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What is Phantom Stock?

Many companies today are looking for creative ways to reward their senior managers and key executives for outstanding performance. One strategy is to provide these employees with what’s commonly referred to as phantom stock.

Also known as shadow stock or synthetic stock, phantom stock isn’t actual shares of company stock. However, it tracks the price movements of company stock and distributes profits to employees as if they actually owned the stock. As a result, employees are able to reap the benefits of stock ownership without shares actually being transferred or shareholder equity being diluted.

Learn More: Get Your Free Guide to Employee Equity Compensation

How do Phantom Stock Plans Work?

Many companies use phantom stock as a tool for employee motivation and retention, as well as a way to give employees some “skin in the game” and help them think and act more like entrepreneurs and business owners. They usually issue shares of phantom stock to employees based on things like their seniority, attainment of performance goals and overall value to the organization.

When phantom stock shares are issued, a delay mechanism kicks in that delays the payout until they have vested based on performance or at some time in the future, such as three, four or five years later. If the company’s stock has appreciated in value during this time period, the employee will typically be rewarded with a cash bonus. The amount of the bonus will depend on how much the stock has appreciated and the type of phantom stock shares issued.

Companies may also choose to convert phantom shares to actual stock once they have vested, though this is less common.

Read More: Stock Options: What Are They and How Do They Work?

Types of Phantom Stock

There are two main types of phantom stock: appreciation only and full value stock. As the name implies, appreciation only shares of phantom stock only pay out the amount of increase in the stock’s value from the time the shares were granted until the end of the vesting period. For example, if an employee received 500 shares of company stock worth $10 when granted and the shares are worth $25 upon vesting, the employee would receive $7,500, or the amount the stock rose in value.

Conversely, full value shares pay out both appreciation and the value of the underlying shares of stock themselves. Using the same example, this employee would receive $12,500 upon vesting, which includes both the appreciation and the value of the underlying shares.

Both appreciation only and full value phantom stock can discriminate in favor of highly compensated employees, which allows companies to award these employees disproportionately in relation to rank-and-file workers. And with both, employees usually risk forfeiting the value if they leave the company before their shares are vested.

Phantom stock programs include a charter that spells out all of the details of the program, including the vesting schedule and how employees qualify to receive shares. The charter should be reviewed and vetted by an attorney who specializes in employee benefit and compensation plans.

Pros and Cons of Phantom Stock

There are potential benefits and drawbacks to using phantom stock as a form of employee compensation. Perhaps the biggest benefit is that they can be a powerful employee motivational and retention tool. Phantom stock can give selected employees a sense of ownership in the company and thus help boost their productivity and company loyalty. Plus, they are financially incentivized to remain with the company at least until their shares vest.

Another big benefit is that granting employees shares of phantom stock doesn’t cost companies anything out of pocket and allows them a great deal of control and flexibility. The shares are simply granted to employees with no cash changing hands. This helps preserve company cash flow and prevents dilution in value of real shares of stock owned by employee shareholders.

One of the main drawbacks of phantom stock is the potential costs that may be incurred by the company, especially if company stock must be valued by an independent valuator. However, establishing a phantom stock program is generally less expensive than setting up more complex equity compensation plans. On the employee side, one of the biggest cons is that if the company’s stock price doesn’t rise in value between the time shares are granted and the time they vest, employees may not realize any financial gain.

How Are Phantom Stocks Taxed?

While no taxes are due on phantom equity until the shares have vested, phantom stock earnings are taxed at ordinary income tax rates. These are usually higher than long-term capital gains rates, during the year when shares vest. This could leave employees with an unusually high tax bill for this year.

Stock Appreciation Rights

Stock appreciation rights, or SARs, are a similar type of executive compensation to phantom stock. Like with appreciation only phantom stock, employees receive cash or shares based on the value of any stock appreciation between the time when the rights are granted and the time when they vest. Also, like phantom stock, employees receive no payout if the company’s stock is stagnant or declines in value over this time.

Investigate Phantom Stock Carefully

In the right circumstances, phantom stock could be a great way to reward key employees and senior managers for strong performance and loyalty. This program must satisfy the criteria required from the IRS. investigate the pros and cons of phantom stock, along with the legal and other requirements, in order to decide if this is a good option for your company.

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