A phantom stock plan is a device similar to the stock appreciation right (SAR). Like SARs, phantom stock plans are designed to give the employees a personal stake in the growth and profitability of the company. In a phantom stock plan, the company grants the employee the right to receive a number of hypothetical shares of “phantom stock,” rather than actual shares. The company bases the grant value of the phantom shares on the current value or book value of the company’s shares at that time. When the employee receives the “phantom stock”, depending on the terms of the plan, he may convert the phantom shares to actual shares, receive cash, or a combination. If he receives cash, it is equal to the amount by which the value of the phantom stock at the date of the receipt exceeds the value of the phantom stock at the date of the grant.
A privately held company can grant the phantom stock based on the book value at the time of the grant. At that time, the company creates a book entry, crediting the phantom stock units to the employee's account. The plan will set out the period between the grant of the phantom stock and its conversion. Much like a SAR or any of the other stock-based compensation plans, a phantom stock plan encourages employees to remain with the company until the phantom shares may be converted to actual stock and/or cash. If the rights to receive cash or convert to stock are staggered, then the incentive to remain covers a longer period of time.
If the phantom stock is simply for cash, then the employee is relieved of the burden of financing the purchase of shares. If the plan covers the right to convert to actual shares, it can be structured so that the shares received are equal in value only to the appreciation portion of the phantom shares. In that event, the employee receives shares without coming up with cash for the purchase price, but the value of the actual shares will be treated as compensation, taxable to the employee. If the cash only option is used, then the existing owners are not diluted, but the company’s cash flow must be in a position to fund the payments. Naturally, this could be a benchmark by which to measure the company’s performance in order to determine if the employee is entitled to the shares.
A phantom stock plan does not entitle employees to special tax treatment. Because the company does not normally fund a phantom stock plan, but only makes an unsecured promise to pay the hypothetical increase in value, employees normally are not deemed to have constructively received income. Additionally, in as much as most plans condition payment on the achievement of certain company and employee benchmarks, employees normally are not taxed until the payments are received. The employees are normally taxed at ordinary income rates, in an amount equal to the cash distributed and the fair market value of any stock distributed. The company can deduct the actual payments made. Due to the fact that most companies do not fund their phantom stock plans but rather use them to provide deferred compensation for a select group of management or highly compensated employees, they are generally exempt from the participation, vesting, funding, fiduciary responsibility, and plan termination insurance provisions of the Employee Retirement Income Security Act of 1974 (ERISA). They are not exempt from the ERISA minimal reporting and disclosure requirements.
Please see the following articles for additional information: Employee Stock Option Plans, Tax Aspects of a Stock Option Plan, Federal Securities Aspects of a Stock Option Grant, Option Plan Decisions, Stock-based Compensation, Stock Appreciation Rights, Performance Units, Non-Qualified Deferred Compensation Plans, Texas Exemption for Employee Stock Option and Similar Plans.
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