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. Most stock plans are built for a large corporation.
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 small businesses like the trades, 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's benefits package.
What is Phantom Stock?
Phantom stock 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 (e.g. 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.
Other names for phantom stock
Phantom stock goes by a few different names. You might hear it called “phantom equity,” “shadow stock,” “synthetic equity,” or even “ghost shares.” All these terms mean the same thing: a way to give employees a financial stake in the company’s success without giving them actual shares.
Phantom equity for LLCs (aka “phantom units”)
Run an LLC? You can still use phantom equity. Instead of “stock,” LLCs grant phantom units that track your company’s value. Employees vest over time and receive cash when a trigger hits (sale, milestone, or a scheduled payout).
Employees remain W-2—no ownership, no voting rights, no K-1s. You keep control and avoid dilution while giving a real upside tied to performance. That’s why phantom equity fits trades businesses (HVAC, plumbing, electrical, roofing) so well.
What is non-qualified deferred compensation?
Non-qualified deferred compensation (NQDC) is a way for businesses to let employees or owners delay part of their pay until a future date. Unlike traditional retirement plans like 401(k)s, NQDC plans don’t have to follow strict government rules about contribution limits or who can participate. This makes them more flexible, but also means they’re usually offered to top employees or executives, not everyone.
With NQDC, an employee can choose to get paid later—maybe when they retire, hit a certain milestone, or leave the company. The money grows tax-deferred until it’s paid out. When the payout happens, it’s taxed as regular income. Phantom stock is one example of a non-qualified deferred compensation plan, since employees get paid out in the future based on the company’s value, not right away.
Types of Phantom Stock Plans
There are two types of phantom stock plans: full value and appreciation-only.
Choosing between full value phantom stock plans 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 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.
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 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.
For ease of taxation and deferral of payment treatments, phantom stock plans set up using Reins' 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
Phantom Stock vs other employee-owner structures?
When you’re thinking about ways to reward employees with a stake in your company, there are a few options out there. But not all of them are created equal—especially for small businesses. The biggest differences come down to cost, how easy they are to set up, whether you have to give up actual ownership, and if they make sense for a business of your size. Here’s how phantom stock stacks up against other common employee-owner structures:
Phantom equity vs equity (actual shares)
Phantom equity and real equity (actual shares) both give employees a stake in your company’s success, but they work very differently.
Ownership & dilution: Phantom equity is cash-settled, so no new shares are issued and there’s no dilution of existing ownership. You keep your cap table simple. With real equity, you issue new shares, which dilutes your ownership and adds complexity to your cap table.
Control: Phantom equity doesn’t give employees voting rights or create minority-owner issues. You stay in control of your business. Real equity gives employees actual ownership, which means they may get voting or consent rights and a say in company decisions.
Cash vs liquidity: Phantom equity pays out cash when certain triggers happen, like a sale or retirement. You can even pay in installments. With real equity, employees usually only see value when there’s a sale, buyback, or dividend—so the reward is tied to a liquidity event.
Admin: Phantom equity is managed through a simple agreement or plan and regular company valuations. Real equity requires updating your shareholder or operating agreement, managing buy-sell terms, handling 409A valuations, and more paperwork.
Taxes: Phantom equity payouts are taxed as ordinary income for employees, and the company gets a tax deduction. Real equity can lead to capital gains for employees, but only if they actually own shares and there’s a qualifying event.
Best fit: Phantom equity is a great choice for small and mid-sized businesses that want to offer ownership-style incentives without giving up control. Real equity makes more sense for companies planning for big liquidity events or raising money from outside investors.
Phantom Stock vs ESOPs
Phantom stock and ESOPs both help align employees with the company’s success, but they work in very different ways. With phantom stock, employees don’t actually own any shares—they just get a cash payout based on the company’s value at a future date. This keeps things simple, avoids ownership dilution, and is much easier to manage, especially for small businesses.
ESOPs, on the other hand, make employees real shareholders through a trust that holds company stock for them. While this can offer bigger long-term rewards and potential capital gains tax benefits, ESOPs are complex, expensive to set up, and come with heavy administrative requirements. They also dilute existing ownership.
For most small businesses in the trades, phantom stock is the clear winner. It gives employees a real stake in the company’s growth without the legal and financial headaches of an ESOP.
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:
Grant of phantom shares
Employees are granted a certain number of phantom shares, which represent a promise of future value rather than actual ownership. In a limited liability company (LLC), these are often called “Phantom Units.”
Phantom stock vesting schedule
Phantom shares usually come with a vesting schedule, similar to real stock options. Employees don’t receive all their shares at once. Instead, they earn a set percentage over time as they continue working and contributing to the company. Full vesting typically happens over several years, encouraging long-term commitment. Learn more about vesting schedules.
Phantom stock payout structure
When it’s time for a payout, employees receive cash based on the current value of the company’s actual stock. The payout amount reflects the growth and success of the business during the time the employee held their phantom shares.
Trigger events for phantom equity
Payouts are 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 on a quarterly or annual basis. Learn more about profit sharing.
Phantom Stock Agreements
Phantom stock terms are detailed in a written agreement, known as a phantom stock agreement. These are essential to avoid misunderstandings and make sure everyone is on the same page. Here’s what a phantom stock agreement typically covers:
Vesting
This section outlines how and when the phantom shares will vest. Vesting schedules vary by company but are often spread out over several years. For instance, a typical plan might vest 20% of the shares each year over five years. Vesting encourages employees to stay longer, strengthening their commitment to the company.
Valuation method
The agreement explains how the value of the phantom shares is determined. This can be based on a third-party valuation, a set formula, or other methods. Clearly defining how the shares are valued ensures fairness and transparency for all parties involved.
Payout triggers
Payouts are not arbitrary and are tied to specific “trigger events.” Common triggers include the sale of the company, retirement of the employee, or other significant business milestones. Knowing what prompts a payout helps employees understand the potential benefits and aligns their interests with the company’s long-term goals.
Forfeiture
This section spells out when and how an employee might lose their phantom shares. Common reasons for forfeiture include leaving the company before vesting, being terminated for cause, or violating company policies. Clear forfeiture rules protect the business and set expectations for employees.
Termination rules
The agreement should address what happens to phantom shares if an employee leaves the company, whether voluntarily or involuntarily. It should specify if unvested shares are forfeited and what happens to vested shares—such as whether they’re paid out, expire, or are subject to other conditions.
Non-compete and non-solicit
Many agreements include non-compete and non-solicit clauses. These prevent employees from joining a competitor or soliciting clients or coworkers for a certain period after leaving the company. Including these clauses helps protect your business interests and the value of the phantom stock plan.
Clawbacks
A clawback provision allows the company to reclaim payouts if certain conditions are met after the payout—such as if it’s later discovered that the employee engaged in misconduct or fraud. This protects the company from having to reward bad behavior.
Change-in-control
This section explains what happens to phantom shares if there’s a major change in the company, like a merger, acquisition, or sale. It might accelerate vesting, trigger payouts, or set other rules to make sure employees are treated fairly during big transitions.
Phantom Stock Plans
It's important to distinguish between a "phantom stock agreement" and a "phantom stock plan." A phantom stock agreement is the legal document detailing the specifics of how and when phantom shares vest, how they're valued, and what triggers their payout. A phantom stock plan, on the other hand, is a broader program that outlines the company's overall approach to offering phantom stock. It's more of a company-wide structure that defines eligibility, how the phantom stock pool is allocated, and any performance conditions attached.
Who is eligible for a phantom stock plan?
Eligibility for a phantom stock plan typically depends on the company’s goals. Many businesses offer phantom stocks to key employees they want to retain long-term. Managers, executives, or other staff who play vital roles in driving company success are often prime candidates. It’s about incentivizing those who make a real impact.
How is the phantom stock pool defined?
The phantom stock pool is the total number of phantom shares the company sets aside as part of the plan. This pool is determined based on the company’s size, financial capabilities, and long-term goals. It has to be big enough to be enticing, but balanced so that it's sustainable.
Performance conditions
Performance conditions can be tied to the company’s overall financial goals, like revenue targets or profitability milestones. Alternatively, they can focus on individual employee performance metrics. These conditions align the interests of employees with the company's objectives, ensuring everyone works towards the same end.
What is an example of phantom stock?
Let’s say you own a plumbing company and want to reward a key employee, Mike, for his hard work. You don’t want to give him actual shares, but you want him to feel like an owner. So, you set up a phantom stock plan.
You grant Mike 1,000 phantom shares. These aren’t real shares—he doesn’t get voting rights or ownership. But they track the value of your company’s real shares.
When you start the plan, your company is valued at $1 million, and you have 100,000 shares outstanding. That means each share is worth $10.
You tell Mike that after five years, if he’s still with the company, he’ll be fully vested in his phantom shares. At that point, you’ll pay him the value of those shares.
Five years go by. Your company grows, and now it’s worth $2 million. Each share is now worth $20.
Mike’s 1,000 phantom shares are now worth $20,000. You give him that amount in cash payment (or sometimes in installments, depending on your plan). Mike gets rewarded for the company’s growth, just like a real owner, but you didn’t have to give up any actual equity.
That’s how phantom stock works. It’s a way to share the upside with key employees, without giving away part of your company.
Benefits of phantom stock plans
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:
Aligns employee interests with company goals
Phantom stock gives employees a direct stake in the company’s growth. When the business does well, so do they. This shared interest encourages employees to work harder, make smarter decisions, and stay focused on long-term goals. It’s a simple way to get everyone rowing in the same direction.
Flexibility
No two businesses are the same, and phantom stock plans don’t have to be either. You can design a plan that fits your company’s size, goals, and culture. Decide who gets phantom shares, how many, and when they vest. You can even tie payouts to specific milestones or performance targets. This flexibility makes it easy to create a plan that works for you and your team.
Stand out as an employer
Offering phantom stock can set your company apart in a crowded job market. Top talent wants more than just a paycheck—they want to feel invested in the company’s future. Phantom stock shows employees you value their contribution and want them to share in your success. It’s a strong tool for attracting and keeping the best people.
No equity dilution
With phantom stock, you don’t have to give up any actual ownership in your business. There are no new shares issued, so your stake—and the stakes of your current partners—stay the same. You get the benefits of an ownership-style incentive without losing control or diluting your equity.
Disadvantages of phantom stock plans
Phantom stock plans have a few drawbacks, but most of these are more of a concern for large companies than for small businesses in the trades.
One potential downside is that payouts from phantom stock are taxed as ordinary income, not at the lower capital gains rate. But for most small business owners and employees, this isn’t a big deal—especially since the payout is real cash, not paper value.
Another thing to consider is that, for very large companies, managing a phantom stock plan can get complicated if there are lots of employees or if the company is growing rapidly. But for small businesses, especially those with tight-knit teams, the plan is easy to manage and doesn’t require a lot of extra work.
Finally, phantom stock doesn’t give employees actual ownership or voting rights. But for most owners, that’s actually a benefit—you can reward your team without giving up control.
In short, while phantom stock plans aren’t perfect for every situation, the main disadvantages are rarely an issue for small businesses like those Reins serves. For most owners in the trades, the benefits far outweigh any downsides.
Phantom stocks pros and cons
What types of businesses benefit from phantom stock plans?
Phantom stock plans are a great fit for small businesses—especially in industries like HVAC, plumbing, electrical, garage doors, roofing, and construction. These are businesses where traditional stock option plans usually don’t make sense. Most owners don’t want to deal with the legal headaches, high costs, or complicated paperwork that come with real equity plans.
If you run a business in the trades, you probably want to reward your best people and keep them around, but you don’t want to give up control or bring in outside investors. Phantom stock lets you do just that. You can offer a real financial upside tied to the company’s growth, without giving away any actual shares.
With Reins, setting up a phantom stock plan is simple and stress-free. It's just three easy steps. First, we'll design a plan that fits your business needs. You'll then grant legally binding awards to your key employees in just a few clicks. Finally, you can manage everything from one place. In our platform, you can track awards, keep your team motivated, and tie incentives directly to your business goals. Reins takes the guesswork out of the process, so you can focus on growing your business. Schedule a call with us to learn more.
How to create a phantom stock plan
Setting up a phantom stock plan doesn’t have to be complicated. With the right steps, you can create a plan that motivates your team and supports your business goals—without the hassle of traditional equity. Here’s how to get started:
Define the terms
Start by deciding how many phantom shares you want to offer and who will get them. Set up a vesting schedule—this is how long employees need to stay before earning their shares. Decide what events will trigger a payout, like hitting certain milestones, selling the business, or reaching retirement. You can also add any special conditions that make sense for your company.
Draft a phantom stock agreement
Put everything in writing with a clear, legally binding agreement. This document should outline all the terms of your plan, including how shares are awarded, what happens if someone leaves, and how payouts are calculated. If you need a starting point, get our free phantom equity template here.
Communicate with employees
Once your plan is ready, explain it to your team. Make sure you can answer the big question: how does phantom stock work? You’ll need to explain the benefits and any rules or conditions. Since phantom stock is usually a long-term reward, it helps to remind employees about this benefit regularly. For tips on how to talk about phantom equity, learn how to communicate phantom equity with employees.
Administration
Keep your plan up to date as your business grows and changes. Update the value of phantom shares as your company’s value changes. Add new employees to the plan when needed, and manage payouts when triggering events happen. Good administration makes sure your plan stays fair, accurate, and valuable for everyone involved.
Reins has helped hundreds of small business owners set up phantom stock plans that are customized for their company. If you book a call with our team, we'll show you how.
Phantom stock tax treatment
Understanding the tax side of phantom stock is important before you roll out a plan. Phantom stock is different from traditional stock options in how and when taxes hit both the employee and the business.
Phantom stock tax for employees
With phantom stock, employees don’t owe any taxes when the phantom shares are granted or as they vest. Taxes only come into play when the payout happens—usually when there’s a triggering event like a vesting milestone, a sale, or a cash-out. At that point, the payout is treated as ordinary income, just like a bonus or regular wages. This means it’s subject to income tax and payroll taxes (Social Security and Medicare).
Compare this to traditional stock options. With incentive stock options (ISOs), employees might get favorable capital gains tax treatment if they meet certain holding requirements. With non-qualified stock options (NSOs), employees pay ordinary income tax on the difference between the exercise price and the market value when they exercise the option. After that, any gain from holding the stock is taxed as a capital gain. Plus, with real equity, employees may face tax bills even if they haven’t received any cash, just because they own shares that have increased in value.
Phantom stock keeps things simple. No tax until there’s a cash payout. No surprise tax bills for employees before they get paid.
Phantom stock tax for employers
For the business, payouts from phantom stock plans are tax-deductible, just like other compensation expenses. This can help offset the cost of rewarding your team. You don’t have to worry about complicated equity accounting or tracking capital gains. Instead, you treat phantom stock payouts as a regular business expense when they’re paid out, making the process straightforward and easy to manage.
For owners, this means you can reward your team without giving up equity or dealing with complex tax rules tied to real stock.
Key Takeaways
Phantom equity explained:
- 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.
