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:
|Time Period||Units (Shares)||Value per share||Original Value||Total Value||Total Gain|
#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:
|Time Period||Units (Shares)||Value per share||Total Value||Total Gain|
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 employees 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
Let’s say that your company has a total of 6,000 diluted shares in the company, including 2,500 common shares, 500 preferred shares, 2,000 options and 1,000 warrants.
This is how the cap table would look like:
Using this information, you can easily create your company profile. Once done, this is how the cap table on Eqvista would look like:
Now, let us assume that you decide to issue 5% of the total current shareholding, or 300 shares, as phantom stock on June 1st ,2017. Once done, this is how the new cap table would look like:
With the phantom stock, a 3 year vesting schedule is applied with 75% of the shares (225 shares) gained equally over 3 years, and the remaining 25% of the shares (75 shares) subject to sales milestones.
You can easily see all these details of the phantom stock plan on Eqvista, as below:
As soon as all the 300 shares are vested as per the time-based and milestone vesting, the employee can choose to sell the shares back to the company. Let’s say these 300 shares were valued at $20 by 2020. If the employee decides to sell their shares on June 15th 2020, they would get $6,000.
And this is how you can track phantom stock on the Eqvista app.
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!