Top 10 frequently asked questions about phantom stock plans

Phantom stock plans can be a valuable method for companies seeking to tie incentive compensation to increases or decreases in company value without awarding actual shares of company stock.  Here are answers to 10 frequently asked questions about phantom stock plans and what they could mean for your company. 

1. What is phantom stock?

Phantom stock, also known as shadow stock, is a compensation plan that grants select employees—typically upper management—many of the benefits of stock ownership without giving out real company stock. The employee is entitled to a cash payout linked to the company's stock value without directly diluting equity for other shareholders. Granting phantom stock is an alternative to stock options; it is sometimes chosen as a method for encouraging employee retention and aligning their interest to the company’s by connecting their payouts to company value.

2. What is a phantom stock plan?

A phantom stock plan, also known as a phantom equity plan, is a written plan that sets forth the terms for the phantom stock a company will award to employees. The phantom stock plan should specify any vesting provisions and when the phantom stock unit payments will be made, among other items discussed below. Essentially a phantom stock plan is a type of long-term incentive compensation plan because it will provide a payout in the future and generally extends over multiple years to incentivize behaviors that drive company growth over an extended period.

The concept of phantom stock is not restricted to corporations. Though the use of the word “stock” is used for simplicity through most of this article, for entities that are not corporations, the value would be tied to a unit of the entity’s equity rather than a corporate share. All other aspects would match those described for stock throughout.

3. How does a phantom stock plan work?

A company can grant an employee a designated number of phantom stock units or a percentage interest in the company’s value pursuant to a prescribed valuation method; this can be done once or multiple times. The phantom stock plan should indicate the number of phantom stock units or the participation percentage interest to be granted to the employee.

For example, the company could grant the employee a 5% interest initially and increase the interest to 10% after the employee completes five years of service.

Whether granted up front or over a period of years, the phantom stock units may either be immediately vested or subject to any vesting schedule determined by the company. For example, vesting may be cliff or graded, time-based, or based on the achievement of specified financial performance goals. 

In addition, special forfeiture provisions can be included in the phantom stock plan to eliminate the company’s obligation to make payments to an executive upon specified events (e.g., if the employee breaches noncompete restrictions in the plan or the employee’s employment is terminated for cause). 

4. What are the advantages and disadvantages of phantom stock vs. actual stock?

5. What is an example of phantom stock or phantom equity?

An executive director is granted 1,000 phantom shares under a retention and performance incentive plan when the company's stock price is $50. After a vesting period of three years, the company's stock price has risen to $75.

If the company’s phantom share plan is full value—as opposed to appreciation-only—the employee should receive a payout of $75,000.

Compare that scenerio to this one: The executive director is issued 1,000 stock options with a strike price of $50 and the right to buy 1,000 shares at $50 each. If the stock price rose to $75, the employee could exercise the options, buy the shares for $50,000 and then sell them for $75,000, realizing a profit of $25,000.

6. How is the value of a phantom stock unit determined?

The value of a phantom stock unit may be measured by the value of a full share of company stock, or it may be based just on the appreciation in value during a specified time frame. (If based only on the appreciation, this is commonly referred to as a stock appreciation right.) The value may be a specified value, determined by an express written formula or determined by a third-party appraisal.

The method used for valuation should take into account adjustments that the parties agree are appropriate. For example, a company could exclude gain or loss attributable to operations or sales of certain divisions of the company. Other adjustments that might be considered include subtractions for capital investments made by the shareholders during the course of the plan, additions for any dividends paid to shareholders during this period, and the amount of accrued deferred compensation attributable to the phantom stock units themselves.

It should be noted that the value of phantom stock units fluctuates from year to year as the value of the company changes. For example, if the company has a bad year and the value of its stock decreases, the value of the phantom stock also decreases. Thus, regardless of any vesting schedule, there is no locked-in value inherent in the phantom stock.

In addition, companies should be aware that events outside the company’s control also affect its value if a third-party appraisal is used. For example, legislative increases or decreases in corporate tax rates may result in companies having more or less cash flow, accordingly (with all else being equal).

The phantom stock plan should specify what events should trigger, or give rise to, a valuation (i.e., what events should entitle the employee to receive benefits under the plan) and at what precise point the value of the phantom stock units should be determined.

Typically, the valuation will follow an event that triggers phantom stock unit payouts so that the amount of such payouts can be determined. Companies can choose what the triggers are—examples include a separation from service, a change in control, or a specified future date or fixed payment schedule. In most cases, a valuation is required upon the employee’s termination, death or disability. In other cases, valuation may be required periodically, such as annually, or on a specific future date.

To the extent possible, any date specified for measuring the value at a triggering event should be based on practicalities consistent with the company’s business practices. For example, once a triggering event has been identified, the company should consider whether the value should be determined on the exact date of the triggering event, or whether it makes more sense to look forward or back to the nearest quarter or year-end, depending on what financial information may be needed to calculate value.

7. How does the executive receive value from the phantom stock?

The number of phantom stock units, vesting schedule, form of payment (i.e., lump sum or installments over a period of years), and triggering payment events are typically set forth in individual grant agreements. Actual payouts of the phantom stock units are usually deferred until a predetermined future date or until the employment relationship is terminated due to retirement, death or disability.

The phantom stock plan must specify when the phantom stock unit payments should commence and at what point a valuation of the units is generally required, as described above. If payments are to be made in installments, the phantom stock unit plan or grant agreement should also specify whether interest will accrue on the unpaid installments.

When designing these provisions, the company should take into account possible phantom stock valuations and company cash flow. It should be noted that even if payments are made after the grantee terminates service, the nature of the payment is generally still treated as compensation for tax purposes and reported on Form W-2 for individuals whose relationship was that of an employee when they were providing services. Phantom stock can also be paid to contractors, but this is not common.

8. How is phantom stock treated for income tax purposes?

Phantom stock plans are usually deferred compensation plans and, as such, must be designed and documented to conform to the requirements of section 409A. For income tax purposes, if the plan is compliant with section 409A, the deferred compensation attributable to the phantom stock will not be subject to income taxation until it is actually paid to the employee.

At the time the payment becomes taxable, the company is entitled to a deduction in a corresponding amount (subject to general limitations under section 162 with respect to the amount being reasonable and not excessive). However, unlike actual stock for which the increase in value on a disposition may be eligible for favorable capital gains tax rates, phantom stock unit payouts are taxable to the employee at ordinary income tax rates.

To make sure these tax results occur, companies should ensure that the terms of the phantom stock plan are in compliance with section 409A prior to the plan becoming effective. A violation of the section 409A rules could cause immediate taxation, plus an additional 20% tax, as well as the assessment of penalties all prior to any actual receipt by the employee.

For the Federal Insurance Contributions Act (FICA), deferred compensation is includible as wages in the later of either the year in which the related services are performed, or the year in which the deferred compensation becomes vested.

The vesting and forfeiture provisions contained in the phantom stock plan or individual grant agreement determine whether and when the executive’s rights are vested.

9. Can entities taxed as partnerships use phantom stock?

Although partnerships do not have common stock, as noted above, entities taxed as partnerships, including LLCs, can implement plans very similar to phantom stock plans. In the case of a partnership, however, the value of a phantom stock unit is tied to partnership equity value rather than common stock value. All other aspects of the plan would be the same. Because the phantom units are not actual equity in the partnership, such a plan should not raise any concerns over partners being considered employees.

10. What should a company consider when designing a phantom stock plan?

Because a phantom stock plan is a nonqualified deferred compensation plan, companies have a lot of flexibility in plan design as long as that flexibility is exercised before the plan becomes effective so no section 409A failures occur.

Companies should address the following when formulating aspects of the written plan:

• What are the objectives of the plan?

• What behavior or performance levels is the company trying to incentivize?

• Who will be allowed to participate? (Consider current and future positions)

• What percentage of the company’s value should be dedicated or reserved for this plan?

• Should participants receive the base value of the phantom stock units, or only participate in growth over and above the base value (if only participating in the growth, this is commonly referred to as stock appreciation rights)?

• Is the potential payment opportunity under the phantom stock plan in line with the company’s compensation and business objectives in three, five, 10, or 15 years given certain performance assumptions?

• How frequently will phantom stock units be granted (e.g., a single upfront grant or annual grants)?

• When will phantom stock units vest? If phantom stock units are awarded annually, will each new grant be subject to a fresh vesting schedule?

• How will the phantom stock units be valued (i.e., based on a formula or an appraisal)?

• What terms will apply should the company have a change in control? How should a change in control be defined?

• Will special vesting rules apply in the case of death, disability, or attainment of specified normal retirement age?

• Will any funding mechanism be used to help the company “fund” its future obligations to pay the amount owed to recipients?

• Should forfeiture provisions apply if the employee enters into competition with the company or is terminated for cause? How broadly or narrowly should the plan define what qualifies as cause for termination?

• When should the value of the phantom stock units be paid out in cash (e.g., periodically every three to five years, upon termination of employment, only upon a future change in control, or, perhaps, other events)?

• Should the payment be made in a lump sum or in installments over a period of years? If payments should be made in installments, over how many years?

• During the installment payout period, should earnings be credited on the balance at a specified interest rate? If so, at what rate? Should the phantom stock units pending payment continue to participate in the growth in value of the company?

• Does the phantom stock plan comply with section 409A?  The plan must be designed and documented to be exempt from, or to conform to, section 409A. This may restrict some of the flexibility of the plan design and operation but generally is not overly burdensome if planned for from the beginning of plan design. 

Various equity compensation methods, including phantom stock, can provide great incentive to employees and employers by cultivating increased engagement that can boost company performance. The attributes of phantom stock units should be carefully considered to determine whether they create the right incentive plan to meet a company’s needs.