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By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 9 minute read

Corporations in the United States and worldwide utilize a wide variety of stock-based compensation programs, although not all of them need or even include the actual use of shares to pay employees. There are stock incentive plans that do not include giving out genuine shares of stock but rather cash or fictitious units instead.

There are several motivations for doing this. In many cases, this can free businesses and their employees from the tax and accounting restrictions that come with using actual shares of stock. For example, SARs and “phantom stock” are both forms of this scheme.

What Are Phantom Stock?

The term “phantom stock,” which can also refer to “shadow stock,” is used to describe the monetary compensation that an employee is entitled to receive under specific circumstances.

Phantom stock programs are non-qualified plans that function similarly to others, including deferred compensation plans. Both types of schemes are supposed to incentivize and keep top-level executives around by offering a future monetary reward with a high risk of loss. The company stands to lose the money if it goes bankrupt, for example.

Conversely, phantom stock plans provide a bonus that is often equivalent to a certain number of shares or a percentage of the company’s outstanding stock, rather than a fixed cash sum like regular deferred compensation plans. After this sum is paid, phantom plans look very much like their conventional non-qualified relatives: Before the employee has constructive receipt of the money, the firm cannot deduct the amount given to the plan. Once the employee has constructive receipt of the funds, he or she must report the benefit as regular income.

Benefits under phantom stock plans are typically paid out in cash, while some plans have a conversion provision that can be used to issue stock instead if the employer so chooses.

Plan Design and Purpose

The term “phantom stock plan” refers to an incentive compensation scheme that uses fictitious stock units. These units, which are allocated to the plan member in lieu of actual shares of the firm, rise and decrease in value in tandem with the price of the company’s stock. The vast majority of stock options with no real value are either:

  1. Plans Based Only on Appreciation. When an employee participates in a plan like this, he or she only stands to gain the value of the increase (if any) in the share price of the firm over a certain time period.
  2. Total Value Packages. Employees receive a larger payout per share or unit under these programs since they account for the stock’s intrinsic worth.

Important Dates and Terms

  • Date of Grant: The calendar day on which workers can begin participating.
  • The duration or term of the plan’s offering period (when employees will receive their benefits).
  • Contribution Formula: The method by which the amount or percentage of business shares that will be granted is decided.
  • Vesting Schedule: Any requirements that must be satisfied in order to obtain rewards, such as tenure or accomplishment of a corporate job or objective.
  • The technique of evaluating the plan benefits is known as valuation.
  • Restrictive Covenants: Provisions that limit certain aspects of the plan, such as who can participate.
  • Forfeiture Provisions: The consequences of circumstances that might result in the plan’s termination, such as death, incapacity, or firm insolvency.

Participants in phantom stock programs are not entitled to dividend payments or voting privileges since they do not own genuine shares of stock. However, if the employer wishes, any benefit might be included in the plan’s charter.

Companies that are privately held and do not issue publicly traded shares are the most likely to employ a phantom stock strategy. This is because stock options don’t interfere with or dilute the present distribution of shares among the company’s owners while providing a type of equity remuneration to essential personnel. The delicate balance of power among the real shareholders is why voting rights are rarely provided.

A vesting schedule defines the conditions under which benefits become payable and is included in many schemes.

The Benefits of Phantom Stock Plans

Use of a phantom stock scheme might be advantageous for both employers and workers. The primary benefits of these strategies are:

  1. Employees are not required to make any form of investment.
  2. Employer ownership of shares is not diminished.
  3. Encourages employee motivation and retention.
  4. They are relatively easy to implement and inexpensive to administer.
  5. They can be structured to accommodate a variety of organizational goals and criteria.
  6. Plans may include a conversion option that, if required, allows employees to acquire actual shares of stock instead of cash.
  7. The employee’s income is not subject to tax until it is actually paid out. Even if the stock is not sold, the amount received must be reported as earned income at this time; the amount reported matches the stock’s fair market value on the day of receipt.
  8. Section 409 of the Internal Revenue Code, which controls typical non-qualified plans such as deferred compensation plans, does not apply to properly constructed schemes. This affords these programs additional structural flexibility and administrative ease.

Phantom Stock Plans’ Drawbacks

  1. There is no tax deduction for employer payments until the employee actually receives the benefit.
  2. Employers must have enough cash on hand to pay benefits on time.
  3. Employers may be required to hire an outside assessor to provide periodic plan valuations.
  4. Employers must yearly report the plan’s status to all participants, as well as to all actual shareholders and the SEC, if the firm is publicly listed.
  5. All employee perks are taxed as ordinary income since they are paid in cash; capital gains treatment is not available.
  6. Plans with high balances may impact the company’s overall worth. The plan balance can be recorded as an asset that the corporation does not “possess” as it will eventually be paid to the employee (barring forfeiture).
  7. Participants in “appreciation-only” programs may get nothing if the price of business shares does not increase.

Stock Appreciation Rights

An alternative kind of equity compensation for workers, stock appreciation rights are less complex than stock option plans. An employee’s gain from a SAR is limited to the difference in price between the grant and exercise dates, not to the value of the underlying stock in the corporation.

Stock or units in a SAR plan are often issued at a certain period, such as when the vesting schedule is met, unlike with phantom stock appreciation-only programs. While SAR plans may also include vesting periods, after the schedule has been met, the beneficiary generally has the freedom to use the SAR whenever they see fit.

Important Dates and Terms

  • Grant Date: The calendar day on which the employee receives the SARs.
  • The date on which the employee exercises his or her rights.
  • Spread: The difference between the company’s stock price on the grant date and the exercise date; hence, the amount of stock appreciation. This is what the participant receives.

Plan Structure

SARs are among the simplest equity compensation plans in use today. Some ways in which they are similar to other schemes are as follows:

  • They frequently include a vesting schedule tied to the completion of company-mandated objectives or milestones.
  • There might be “clawback” clauses. For example, if the employee leaves to work for a rival company or if the business goes bankrupt, the employer may demand repayment of any or all of the benefits received under the plan.
  • In most cases, you can give them to someone else.

Procedures for SARs are straightforward and generally similar to those for other stock programs. Like with non-qualified stock options, participants are given a specified number of rights on the grant date and can later choose to exercise those rights (NQSOs).

Using SARs in Relation to NQSOs

However, SAR holders only receive the dollar amount of growth in the share price between the grant and exercise dates, whereas NQSO holders receive an option to acquire shares at a fixed price. Shares equal to the value of the benefit, less any applicable withholding taxes, are often awarded rather than a cash payment.

Let’s pretend that Amy is awarded 1,000 SARs and 1,000 NQSOs by her employer, and that the closing price of the company’s shares on the grant date is $20. For the sake of brevity, we shall ignore withholding taxes. Six months later, on the same day, she exercises both types of awards, and the stock closes that day at $40. For example, if Amy’s SARs are worth $20,000 and she exercises them for 500 shares, she will receive 500 shares worth $20,000.

However, Amy must buy those 1,000 shares with her own money — $20,000 — before she can realize the advantage of her non-qualified options. She may save enough for them, but more likely, she will borrow the money. She must then sell enough shares to cover the principal plus interest on the loan she took out to pay back the money she borrowed. 

Therefore, she must sell 500 shares in order to pay back the $20,000 loan she took out. Following selling 500 and recouping her initial investment, she will own 1,000 shares with a total value of $40,000, plus 500 shares with a value of $20,000 after the sale.

Since her SARs entitled her solely to the $20 per share appreciation and not to the value of the underlying shares, no action was required on her part to realize this gain. Amy will receive the same amount of money whether she exercises her SARs or her NQSOs, but the exercise method for the SARs will be easier.

Taxation

The tax treatment of SARs is similar to that of non-qualified stock option schemes. There are no taxes due at the time of grant or vesting. On the other hand, participants must pay ordinary income tax on any gain in the stock price between the grant and exercise periods. 

Whether or whether an employee sells their shares at the time of filing, they must record this amount as income on Form 1040.

In addition to federal income tax withholding at the obligatory supplementary rate of 25%, plus state and local taxes, most employers additionally impose payroll taxes on this income. 

Withholding also occurs for Social Security and Medicare. Typically, this withholding is handled for SARs by reducing the number of shares that the participant receives, such that the member receives just the number of shares that equal the amount of after-tax income. 

For instance, out of Amy’s hypothetical 500 shares, the corporation may only distribute 360 to her.

When figuring out the tax due on the sale of shares, SARs are treated the same as NQSOs. After receiving their shares through an exercise, employees are under no obligation to sell them and can keep them for as long as they choose. When selling shares acquired under either plan, those held for less than a year generate short-term profits or losses, while those held for a year or more generate long-term gains or losses. Cost basis for the sale is the amount of gain that is included in ordinary income upon exercise.

For illustration, let’s say that a year after the grant date, six months later, Amy sells her SAR shares at a price of $50 each. For the near term, she will record a gain of $3,600 (360 shares x $10 per share). The vesting schedule kicks in on the exercise date. The number of shares she actually received after taxes were withheld will serve as her cost basis, not the amount she was originally allotted.

The Benefits of SARs

Significantly, SARs have several advantages:

  1. When compared to other stock plans, such ESPPs or NQSOs, this plan limits the number of business shares that can be issued to participants.
  2. SARs are treated more favorably by accountants than share-issuing programs since they are considered a fixed expenditure rather than a variable one for businesses.
  3. When employees exercise their stock options, they do not need to make a corresponding sell trade to offset the award amount.
  4. The proper payroll tax amount can be automatically withheld by the employer.
  5. Employees may easily account for the appreciation as earned income in the year they receive it.
  6. SARs, like other types of equity pay, have the potential to encourage workers to up their game and stay put in their current positions.

SAR Drawbacks

SARs are subject to just two legitimate limitations:

  1. There are no dividends paid to participants.
  2. Participants lack the right to vote.

Bottom Line

Employers can give stock-based remuneration to their workers through SARs and phantom stock without having to issue a huge number of shares to do so. This is why, despite their drawbacks, many professionals in the field of stock compensation anticipate both types of plans to experience rapid expansion in the coming years.

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