a phantom stock or shadow stock plan is an employee benefit program that gives certain employees typically senior managers many of the benefits of stock ownership without actually handing over company stock 1
rather than getting physical stock the employee receives mock stock even though it s not real the phantom stock tracks the price moves of the company s actual stock paying out any resulting profits phantom stock plans are an alternative to the equity based incentive plans typically offered by public companies particularly stock option grants these plans can be structured to mimic whole shares of stock allowing participants to receive accumulated returns plus the initial value per share here are the two types of phantom stocks like restricted stock full value phantom shares have a higher per share value than stock options at the time of grant enabling companies to grant fewer shares while still providing competitive grant value this approach is commonly used when employee retention is a concern 2however in most cases companies opt for appreciation only grants where awards are based only on total share return rather than the initial value 1 companies often aim to create performance and award leverage like stock options in addition discounted grants and grants that pay out when returns exceed a specific hurdle rate are also used 3phantom stock plans often have a vesting schedule and may pay out after the occurrence of a predetermined event such as a number of years of employment retirement or termination both phantom stock plans and traditional nonqualified plans share several similarities they can be discriminatory meaning the company can choose which employees participate in the plan these plans are also usually subject to a substantial risk of forfeiture which means that the employee s right to receive the benefit is contingent upon meeting certain conditions such as remaining with the company for a specific period once the benefit is paid to the employee the employee recognizes it as income and the employer can claim a tax deduction for the amount paid although the phantom stock is notional it mimics the behavior of real stock it can pay out dividends and experience price changes just like actual shares after a set period the cash value of the phantom stock is distributed to the participating employees a key advantage of phantom stock is its flexibility there are no inherent requirements or restrictions on how it can be used giving the organization the freedom to structure the plan how it wishes here are phantom stock s advantages and disadvantages summarized employees can benefit from the company s growth without owning shares the company can offer incentives without diluting ownership or control phantom stock plans can be tailored to specific performance goals or periods employees do not have voting rights do not receive dividends or have actual ownership shares in the company payouts are taxed as ordinary income which may be higher than long term capital gains tax rates for actual stock phantom stock is considered a deferred compensation plan and must follow the requirements outlined in the internal revenue service irs code 409 a to ensure compliance an attorney must thoroughly review the plan and all relevant details must be clearly documented 4phantom stock plans have a lot in common with traditional nonqualified stock plans using phantom stock as an organizational benefitsome organizations may use phantom stock as an incentive to upper management phantom stock ties a financial gain directly to a company performance metric it can also be used as a reward or a bonus to employees who meet particular criteria phantom stock can be given to every employee either across the board or distributed according to performance seniority or other factors phantom stock also provides other organizations with a way to offer incentives tied to stock value this can apply to a limited liability corporation a sole proprietor or s companies restricted by the 100 owner rule here are two other common stock related employee benefits along with a table of similar plans stock appreciation rights sars are like a phantom stock based program they are a form of bonus compensation given to employees equal to the appreciation of company stock over a given period like employee stock options eso sars are worthwhile to the employee when company stock prices rise the difference with sars is that employees do not have to pay the exercise price but receive the sum of the increase in stock or cash typically awarded to upper management sars can function as part of a retirement plan they provide incentives that go up as the value of the company does this can help ensure employee retention especially in times of internal volatility such as an ownership change or a personal emergency it reassures employees since phantom stock programs are generally backed in cash this can in turn result in higher selling prices for a business if a prospective buyer perceives the upper management team as stable in a stock option plan employees are granted the right to buy a specific number of company shares at a preset price strike price within a given time frame employees can exercise their options and buy the shares once they vest typically over several years if the company s stock price rises above the strike price employees can profit by exercising their options and selling the shares employees can own actual shares in the company if the stock price increases employees can realize significant gains gains from exercising stock options may be taxed at lower long term capital gains rates employees must pay the strike price to exercise their options and buy shares the options may be worthless if the stock price exceeds the strike price stock options can be complex and require a good understanding of financial markets phantom stock examplelet s say an employee is granted 1 000 phantom shares under an appreciation only plan when the company s stock price is 50 after a vesting period of three years the company s stock price has risen to 75 under the phantom stock plan the employee would receive a cash payout of 25 000 1 000 shares 75 50 but no actual shares of stock the total payout would have been 75 000 if it were a full value phantom plan in contrast an employee granted 1 000 stock options with a strike price of 50 would have the right to buy 1 000 shares at 50 each if the stock price rises to 75 the employee could exercise the options buy the shares for 50 000 and then sell them for 75 000 realizing a profit of 25 000 