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9 frequently asked questions about phantom stock plans

How to base compensation on company value

INSIGHT ARTICLE  | 

Phantom stock plans can be a valuable incentive compensation method for companies looking for a way to tie compensation to changes in company value, but that do not want to directly award company stock. Following are answers to nine frequently asked questions to give you further insights into phantom stock plans and what they could mean for your company.

Q. What is a phantom stock plan?

A. A phantom stock plan is a deferred compensation plan that provides the employee an award measured by the value of the employer’s common stock. However, unlike actual stock, the award does not confer equity ownership in the company. In other words, there is no actual stock given to the employee. Instead, the employee is granted units of phantom stock, and the plan provides that each unit is equal in value to one share of common stock.

Q. Why might a company want to issue phantom equity instead of actual equity?

A. Phantom equity does not have some of the drawbacks associated with providing actual equity. Companies may not want to issue actual equity because:

  • Making the employee an actual shareholder might give him or her voting rights or unforeseen minority rights under state law
  • Additional agreements, such as a shareholder’s agreement, may come into play that increase complexity and legal fees
  • Consideration must be given to the fate of shares issued to an employee that separates service from the company
  • If the company has a buyout provision that applies to a departing shareholder, the plan can increase the company’s cost of keeping the stock in the possession of the company

Q. How does a phantom stock plan work?

A. The phantom stock plan should indicate the number of units of phantom stock or the participation percentage interest to be granted to the employee. The company can grant an employee a designated number of units or percentage interest initially that will be increased in installments over a period of years. For example, a company could grant the employee a 5 percent interest initially and increase the interest to 10 percent after the employee completes five years of service. Whether granted upfront or over a period of years, the phantom stock units may either be immediately vested or subject to any vesting schedule the company chooses. In addition, special forfeiture provisions can be included in the phantom stock plan to eliminate the company’s obligation to make payments to an executive in certain events (e.g., if the employee breaches non‑compete restrictions in the plan or is terminated for cause).

Q. How is the value of a phantom stock unit determined?

A. The value of phantom stock units is measured by the value of the company stock. The value may be stipulated, determined by an express written formula, or determined by appraisal. The approach used for valuation should take into account adjustments that the parties agree are appropriate. For example, a company could exclude gain or loss attributable to operations or sales of certain divisions of the company. Other adjustments that might be considered include  subtractions for capital investments made by the shareholders during the course of the plan and additions for any dividends paid to shareholders during this period and the amount of accrued deferred compensation attributable to the phantom stock units themselves. It should be noted that the value of the phantom stock units fluctuates from year to year as the value of the company changes. For example, if the company has a bad year, the value of its stock, and the value of the phantom stock, decreases. Thus, regardless of any vesting schedule, there is no locked-in value inherent in the phantom stock.

The phantom stock plan should specify what events should trigger, or give rise to, a valuation (i.e., what events should entitle the employee to receive benefits under the plan) and at what precise point the value of the phantom stock units should be determined. In most cases, a valuation is required upon the employee’s termination. In other cases, valuation may be required at a specific date or following a specified number of years. A practical date for measuring the value associated with a triggering event should be specified. Once a triggering event has been identified, the company should evaluate whether the value should be determined on the exact date of the triggering event or whether it makes more sense to look forward or back to the nearest quarter or year end.

Q. How does the executive receive value from the phantom stock?

A. Actual payment of the benefits is usually deferred until a predetermined date or until the employment relationship is terminated due to retirement, death or disability. The phantom stock plan must specify when the phantom stock payments should commence, at which point a valuation of the units is generally triggered as described above. In addition, the plan should state whether payment of the determined value should be made in a single lump sum or in installments over a period of years. If made in installments, the plan should also specify whether interest will accrue on the unpaid installments. When designing these provisions, the company should take into account  possible phantom stock valuations and company cash flow.

Q. How is phantom stock treated for income tax purposes?

A. Phantom stock plans are deferred compensation plans and, as such, the plans must be designed and documented to conform to the requirements of section 409A. For income tax purposes, if the plan is compliant with section 409A, the deferred compensation attributable to the phantom stock will not be subject to income taxation to the employee until it is actually paid to, and received by, the executive. At the time the payment becomes taxable, the company can deduct a corresponding amount (subject to general limitations with respect to the amount being reasonable and not excessive). However, unlike actual stock for which the increase in value on a disposition may be eligible for favorable capital gains taxation, the value of the phantom stock paid to the employee is taxable as ordinary income. Companies should ensure compliance with section 409A prior to a plan becoming effective to ensure these tax results occur. A violation of the rules could cause taxation of and the assessment of penalties related to the income prior to actual receipt by the employee.

Q. What are the payroll tax consequences of phantom stock?

A. For Federal Insurance Contributions Act (FICA) and Medicare tax purposes, deferred compensation is includible as wages in the later of (1) the year in which the related services are performed, or (2) the year in which the deferred compensation becomes vested. The plan vesting and forfeiture provisions determine whether the executive’s rights are vested. As the phantom stock units become vested, the value of the phantom stock units is includible as wages subject to FICA and Medicare taxes. This is the case even though the amounts are not subject to income tax until actually paid to the employee. If the employee base pay (before the phantom stock) exceeds the FICA wage base, no additional FICA tax would be assessed on the phantom stock payments. However, the company and the employee would each be subject to the 1.45 percent Medicare payroll tax since the Medicare tax is imposed on total wages, without any wage cap.

Q. Can entities taxed as partnerships use phantom stock?

A. Although partnerships do not have common stock, entities taxed as partnerships can implement plans very similar to phantom stock plans. In the case of a partnership, however, the value of a phantom unit would be tied to partnership equity value rather than common stock value. All other aspects of the plan would be the same. Because the phantom units are not actual equity in the partnership, such a plan should not raise any concerns over partners being considered employees.

Q. What should a company consider when designing a phantom stock plan?

A. Because a phantom stock plan is a nonqualified deferred compensation plan, companies have a lot of flexibility in plan design. Companies should address the following when formulating aspects of the written plan:

  • What are the objectives of the plan?
  • Who will be allowed to participate (think about this in terms of both current and future positions)?
  • What percentage of equity should be dedicated or reserved for this plan?
  • Should participants receive the base value of the units or only participate in growth over and above the base value?
  • Are there targets in mind for what the benefits from the plan should be worth to an executive in five, 10 or 15 years given certain performance assumptions?
  • How frequently will phantom units be granted (e.g., a single upfront grant or annual grants)?
  • When will units vest? If units are awarded annually, will each new grant be subject to a fresh vesting schedule?
  • How will the units be valued (i.e., based on a formula or an appraisal)?
  • How will the units be valued if there is a sale, merger, consolidation, or a change in control of the company? How should a change in control be defined?
  • Will special vesting rules apply in the case of death, disability or attainment of a specified normal retirement age?
  • Will any funding mechanism be used to help the company fund its future obligations?
  • Should forfeiture provisions apply if the employee enters into competition with the company or is terminated for cause? How broadly or narrowly should ‘for cause’ be defined?
  • When should the value of the phantom stock units be paid out in cash (e.g., periodically every three to five years, upon termination of employment, or upon exercise by the participant)?
  • Should the payment be made in a lump sum or in installments over a period of years? If payments should be made in installments, over how many years?
  • During the installment payout period, should the balance bear interest? If so, at what rate? Should the phantom stock units pending payment continue to participate in the growth in value of the company?
  • The plan must be designed and documented to conform to section 409A. This may restrict some of the flexibility of the plan design.

Various equity compensation methods, including phantom stock, can provide great incentive to both employees receiving them and the employer providing them through increased engagement that can boost company performance. The attributes of phantom stock should be carefully considered to determine whether it is the right incentive plan to meet a company’s needs.

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