What is Phantom Stock and How Does it Work?

by | Mar 7, 2013 | Articles

What is Phantom Stock?

The basic concept of a phantom stock plan involves a company’s agreement or promise to pay an employee or other participant in the plan an amount equal to the value of a certain number (or percentage) of shares of the company’s stock. Commonly structured through the award of phantom units, a phantom stock plan enables a company to make an award that tracks the economic benefits of stock ownership without using actual shares. Since phantom stock is a contractual right and not an interest in property, the tax event for the employee and the employer occurs at the payment in settlement of a properly designed phantom stock arrangement.

Phantom stock plans are shadows that mimic their real equity counterparts; phantom stock and shadow stock are terms that often are used interchangeably. Although phantom shares of real stock can be traded at will, a phantom stock plan typically does not require investment or confer ownership, so its recipient does not have voting rights.

How Does Phantom Stock Work?

In making awards under a phantom stock plan, there is a determination of the value of a phantom share or unit in connection with awards to one or more participants. Valuations will be needed for periodic reporting to participants as well as for determinations of amounts payable at the time of settlement.

Phantom stock plans can be designed simply. However, they should be created to meet the company’s needs and objectives in protecting the knowledge and skill base that is represented by the key employees selected for awards.

The two types of Phantom Stock that are most prevalent are:

• The “Appreciation-Only” or “Growth” Plan.

Under most phantom stock plans, the employer credits an employee account in the form of hypothetical shares of its stock. The stock is known as “phantom” stock and is credited to the employee’s account as are all cash and stock dividends and stock splits which are attributable to his/her phantom shares. No tax is payable by the employee at the time of such crediting.

Upon the termination of his/her employment (due to retirement, death, or other cause), or at a specified future date, the employee becomes entitled to receive an amount equal to the excess (if any) of the market value of all his/her phantom shares on the date of such termination over the value of such shares on the date (or dates) on which the shares were awarded and credited to his or her account. This amount can be paid out in installments over a period of years. Only the growth in value of the phantom stock is paid out.

• The “Full-Value” Plan

The award includes the underlying value of the stock. Other phantom stock plans grant units corresponding to shares of stock and credit the same, and not merely the growth in the same, to an employee’s account. The employee’s account also is credited with all cash and stock dividends and stock splits which are attributable to the phantom stock.

Upon termination of service, the employee receives in installments cash equal to the number of shares credited to his/her account. Under this type of plan, the employee is assured of receiving something for his/her shares even if the market value of the stock at the specified future date is less than what it was at the time the stock was awarded to him/her.

Generally, a phantom stock plan or agreement spells out how the program operates and how payments are determined along with various other details, often including:

• Eligibility criteria.
• Vesting schedule.
• Valuation method or formula.
• Settlement and payout events.
• Handling of various termination events, including retirement, death, disability, dismissal and resignation.
• Restrictive covenants.
• Form of payment.
• Provisions for the sale of the company.

Generally, for financial accounting purposes, phantom shares must be treated as an expense over the required service period and the company does not receive its income tax deduction until the benefits are paid. In addition to its incentive components, a phantom stock plan involves deferred compensation and can act like golden handcuffs in retaining key executives. Phantom stock most often is used by privately held companies.

Phantom stock plans can be especially useful in providing the economic benefits of equity without diluting shareholder value. Because recipients of phantom stock lack voting rights, a company can issue these units without altering the governance of the company or worrying about dilution issues. While phantom stock does not dilute the value of real outstanding shares directly, phantom stock awards do have a significant effect on cash flow at payout. This is why some plans have a conversion feature and might pay out in actual stock.

Another advantage to a company is the ability to design an award so that an executive receives no benefit unless vesting conditions are met and, under the appreciation-only model, the company’s value has increased. The fair market value of the stock is commonly used by public companies, while private companies have various approaches. For example, a professional valuation might be preferred but viewed as too costly; many companies then turn to book value. Other approaches include a formula using revenue, EBIDA (earnings before interest, taxes, depreciation and amortization), net income, or a combination of relevant measures; a formula can help with consistency of the valuation over time.

There are many reasons a company would consider a phantom stock arrangement, including:

• A public company might find that it has insufficient authorized shares to award the desired amount of awards that require actual stock.
• A company’s leadership might have considered other plans but found their rules too restrictive or implementation costs too high.
• The owner(s) might desire to maintain actual and effectual control, while still sharing the economic value of the company.
• There might be ownership restrictions for certain types of entities (i.e., sole proprietorship, partnership, limited liability company), such as the S corporation 100-shareholder rule.
• The objective is to provide equity-type incentives to a restricted group of individuals. For instance, phantom stock can be used in situations involving:
– A corporate division that can measure its enterprise value and wants its employees to have a share in that value even though there is no real stock available.
– A desire to focus on an event or contingency, such as a sale, merger, initial public offering, etc.

A phantom stock plan typically provides a more flexible alternative that is not subject to the same restrictions as most equity ownership plans. For many, the simple desire to use an “equity-like” vehicle without giving up true ownership might be reason enough to implement a phantom stock plan.

Employees generally like phantom stock plans because it allows them to share in the growth of the company’s value without making an investment, and with no risk or very little risk (especially in the “growth plan”).

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