Deep Dive into Profit-Sharing Plans: Phantom Stock

Phantom stock plans are popular with employers who want to incentivize key employees — typically upper management — through a profit-sharing plan, but don’t want to dilute their ownership by offering traditional stock options.

If you’re looking to achieve financial objectives and growth through your workforce, and possibly boost employee retention, here is some helpful information about this kind of employee compensation and whether it might be the right fit for your company.

Defining Phantom Stock

Phantom stock plans — also known as synthetic equity programs or shadow stock — offer many of the financial benefits of stock ownership: they provide the value of a share to an employee, without the company relinquishing actual shares. Phantom stock follows the movement of the company stock share price and provides a payout based on an internal formula.

If the market value of the company increases, employees receive a cash payment, after a specified vesting period. The time period for receiving these cash bonuses can vary: some companies offer a set number of years, while others tie it to retirement, which makes it a powerful retention tool.

However, employees do not own actual stock, which means they do not have the voting rights typically associated with stock ownership.

With that said, employees still gain from this investment option, as they profit from company stock performing well on the market. Meanwhile, companies can even track the economic benefits of owning company stock without having to distribute equity through the allocation of real shares.

Advantages and Disadvantages of Phantom Stock

From the employer perspective, phantom shares have various tax benefits, including the fact that employers do not have to claim it until they pay an employee any profits earned per the plan agreement. The plan is also flexible, in that employers can use it as they see fit and change the parameters at their discretion, since no equity is being distributed. Also, since no real shares are being allocated, companies can avoid diluting their stock, thereby boosting their stock’s value.

However, plan payments can potentially disrupt a company’s cash flow since they are considered an expense: The company has to set aside money on its balance sheet to fund that payday, no matter how far down the road it might be.

From the employee perspective, a major advantage of phantom stock over shares of the company’s actual stock is that it lets them benefit from company performance without complicating their tax situation. If the business is a flow-through entity, operating in several states, employees with actual shares will receive a K1 form from the IRS, reporting income in every state the business operates in, rather than just a W2.

On the downside, employees must list any payments received from their phantom stock as ordinary income. This requirement means that employees will pay income tax on these payments, as opposed to capital gains, which often has a higher taxation rate.

Employees who receive phantom stock are essentially receiving a deferred compensation plan. According to John Scott, CPA and Tax Partner at Anders CPA + Advisors, although section 409a was not necessarily meant to cover non-public companies, it does pull in many small businesses’ deferred compensation plans, which essentially means that there could be some current compensation to the employee years in advance of them actually realizing the cash.

Bottom line: an employee who receives phantom stock doesn’t take the same risk as an equity partner, which means they also don’t have the same upside. For better and for worse, they are a PINO: “partner in name only.”

Types of Phantom Stock Plans

Companies have two options they must choose from regarding what phantom stock plan they would like to implement. Appreciation-only plans involve payments that do not include the value of the actual company shares and can only pay out resulting profits over a specific period beginning from the date the plan goes into effect. Full-value plans pay both the value of the stock along with appreciation.

Stock Appreciation Rights (SARs)

The major difference between phantom stock and SARs is that it the payout — which could be cash or additional shares of stock — is based on a set number of shares. If SARs are granted alongside stock options, they are called “tandem SARs.” Designing a SARs plan is complicated because of their extreme flexibility. Considerations include: vesting timeline, number of shares issued, any selling restrictions, and whether the SARs come with voting rights.

Plan Creation and Implementation

If you do wish to proceed with adding phantom stock to your employee benefits package, creating a robust plan to help ensure that both you and your team benefit from this option is crucial. Highlighted below are a few steps you can take to establish and implement this profit-sharing plan.

• Recognize your company objectives. All phantom stock plans should help realize a company’s short and long-term business goals. Therefore, it’s imperative that you identify or review your company objectives to ensure the plan you’re establishing will help further them.

• Select the type of plan you would like to follow, appreciation-only or full-value.

• Create a plan that addresses the relevant factors. Formulate a document that lays out the details of your plan along with how payments will be determined. These details should include considerations like eligibility requirements, a vesting schedule, a valuation formula, and payout details and circumstances.

• Roll out the plan. After forming your plan, you can put it into action by first informing eligible parties of the plan’s availability and offering access to it. You can then remind your team of the company objectives before officially executing the plan.

Phantom stock provides flexibility that other profit-sharing plans do not, and many businesses and organizations can use it to their advantage. In a growing business, a phantom stock program can be a useful retention tool that avoids complicating employees’ income tax situation and prevents dilution of the company’s stock price.

With that said, not every company will want to reward employees in this way: it can make for a costly cash flow situation as employees are paid out when they leave or retire. It is also imperative to remember that this stock is only useful if the company grows. Therefore, if you’re looking to maintain your company’s current size, this might not be the ideal plan for you. Meanwhile, for business leaders looking to invest in growing their company, this particular plan might be ideal. 

Read more on profit-sharing plans, including employee stock ownership plans (ESOPs) and variable pay.

Questions about how to structure your employee compensation? Schedule a free consultation with our Virtual CFO team.