What is “Phantom Stock” or a “Phantom Equity Plan”?

There are many benefits that business owners can offer to their employees. Despite the surge in creativity when it comes to incentivizing the modern worker, many employee benefits fail to appropriately align incentives with the work that gets done. One surefire way to align incentives so that everyone acts like an owner is to create an employee stock ownership plan. The problem is that most forms of ownership are not available or are too costly for the average American business.

Phantom stock, also known as phantom equity, is an innovative, affordable way to reward employees without granting them actual stock in the company. This concept is particularly intriguing for businesses in industries such as professional services, health care or construction, where traditional stock options might not be feasible or preferred. In this article, we’ll dive into what phantom stock is, how it works, and why it might be a beneficial addition to your company benefits package.

What is Phantom Stock?

Phantom stock, also known as phantom shares, ghost shares or a phantom stock plan, is a type of employee benefit plan that gives employees a stake in the potential success of the company without giving them actual equity or shares. It’s a promise to pay a cash bonus equal to the value of a certain number of company shares, typically paid out after a set period or upon certain events (eg. sale of the business) and in most cases classified as non-qualified deferred compensation.

Unlike real stock, phantom stock doesn’t give employees control or standard dividends. Instead, it’s a contractual agreement where the value of this ‘virtual stock’ is tied to the company’s performance, much like real stock.

The modern agreement for rewards and equity (MARE) is the leading framework for offering deferred compensation plans like phantom stock.

Types of Phantom Stock Plans

There are two types of phantom stock plans: 1) full value and 2) appreciation-only.

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

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.

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.

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.

Appreciation Only 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.

For ease of taxation and deferral of payment treatments, MARE awards are typically taxed only when they are paid out in both full value and appreciation-only plans.

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

How does Phantom Stock Stack up Compared to Other Employee-Owner Structures?

How Does a Phantom Equity Plan Work?

Plans can vary and be tailored to the individual needs of a business, but they typically involve a few key components:

1. Grant of Phantom Shares: Employees are granted a certain number of phantom shares. Within a limited liability company (LLC), they’re typically referred to as “Phantom Units.”
2. Vesting Schedule: Similar to real stock options, phantom shares often have a vesting schedule. Vesting essentially means that they don’t get all of the shares at once. With each month they work at the company and contribute value, employees earn a set percentage. They typically become fully vested in these shares over a period of years, incentivizing long-term commitment. Learn more: Phantom Stock Vesting Schedules Explained
3. Payout Structure: The payout of phantom shares is usually made in cash, based on the current value of the company’s actual stock.
4. Trigger Events: Payouts are usually triggered by specific events, such as the sale of the company, retirement, or other predetermined milestones. Some companies even choose to share profits with their phantom stockholders quarterly or annually.

What is an example of phantom stock?

Let’s say a company grants 1,000 phantom shares to an employee. If the company’s stock is valued at $10 per share at the time of payout, and the employee is fully vested, they would receive $10,000.

Is phantom stock a good idea?

Phantom stock can be a powerful tool for businesses, especially those in industries where traditional equity offerings are not common. Here are some reasons to consider it:

1. Aligns Employee Interests with Company Goals: Employees benefit financially from the company’s success, fostering a sense of ownership and motivation.
2. Flexibility: Each plan can be customized to suit the specific needs of your business and workforce.
3. Stand Out as an Employer: Such plans can help attract top talent and retain key employees by offering a piece of the company’s future success.
4. No Equity Dilution: Since phantom stock doesn’t involve actual shares, there’s no dilution of ownership among existing shareholders.

Setting Up a Plan

Creating a plan is relatively simple, but there are several steps to set one up:

1. Define the Terms: Determine how many phantom shares will be offered, the vesting schedule, the payout events and any specific conditions you may want to have.
2. Draft a Phantom Stock Agreement: This legal document outlines all the terms of the plan. Get our free phantom equity template here.
3. Communicate with Employees: Clearly explain how the plan works, its benefits, and any conditions attached to it. It’s important to have a way to continually remind employees of this special benefit, as the reward typically involves delayed gratification. Learn how to communicate phantom equity with employees.
4. Administration: Regularly update the plan to reflect changes in company valuation, change in structure, issue phantom equity awards to new employees and more. You’ll also need to manage payouts as necessary, depending on the triggering events you have chosen.

Tax Considerations

It’s crucial to understand the tax implications of phantom stock plans. Unlike traditional stock options, phantom stock payouts are typically treated as ordinary income and subject to payroll taxes—they are not usually treated as capital gains. That being said, payouts can be a write off for the employer when treated as ordinary income (like W2 income, for example). Perhaps most importantly, phantom stock is not taxed until a payment has been made, which is not the case when issuing real equity.

Key Takeaways

• Phantom stock provides a cash bonus based on the value of the company’s stock.
• It aligns employee interests with company performance without the pitfalls of real equity.
• The plan can be tailored to fit the needs of both the company and its employees.
• It’s important to understand the legal and tax implications of such plans.

Phantom stock represents a smart, adaptable tool for fostering a shared sense of success and commitment within your company. Whether you’re a seasoned business owner looking for successors who, one day, may be able to take the reins, or a budding entrepreneur looking to motivate key management, considering phantom equity as part of your compensation strategy could be a game-changing move.