This is part one of a three-part series introducing different stock plans one should consider for their business. This is only meant to be an introduction; a trusted professional should be contacted to discuss what stock plan is right for your business. This first installment focuses on phantom stock plans.
A phantom stock plan is a plan whereby an employee is awarded units whose value is related to the value of the employer’s common stock; however, the units do not represent actual stock of the employer and distributions under the plan may be in cash. Phantom stock plans (often also called stock appreciation rights) are often used when the employer, for various reasons, does not desire to give its employees shareholder status and, thus, seeks an arrangement that does not result in the actual issuance of its stock to employees. This is often true with respect to privately-held companies. The issuance of common stock to employees of privately-held companies will create additional shareholders with voting and other rights of minority shareholders under state law. In addition, the issuance of common stock to employees creates problems when the employee leaves the employer due to termination, retirement or death. If the employee owns employer stock at that time, arrangements must be made, generally through a stock restriction agreement, to obligate the employee and his family to sell the stock to the employer or the majority shareholder following termination of employment. Such an arrangement may impose difficult cash burdens upon the employer or the majority shareholders at the time of the purchase under the stock restriction agreement.
Phantom stock plans generally involve the granting of a stated number of stock units which are credited to the employee’s account. Each unit has the equivalent value of an outstanding share of the employer’s common stock. The benefit provided to the employee equals the appreciation in the value of the phantom stock between the date the employee is credited with the phantom shares and the date the benefit is paid. Instead of merely paying a benefit equal to the appreciation in value of the phantom stock between the date the phantom shares are granted and the payment date, it is possible to structure the benefit so that it equals the entire value of the phantom shares as of the payment date.
Payment of the benefit generally occurs upon termination of employment as a result of retirement, death or disability, or at a specified future date. The benefit can be paid out in installments over a period of years.
No tax is payable by the employee at the time the phantom stock is credited to the employee’s account. The employee is taxed when the benefit is actually paid. There is no deduction available to the employer upon the initial crediting of the phantom stock to the employee’s account under the phantom stock plan. When the employee is paid the benefit, the employer is entitled to a compensation deduction for the same amount as the employee includes in income.