Types of Phantom Stock Plans: Full Value and Appreciation-Only

May 22, 2024

Small business owners across America face a challenge that all companies encounter: keeping their key employees. Even though large corporations also face this challenge, they typically set up infamous “golden handcuffs” in the form of stock options, RSUs, or other benefits to discourage an employee from taking employment elsewhere.

It turns out, LLCs and other small business structures don’t have to sit by the wayside. They can also offer incentive programs to keep their key employees for the long haul. Profit sharing and phantom stock plans are great ways to encourage employees to stick around and motivate staff with owner-like benefits.

In a recent 60 Minutes segment titled, “Work to Own,” a private equity firm employed Pete Stavos to manage a factory. Private equity (PE) firms are renowned for their aggressive business practices and ability to “slash and burn.” In the case of Pete Stavos, however, he informed the entire workforce that they would now be part owners in the company, with a one time payout up to 6.5x of their annual salary depending on tenure. With “skin in the game, they’ll be able to work harder and smarter.”

From factories, flatbeds and farms, phantom stock agreements, one of the underlying instruments of the MARE, can make a huge difference in the lives of all who get to participate in them. To understand phantom equity plans a little more, let’s go one step further and highlight the differences between the two plan types: full value and appreciation-only phantom stock plans.

Full Value Phantom Stock Plans

In a full value phantom stock plan, employees are granted units that represent the full value of the company’s stock. These units mimic actual shares of company stock in terms of value appreciation and dividend payments.

When the value of the company’s stock increases, the value of the phantom stock units also increases. Conversely, if the stock value decreases, the value of the phantom stock units decreases. Upon a triggering event, such as retirement, termination, or a predefined period, employees receive cash or company stock equivalent to the value of their accumulated phantom stock units. The payout is usually based on the difference between the initial grant value (known as a strike or exercise price in normal stock terms) and the current value of the phantom stock units.

Full Value Example

Let’s say a business owner grants an employee 50,000 units of phantom stock. Years later, the company sells for $1 million with a total of 1 million shares (each share is now worth $1). To calculate the payout of a full-value phantom stock deal, simply multiply the number of phantom units the employee holds (50,000) by the value of each unit ($1) at the time of sale. In this case, the payout would come to $50,000.

Ex: 50,000 (units) X $1 (value) = $50,000 (payout)

Appreciation-Only Phantom Stock Plans

An appreciation-only phantom stock plan is defined as a promise for a certain amount of future cash, where that amount is equal to an increase in the value of company shares over a period of time.

Employees receive a payout only on the appreciation in the value of the phantom stock units from the time of grant to the time of payout. This means they benefit solely from the increase in the company’s stock price.

The payout is typically in cash and is calculated based on the difference between the initial grant value and the value of the phantom stock units at the time of payout.

Appreciation-Only Example

For example, a business owner might grant an employee 50,000 units of phantom stock in January 2024. Let’s say the value of the business at the time the shares are granted is $500,000, represented by 500,000 shares; this means that each share is valued at $1.

In January 2030, let’s say the company is valued at $1 million dollars, now represented by the same 500,000 shares (assuming no additional shares were issued); this means that each share is valued at $2.

In an appreciation-only scenario, the growth in value between the time of stock being granted and the sale of the company (or other triggering event) is what’s relevant. The change in value per share in this case is $1. Multiply that change in share value by the employee’s 50,000 shares, and the employee walks away with $50,000.

Ex: $2 (current value) – $1 (original value) = $1 (appreciated value)

      $1 (appreciated value) X 50,000 (granted units) = $50,000 (payout)

Key Differences Between Full Value and Appreciation-Only Plans

Nature of Grant

Full value plans grant units representing the full value of the company’s stock, while appreciation-only plans grant units representing only the appreciation in stock value.

Dividend Payments

Full value plans may entitle employees to dividend equivalents, whereas appreciation-only plans generally do not – the terms of each plan determine how dividend payments are treated. As an added benefit, Reins offers the flexible ability to split dividends out of the phantom plan and add it separately. So regardless of full-value or appreciation only you could customize the issue of dividends.

Payout Calculation

Payout in full value plans is based on the total value of the units granted, while payout in appreciation-only plans is based solely on the increase in value.

Tax Implications Between Phantom Equity Plans

Note: Reins is an online service providing legal forms and information. We are not a law firm and we do not provide legal advice.

There are tax implications associated with both full value and appreciation-only phantom stock plans, which might affect the attractiveness of each option for employees. Here’s a breakdown of tax considerations for both types of plan:

Full Value Phantom Taxes

Taxation upon Grant: Typically, there are no tax consequences to employees upon the grant of full value phantom stock units because they do not represent actual ownership in the company.

Taxation upon Vesting: When typical phantom stock units vest, meaning they become available for payout, employees may incur ordinary income tax on the value of the units at that time. This is similar to how restricted stock units (RSUs) are taxed. For ease of taxation and deferral of payment treatments, MARE awards are typically taxed only when they are paid out.

Taxation upon Payout: Upon payout, employees may incur additional taxes. The difference between the value of the phantom stock units at the time of grant and the value at the time of payout is usually taxed as ordinary income.

Appreciation-Only Phantom Taxes

Taxation upon Grant: As with full value plans, there are typically no tax consequences upon the grant of appreciation-only phantom stock units.

Taxation upon Vesting: Similarly, employees usually do not incur taxes upon vesting because there is no taxable event until the units are paid out.

Taxation upon Payout: When the appreciation-only phantom stock units are paid out, employees are taxed on the appreciation in the value of the units as ordinary income. This is calculated as the difference between the value of the units at the time of grant and the value at the time of payout.

Full Value vs Appreciation-Only Tax Considerations

Timing of Taxation: Full value plans may trigger taxes earlier, upon vesting, while appreciation-only plans delay taxation until payout.

Tax Rates: The tax rates on ordinary income versus capital gains may influence employees’ preferences. Appreciation-only plans may offer potential tax advantages if employees can defer taxation and potentially qualify for lower capital gains rates upon payout.

Complexity: Appreciation-only plans may have simpler tax implications since the taxation is based solely on the appreciation in value.

MARE Agreement: Selecting Full Value or Appreciation-Only

The Reins MARE agreement is a customizable phantom stock template, specifically designed for small businesses. One example discussed above relates to dividend payouts between full value and appreciation-only plans. As an added benefit, Reins offers the flexible ability to split dividends out of the MARE plan and add it separately. So regardless of full-value or appreciation only you could customize the issue of dividends.

Taking only a matter of minutes to set up, Reins enables customizing your plan as unique as your company is. Selecting between Full Value and Appreciation-Only couldn’t be easier.

Select your plan type in the Plan Features section.

Conclusion

Ultimately, choosing between full value and appreciation-only phantom stock plans should take into consideration not only the tax implications but also the company’s goals, financial situation, employee preferences, and the desired alignment of incentives. Full value plans may provide more immediate benefits and a sense of ownership, while appreciation-only plans may align better with growth-oriented companies and provide simpler payout structures.

Consulting with tax advisors and legal professionals is advisable to fully understand the tax implications and make informed decisions.

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