As an incentive to motivate hard-working key employees, private employers can issue phantom stock, also known as “shadow stock,” as equity compensation. While the value of these phantom shares will rise and fall in line with the company’s stock, the employee will not gain any actual ownership over the company or minority shareholder rights.
Privately held businesses can retain talent for their chosen vesting period as the phantom stock appreciates, and also ensure that their key employees are personally invested in the company’s performance. This arrangement can be very beneficial for both managers and employees, but there are several things to know before deciding if a phantom stock program will work for your business.
How Does Phantom Equity Work?
Once an employee makes a big enough contribution to the company’s performance, their employer may choose to give them a number of phantom shares based on the significance of the contribution. The employer is able to dictate the terms of the program and will present the employee with a vesting period. The length of this period is established by the employer at the time of grant and most attorneys would tell you the vesting is often set at five years, which is when the employee is "vested" and could receive a payout.
The challenge with vesting is related to taxation of the phantom equity plan for the employee. Yes, it is great to create a plan that vests quickly and is perceived as more "liquid" by the employee. Unfortuantely, once the equity is vested and there is no longer a risk of forfeiture, the employee will need to pay taxes on the non-cash compensation, which is likely to force them to liquidate some/all of their phantom equity, even if they otherwise wouldn't. For example, if the employer is growing quickly, and the employee vests in year five, even if the employee doesn't exercise the phantom equity to be paid out, the risk of forfeiture is gone and the taxes are due from the employee as if they had been paid out.
To avoid this, the plans Succession Resource Group helps establish with clients typically have vesting tied to a specific triggering event, and not a moment sooner. By pushing the vesting out and connecting it to a triggering event (such as a sale, the founder's retirement, or the employee's retirement), the employer can now control when the employee has to pay taxes - pushing the tax liability out until the employee would expect to receive cash. In the meantime, the plan can continue to appreciate in value as the employer grows without generating a short-term tax liability, and the phantom equity plan can act as intended - as a form of "golden handcuffs."
Once the vesting period is completed or based on the agreed-upon payout schedule, the employee is paid based on the appreciation of the company’s actual stock price. As there is no buying or selling of real shares, this bonus is considered regular income for tax purposes, not as capital gains.
It is also possible for some phantom stock programs to convert the cash payout into the real equity along with voting rights, the details of which would depend on what the employer is willing to offer.
Types of Phantom Stock
While the specifics of these programs are decided by each individual employer, there are generally two kinds of phantom stock awarded to key employees. These are called “appreciation rights” and “liquidation rights” plans. While similar in many respects, the two types have key differences.
Appreciation-rights allow employees to benefit from the increase in value of the company following a grant, but does not give employees any perceived value at the time that the program begins. Instead, the amount awarded is actually the difference between the actual stock price at the time of the program’s payout and the price at the start of the vesting period.
This type of phantom stock plan is more beneficial for the company, as it still encourages the employee to improve company performance without being as significant a cost for the company. That said, employees stand to gain nothing if the company’s actual value does not increase.
This version of a phantom equity plan does grant employees the full value of the equivalent number of actual shares. Employees would still need to remain with the company for the entirety of the vesting period, but they would not have to run the risk of completing the program empty-handed. Liquidation Rights plans work really well when an employer is using the plan initially to reward past performance, such as showing appreciation for key staff that may have accrued some "sweat equity" in the business.
That said, the company would need to be prepared to pay out that full amount on time or at least convert the value to actual ownership in the business, no matter how high the actual share price may have risen on the market.
Shortfalls and Benefits
Like any venture in any business, phantom stock-based compensation plans come with their share of possible issues, but plenty of positives that outweigh the other considerations.
Some of these potential issues have been reviewed already, but it is critical that any employer considering implementing this kind of equity sharing plan bear them in mind.
As stated previously, when employees do vest, employers must ensure that they have enough cash to pay out the amount when the vesting period is over. Offering more phantom shares than you will be able to payout could be detrimental, so it is important to take that into consideration. Again, plans provided by SRG have some failsafe mechanisms built-in to ensure this isn't possible, but it is important to run pro format scenarios to calibrate the plan before use.
The company is also required to report any phantom stock plans to the real shareholders of the company as well as the DOL. It is also important to start have an annual third-party valuation done so the participants can better understand and track the value of their accused equity. This can be done cost effectively, but it is an ongoing cost to be aware of.
Employees also have less control over the program than they would if they were given actual stock options and voting rights as shareholders. In some cases, employers may even be able to terminate the agreement without reprise. Not only that, but again, since the employee is only being granted the cash equivalent of the number of shares, they are not able to file this bonus as capital gains for their taxes.
For those on appreciation-right plans, there is also the potential to gain nothing if the stock falls or fails to appreciate.
Despite the potential negatives for employers and employees, it has definite advantages for both companies and the employees they choose to give phantom equity to. Phantom equity plans are incredibly flexible and are another compensation tool employers can use to motivate and retain key staff, while also getting the staff to start thinking and acting more like owners. These plans are not designed as a solution for succession planning, but there are plan features that can be built in that can allow a phantom equity plan to someday seamlessly merge into the overall succession plan for the firm.
The other benefit, from the employer's perspective is, equity can be shared without having to share profits, decision making power, or the need to share the company financials. And, employees do not need to handle buying or selling real shares, nor do they need to report phantom shares for tax purposes until vesting/payout. Employers can ensure that certain goals are achieved in exchange, and if an employee does wind up being terminated or resigning before the vesting period is over, the employer will not need to handle buying back real shares.
Legal and Financial Considerations
When using a phantom plan, you and your company will most definitely be subject to meeting Employee Retirement Income Security Act of 1974 (ERISA) requirements, which protect employees under most private company retirement and health plans. This would mean identifying all of the key employees, or “top hat” employees in the agreement, and providing a very specific language for the plan.
The company is also required to be compliant with IRS Section 409A, which outlines rules for things like payout timing, qualified payout events, and limitations. Straying from these requirements could potentially lead to a tax for the employer equal to up to 20% of the amount of the bonus payment.
When it comes to taxation, be aware of US tax code 280G, which imposes a tax of up to 20% as well as revoking a corporate tax deduction for “Golden Parachute” payments that are considered excessive. What is considered excessive is if the value of the payment is greater than or equal to three times the average compensation of the bonus recipient for the previous five years when a change in control (CIC) occurs.
The Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and medicare taxes still need to be paid, however, on this “income.” That said, paying FICA and FUTA can possibly be avoided if the employee’s normal compensation already exceeds the wage base for FICA.
Things to Bear in Mind
Overall, the benefits of a phantom stock plan far outweigh any potential detriments when compared to other employee compensation options. Ultimately, you need to decide if a phantom plan is the best fit for you and your company. When making your decision, there are some key takeaways to consider.
In terms of cost, phantom stock is fairly low risk to both owners and their employees. If the specifics of the agreement are not met, the employee in some way leaves the company, or stock prices do not appreciate much, neither party directly loses money as a result.
In addition to the comparatively low risk, you can still use phantom stock as a major incentive for your employees to increase the overall value of the company and complete specific goals. As an employer, you also have near-total control of the agreement.
You can decide what needs to be accomplished and/or how much time must pass before options vest, whether the vested amount is paid in full or with installments, as well as when the payout has to be made. You can personalize your company’s plan however you see fit.
We at Succession Resource Group understand the needs that your business has and are able to help. Contact us today for a consultation, and we will help you explore employee compensation options that work best for your company.