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University of Massachusetts Amherst

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The Use of Phantom Stock Plans is a Growing Compensation Trend

By Kris Houghton, CPA, Tax Partner, Meyers Bros.PC

In today's highly competitive labor market, the total compensation package that an employer offers to key personnel can make the difference in a company's ability to attract and retain the type of employees needed to run a successful business. Providing employees with cash salaries alone often just does not do enough to enable an employer to pick and choose from the best and brightest available employees. Employers must offer a full panoply of benefits to be able to recruit and retain employees.

The hottest compensation trends include not only ESOPs and other stock plans but also equity like incentive compensation programs. This article will discuss the latest trend and tax issues involved in one such plan: phantom stock plans.

The name “phantom stock” plan denotes that the employee participant does not receive actual stock, just phantom stock, which is a bookkeeping entry in an account kept for the employee under the plan. The employee, therefore, is not actually granted equity in the company. As a result, the employee does not attain the rights of a minority shareholder, such as the right to receive notice of shareholder meetings, the right to vote, and the right to inspect the books and records.

Although the features of phantom stock plans vary, there are some features that are common to most of these plans. Generally, a company establishes a phantom stock account for the employee and credits the account with fictional shares as they are granted or purchased. Sometimes phantom stock plans credit employees with an amount of deferred compensation each year, which the plan converts into an equivalent number of shares of phantom stock, which are credited to the employee's account. The employee's account avoids current taxation since it is merely a bookkeeping device.

In some plans, at the end of the deferral period the employee is paid an amount equal to the market value at that time of the shares credited to his account. If the phantom stock plan is structured in this manner, then the value of each unit of phantom stock equals the appreciation in fair market value of the stock between the date the unit is granted and the date the unit is paid. Some phantom stock plans credit to the employee's account the value of dividends as they are declared, so that the position of the employee even more closely resembles that of a shareholder. In this case, the phantom dividends are taxable as ordinary income to the employees and are deductible to the company. These plans are provided primarily as a form of incentive compensation, because the amount of the employee's deferred compensation increases with the value of the employer's stock.

Tax Treatment of Phantom Stock Plans The employees are taxed at ordinary income rates on the phantom stock awards at the time the awards are actually or constructively received in stock, cash, or both. The employer is generally entitled to a deduction in the year that the employee reports income. The income is reported on the employees W-2 and is also subject to withholding requirements.

Advantages and Disadvantages of Phantom Stock Plans For closely held companies that want to offer employees the ability to share in the company's success without giving the employee an actual equity stake in the business, phantom stock plans provide ideal flexibility. The company can utilize creative measuring criteria and vesting schedules that act as golden handcuffs to retain valued key employees and to align the employees' interests with those of the company. Furthermore, the company can offer economic compensation to its key employees without the burden of the obligations owned to actual shareholders.

The potential negative that exist with this type of plan are (1) the employee knows that they are not getting an actual ownership stake in the company, (2) the compensation leads to ordinary income, whereas it could lead to capital gain if true stock options were provided, and (3) an agreement regarding actual shareholder compensation is generally desirable since the amount withdrawn as salary effects the income available for dividends or equity growth.

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