payroll tax is applicable on phantom stock plans since it is imposed on total wages without any wage cap.

Tax implications for the company

The company has the right to a deduction in the payment amount when it becomes taxable (subject to the general restrictions outlined in section 162 regarding the amount’s reasonableness). Phantom stock unit distributions are taxable to the employee at ordinary income tax rates. On the contrary, the increase in value on a disposition for actual stocks may be eligible for favorable capital gains tax rates.

Companies should make sure that the provisions of the phantom stock plan are in line with section 409A before the plan comes into effect to guarantee these tax outcomes. A violation of section 409A provisions may result in immediate taxation, an extra 20% tax, and the application of penalties. FICA and Medicare payroll taxes apply to the company.

Treatment of phantom stock plans for tax purposes

Businesses should speak with their accountants or attorneys if any tax deferral or reduction plans are available in the relevant jurisdiction. Treatment of phantom stock plans for tax purposes also requires taking notice of any additional regulations that may apply specifically to international personnel. It is crucial to precisely understand what is subject to taxation, when the tax becomes due, and how much tax must be paid.

Considerations for Implementing Phantom Stock Plans

Phantom stock and taxation require specific considerations by the employers for the plan to be lucrative. These include the advantages and disadvantages of a phantom stock plan, factors to consider before implementing a plan, and the importance of consulting a tax professional for the same.

Advantages and disadvantages of phantom stock plan

Phantom stock plans are advantageous for employers for several reasons. Companies can use them to reward staff without having to give participants a share of ownership. Because of this, closely held businesses are more likely to employ these plans, but some publicly traded companies do as well. Phantom stock plans, similar to other employee stock plans, can be used to boost employee retention and engagement. They can also prevent key personnel from leaving the company by using the “golden handcuff” clause.

As for the disadvantages, significant cash payments made by employers to employees are always taxable to the receiver as ordinary income and, in some situations, may interrupt the company’s cash flow. In many instances, the variable liability that comes along with the typical variation in the stock price of the company negatively affects the balance sheet of the corporation.

Factors to consider before implementing a phantom stock plan

There are some factors to consider for a company before structuring and implementing a phantom stock plan. These are the top factors you should consider:

Factors to consider before implementing a phantom stock plan

  • Company Goals – Your company goals need to be on your priority list before implementing a plan. Choose the eligible employees, set the goals, and choose the equity percentage. Because phantom stocks are a type of delayed employee compensation plan, businesses can alter the arrangement as needed. A phantom stock plan should eventually represent the corporate culture you want to create.
  • Phantom Stock Valuation – While going for phantom stock valuation, you can either obtain a formal appraisal or decide on the price yourself. The majority of businesses utilize a formula or one of their key measures (such as EBITDA) to calculate the worth of their company. Be careful, as you should not raise the value too high, as it would make your shares worth more than the firm itself.
  • Legal Compliance – Phantom stock plans must adhere to several laws and regulations. The plan must conform to all applicable laws, including tax laws and securities regulations, to be effective. We have discussed tax implications in this article, and keeping those in mind, legal compliance, such as meeting ERISA requirements, is a key factor for a successful plan.
  • Financial Impact – Phantom stock plans have a significant financial impact on a company’s bottom line. Before implementing a plan, assessing the potential costs and benefits, including the impact on the company’s financial statements, taxes, and cash flow, is essential.

Importance of consulting with a tax professional

Consulting with a tax professional can help navigate the complexities of phantom stock and taxation. It’s crucial to abide by all local, state, and federal tax regulations while using phantom stock plans. A tax professional can guide the tax consequences of different phantom stock plan structures and help ensure compliance with relevant tax laws and regulations. Additionally, they can assist in maximizing tax benefits and minimizing tax liabilities. Consulting an expert in this area can help avoid potential pitfalls and ensure that the phantom stock plan is structured in a way that aligns with the company’s goals and values.

Tax professionals from a renowned company such as Eqvista can assist businesses in navigating the tax system, comprehending their responsibilities, and ensuring compliance with all relevant regulations. Eqvista provides a range of advanced technological tools and features that can help with the taxation of phantom stocks, including tracking of vesting schedules, real-time valuations, customizable taxation rules, tax reporting, etc.

Manage your phantom stock with Eqvista!

Employers can give equity-linked pay to workers without considerably diluting their stock through phantom stocks. There are numerous aspects you need to take care of while handing out non-tradition equity compensation, and one needs to be well-versed in all the financial and legal work for this. With Eqvista, you can rest assured as we have an accurate cap table app to manage your shares and provide professional help. Contact us for more information.

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