Phantom stock can be a good alternative to issuing actual stock, allowing companies to compensate and incentivize key employees over the long term without giving up equity ownership. But there are some potential pitfalls, including tax and regulatory compliance traps, for the unwary.
What is Phantom Stock?
Phantom stock is an agreement whereby a business grants hypothetical stock to an employee and agrees to pay them the value of the vested “shares” at a designated time or upon the occurrence of specified events. The value of phantom stock is typically tied to the businesses’ common stock, which allows the employee to benefit from any appreciation in the value of the company.
The issuance of phantom stock has long been used by privately-owned companies, including family businesses who wanted to provide long-term incentive compensation to certain employees without actually issuing stock and diluting family ownership. More recently, larger publicly traded companies have also started taking a closer look at phantom stock.
The main advantage of phantom stock is that it gives business an opportunity to reward certain employees while avoiding the complications of issuing equity ownership. Phantom stock plans are generally quite flexible and can be tailored to each plan. There are any number of events which can be designated to trigger a cash payment or conversion to actual shares, whether it be the sale of the business or set other milestones. Distributions can be made at various intervals, or a vesting schedule might be included to encourage employees to remain with the company.
Tax Considerations and Potential Pitfalls
Phantom stock is generally treated as bonus compensation. Accordingly, there is no tax impact when phantom stock is awarded. Rather, when payments are made under the plan they are considered taxable wages for the employee and subject to applicable withholding taxes.
Companies should also be aware of some of the risks that phantom stock plans can pose. For example, depending on how the plan is structured, it might come under the umbrella of the Employee Retirement Income and Security Act of 1974. If ERISA applies, the employer will owe fiduciary duties to the participants of the plan.
Businesses will also want to structure the plan in way to avoid Section 409A of the Internal Revenue Code, which imposes restrictions on the timing of certain deferred compensation payments. Furthermore, if the plan appears to provide for the sale of stock to employees, there could be problems if the plan doesn’t comply with the requirements of state and federal securities laws.
Most companies still issue options to employees, specifically incentive stock options (ISOs). The benefit to the employee is that, if the employee holds the stock at least 2 years from the date the option was issued and 1 year from the date of exercising the option, the employee will receive capital gains treatment on the spread between the exercise paid and the stock sale price. Ultimately, incentive stock options often only end up benefiting employees who leave prior to a sale event because they are required to exercise their options within 90 days of termination of their service to the company to maintain ISO treatment. The employees who remain employed through the sale date typically won’t exercise their options until immediately before the closing of the sale. So, they won’t have held the stock for at least 1 year from the date of exercise as required by the ISO rules, which would result in the employee paying short term capital gains tax on the increase in value.
The Corporate Securities Law of 1968, which regulates offers and sales of securities in the state, also provides an exemption (Rule 260.105.5) from the issuer qualification requirement any transaction in which an issuer allocates to its employees units representing a right eventually to receive cash measured by dividends paid on shares of capital stock or the market value of shares of capital stock of the issuer. This rule is an exemption only from the qualification provisions of the Section 25110, which means that any resales or changes in the rights or restrictions in phantom stock units are not exempted by the rule.
Issuing phantom stock can be a good way to reward key employees and motivate them to keep working for the company. But it is important to consult with counsel in order to avoid falling into one of the traps that can come along with this option.