Key Points:
- Nature of Phantom Stock: Phantom stock is a type of executive compensation that provides benefits similar to stock ownership without actual stock transfer. It’s a simpler form of stock appreciation rights (SARs), offering “appreciation only” and “full value” plans.
- Vesting and Payout: Unlike SARs, which have an exercise period allowing some control over tax impacts, phantom stock is typically paid based on a vesting schedule, limiting timing options for income recognition.
- Advantages of Phantom Stock: Provides liquidity and flexibility, allowing professionals to monetize their compensation and manage financial goals effectively. It also reduces concentration risk by offering cash-based rewards instead of direct equity in the company.
- Drawbacks of Phantom Stock: Executives don’t receive dividends or voting rights, as phantom stock doesn’t grant actual ownership. Also, the income received upon vesting is subject to income tax, necessitating thorough tax planning.
Introduction
If Stock Appreciation Rights (SARs) are the little sister of stock options, Phantom Stock is the baby brother of both. Phantom stock is a form of executive compensation that provides selected employees, typically in senior management, the benefits of stock ownership without actually giving them company stock. Also known as shadow stock or phantom shares, it is a simpler form of stock appreciation rights (SAR) previously discussed.
Although there are two types of phantom stock awards, “appreciation only” and “full value,” they are more straightforward because the phantom stock is usually paid in periods defined by a vesting schedule. SARs, however, usually have an exercise period that lets the professional control some of the tax impact.
Example
Phantom stock awards pay a cash award at a specific time to an employee equal to a set number, or fraction, of company shares multiplied by the current share price at the future time. The award amount is typically monitored through hypothetical units, also known as “phantom” shares, designed to imitate the stock price.
There are two main phantom stock plans: “appreciation only” and “full value.” Appreciation-only plans do not include the value of the actual underlying shares themselves. They usually only pay out the value of any increase in the company stock price over a certain period that begins on the date the plan is granted. The second type, full-value plans, pays the value of the underlying stock and any appreciation.
Let’s start with an example of an “appreciation only” plan. You are granted 1,000 phantom stock shares with a strike price of $50. Assuming a one-year vesting period for the grant, at the end of that year, you would receive the difference between the $50 per share value when the grant was made and the $70 per share. The $ 20,000 difference is paid as compensation, considered ordinary compensation, and reported on your W2 for that year.
Like Restricted Stock Units (RSUs), there are limited options for choosing the timing of recognizing the income. When the phantom stock vests, the income is recognized.
In tabular format:
Phantom Stock
“Appreciation Only”Market Value of Stock at Exercise$70Grant Price$50Gain Per Share$20Number of Shares1,000Pre-Tax Gain$20,000Ordinary Inc Tax Rate (Assumption)32%Tax$6,400After-Tax Gain$13,600
Now, let’s look at an example of the “full value” plan. You are granted 1,000 phantom stock shares with the same one-year vesting period. With a “full value” plan, there is no grant price because you will receive the full value of the shares once vested. At the end of the vesting period, the stock is worth $70, so you would receive $70,000 (1,000 shares multiplied by the $70 current market value).
As in the appreciation-only example, the total payment amount is considered ordinary compensation and reported on the W2 for that year.
In tabular format:
Phantom Stock
“Full Value”
Market Value of Stock at Exercise$70Number of Shares1,000Pre-Tax Gain$70,000Ordinary Inc Tax Rate (Assumption)32%Tax$22,400After-Tax Gain$47,600
Vesting
At this point, we have beaten the concept and goals of vesting to death. If you want more information on vesting, please refer to the relevant section. However, there is one topic related to phantom stock to address.
While vesting, phantom stock is like Restricted Stock Units (RSUs) because there are no actual underlying shares. You will not receive dividends or voting rights like you would for Restricted Stock (RS). Restricted Stock is linked to actual shares.
It is essential to read the actual plan documents regarding vesting as the complexity and different ways compensation tools, including phantom stock, can vest are only limited by the company’s imagination.
Advantages & Disadvantages
Phantom stock plans offer similar advantages and disadvantages as other compensation tools for professionals and organizations.
Advantages
- Liquidity and Flexibility: Unlike some other equity-based compensation plans, phantom stock provides professionals a clear path to monetize their compensation. By converting their accumulated value into cash or company stock, professionals gain liquidity and flexibility to manage their personal financial goals.
- Reduced Concentration Risk: With many other equity-based compensation plans, there is a risk that the professionals will leave the program on cruise control, gathering more and more equity in the company over time as more shares/options vest. After many years, they may find a higher percentage of their net worth in a single asset (their company) than they were planning to – if they even had a plan. Phantom Stock greatly reduces this risk as the award is ultimately in cash. The executive still has the option to purchase additional shares, but since this now has to be an active decision with an additional step, it becomes much less likely.
Disadvantages
Despite its benefits, phantom stock also poses some potential drawbacks:
- Lack of Dividends and Voting Rights: Since phantom stock does not grant actual ownership, executives do not possess dividends or voting rights in the company. The lack of dividends reduces the total compensation value of phantom stock compared to restricted stock. Some companies provide additional payments to compensate for this, but that is optional and unusual.
- Tax Implications: Executives must consider the tax implications associated with phantom stock, as the value received upon vesting is subject to income tax. Tax planning covering all income sources is essential to avoid surprises.
Summary
Phantom stock offers executives liquidity and flexibility, allowing them to convert their compensation into cash or stock, effectively managing their financial goals and reducing concentration risk. However, it lacks any control by the recipient to decide the timing of the tax impact, necessitating careful tax planning and consideration of the timing of other income sources.
Frequently Asked Questions (FAQ)
Q: What is Phantom Stock?
A: Phantom stock is an executive compensation plan that mimics stock ownership benefits without transferring actual company stock. It’s an alternative to traditional stock options and SARs.
Q: What are the types of Phantom Stock plans?
A: There are two main types: “appreciation only” which pays out based on the increase in stock price, and “full value” which pays the total value of the stock at vesting.
Q: How does Phantom Stock differ from SARs?
A: SARs usually have an exercise period that allows professionals to control the tax impact, while phantom stock is paid based on a vesting schedule, offering less control over tax timing.
Q: What are the advantages of Phantom Stock?
A: It offers liquidity and flexibility, enabling executives to convert their compensation into cash or company stock. It also helps in managing financial goals and reduces concentration risk.
Q: What are the drawbacks of Phantom Stock?
A: Executives holding phantom stock don’t have dividends or voting rights, and the compensation received is subject to income tax, which requires careful tax planning.
Q: How does Phantom Stock impact financial planning for executives?
A: It offers a clear path to monetize compensation, but executives must consider the lack of control over tax timing and the absence of dividends or voting rights in their overall financial strategy.
If you have any questions about phantom stock, equity compensation tools, or want to explore how a Flat-Rate Fee-Only structure can help you achieve your goals, set up a time to talk.
Your financial well-being is too important to leave to chance. Choose wisely.
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