Although there are many different types of stock-based compensation used by corporations in America and elsewhere, not all of these plans involve or require the use of stock itself. Some types of stock incentives substitute cash or hypothetical units for actual shares of the company.
This is done for a variety of reasons. Often, it can allow employers and employees to avoid certain tax or accounting limitations that come with the use of real shares of stock. Phantom stock and stock appreciation rights (SARs) are two types of plans in this category.
What Is Phantom Stock?
Phantom stock (also commonly referred to as “shadow stock”) represents an amount of cash that is due to an employee under certain conditions. Phantom stock plans are very similar in nature and purpose to other types of non-qualified plans, such as deferred compensation plans. Both types of plans are designed to motivate and retain upper-level executives by promising a cash benefit at some point in the future, subject to a substantial risk of forfeiture in the meantime. This means that the employer could lose the money under certain circumstances, such as if the employer were to become insolvent.
But while traditional deferred compensation plans usually pay out a set cash amount, phantom stock plans offer a bonus that is typically equal to a specific number of shares or percentage of outstanding stock in the company. When this amount is actually paid, phantom plans once again resemble their traditional non-qualified cousins: The company cannot deduct the amount donated to the plan until the employee takes constructive receipt of the funds, at which time he or she must report the benefit as ordinary income.
Most phantom stock plans pay out their benefits in cash, although some plans have a conversion feature that instead issues stock, if the employer so chooses.
Plan Design and Purpose
Phantom stock plans get their name from the hypothetical units that are used within the plan. These units represent “phantom” shares of the company that are assigned to the plan participant and rise and fall in value in tandem with the company share price.
The majority of phantom stock plans fall into one of two main categories:
- Appreciation Only Plans. This type of plan only pays the employee an amount equal to the value of the growth (if any) of the company share price over a predetermined period of time.
- Full Value Plans. These plans also include the underlying value of the stock itself, and thus pay out considerably more to the employee on a per-share/unit basis.
Key Dates and Terms
- Grant Date: The calendar day when employees can begin participating.
- Offering Period: The length or term of the plan (when employees will receive their benefits).
- Formula for Contributions: How the number or percentage of company shares that will be awarded is determined.
- Vesting Schedule: Any criteria that must be met in order to receive benefits, such as length of tenure or the completion of a company task or goal.
- Valuation: The method of valuing the plan benefits.
- Restrictive Covenants: Provisions that restrict various elements of the plan, such as who is eligible to participate.
- Forfeiture Provisions: Consequences of events that would end participation in the plan, such as death, disability, or company insolvency.
Because phantom stock plans do not involve ownership of actual shares of stock, participants are not paid any dividends, nor do they receive voting rights of any kind by default. However, the plan charter can dictate that both privileges can be granted if the employer so chooses.
Phantom stock plans are most often used by closely-held businesses that do not have publicly traded stock. This is because they allow the employer to offer a form of equity compensation to key employees without altering or diluting the current allocation of shares among the owners of the company. Therefore voting privileges are seldom granted, as this could upset the balance of power among the true shareholders.
Many plans also contain a vesting schedule that outlines when benefits are to be paid and under which circumstances.
Advantages of Phantom Stock Plans
Employers and employees can benefit from the use of a phantom stock plan in several respects. The main advantages that these plans offer include:
- There is no investment requirement of any kind for employees.
- Share ownership for the employer is not diluted.
- Employee motivation and retention is fostered.
- They are relatively simple and inexpensive to implement and administrate.
- They can be structured to meet any number of company needs or criteria.
- Plans may contain a conversion feature that permits employees to receive actual shares of stock instead of cash, if necessary.
- Income is tax-deferred until it is actually paid to the employee. The amount of stock received must be reported as earned income at this point, even if it is not sold; the amount reported equals the fair market value of the stock on the day the employee receives it.
- Plans that are structured properly are exempt from subjection to Section 409 of the Internal Revenue Code, which regulates traditional non-qualified plans such as deferred-compensation plans. This gives these plans greater freedom of structure and simplicity of administration.
Disadvantages of Phantom Stock Plans
- There is no tax deduction for employer contributions until the benefit is paid to the employee.
- Employers must have sufficient cash on hand to pay benefits when they are due.
- Employers may have to employ an appraiser from outside the company to value the plan on a regular basis.
- Employers must report the status of the plan at least annually to all participants, as well as to all true shareholders and the SEC if the company is publicly traded.
- All benefits are taxed as ordinary income to employees – capital gains treatment is not available since benefits are paid in cash.
- Plans with substantial balances may affect the overall valuation of the company. The plan balance can be listed as an asset that the company doesn’t really “own,” since it will be paid to the employee at some point (barring forfeiture).
- Participants in “appreciation-only” plans may not receive anything if company stock does not appreciate in price.
Stock Appreciation Rights (SARs)
Stock appreciate rights constitute another form of equity compensation for employees that is somewhat simpler than a conventional stock option plan. SARs do not provide employees the value of the underlying stock in the company; rather, they provide only the amount of profit reaped from any increase in the price of the shares between the grant and exercise dates.
SARs resemble phantom stock appreciation-only plans in many respects, but their stock or units are usually awarded at a definite time, such as when the vesting schedule is satisfied. Although SARs plans also often have vesting schedules, recipients can usually exercise their rights whenever they choose after the schedule is complete.
Key Dates and Terms
- Grant Date: The calendar day on which the SARs are granted to the employee.
- Exercise Date: The day that the employee exercises the rights.
- Spread: The difference between the company stock price on the grant date vs. the exercise date; hence, the amount of appreciation in the stock. This is what is paid to the participant.
SARs are one of the simplest forms of stock compensation in use today. They resemble other types of plans in the following respects:
- They often contain a vesting schedule that is linked to the accomplishment of certain tasks or goals dictated by the company.
- They may have “clawback” provisions. These are conditions under which the employer may require the repayment of some or all of the benefits under the plan, such as if the participant were to leave and go work for a competitor, or if the company goes bankrupt.
- They are generally transferable to another party.
The procedures for SARs are fairly simple and also closely mirror other types of stock plans. Participants are granted a certain number of rights on the grant date and then exercise them, just as with non-qualified stock options (NQSOs).
Exercising SARs Relative to NQSOs
But unlike NQSOs which give the option to purchase shares at a predetermined price, holders of SARs only receive the dollar amount of appreciation in the share price between the grant and exercise dates. However, they often do not receive this benefit in cash – it is frequently awarded in the form of shares that equal this amount minus withholding taxes.
Suppose that Amy’s company grants her 1,000 SARs and 1,000 NQSOs, and the company stock price closes at $20 on the grant date. (For simplicity, withholding taxes will be kept out of this scenario.) She decides to exercise both types of grants six months later on the same day, and the stock closes at $40 on the date of exercise. Amy simply receives 500 shares from her SARs – the value of these shares is equal to the amount 1,000 shares would have appreciated between the grant and exercise dates, or $20,000.
However, in order to receive the benefit for her non-qualified options, Amy must first purchase those 1,000 shares with her own funds – $20,000. Or, more likely, she’ll essentially borrow the money to purchase them. Then, after shares are purchased, she needs to sell the number of shares equal to the amount she borrowed in order to repay that amount. In this case, she needs to sell 500 shares to repay the $20,000 she borrowed. Since the 1,000 shares she has purchased are worth $40,000, after she sells 500 and repays the purchase amount, she’ll also hold 500 shares worth $20,000.
No transaction of any kind was necessary for her SARs shares, as she only had the right to receive the appreciation of $20 per share, not the value of the original underlying shares themselves. Though the net dollar amount that Amy ends up with is the same for both her SARs and her NQSOs, the exercise process for the SARs is a bit simpler.
SARs are taxed in essentially the same manner as non-qualified stock option plans. There is no tax assessed when they are granted, nor during the vesting process. However, any appreciation in the stock price between the grant and exercise dates is taxed to participants as ordinary income. Employees must report this amount as such on the 1040, regardless of whether or not they sell the shares at that time.
Payroll taxes are also typically assessed on this income, and most companies withhold federal tax at a mandatory supplemental rate of 25%, plus any state or local taxes. Social Security and Medicare are also usually withheld. For SARs, this withholding is usually accomplished by a reduction in the number of shares that the participant receives, so that the participant only receives the number of shares that equal the amount of after-tax income. For example, in the prior example, Amy might only receive 360 of her 500 shares, with the other 140 withheld by the company.
SARs also mirror NQSOs when it comes to computing the tax on the sale of shares. Employees are not required to sell their shares at exercise, and can hold them for an indefinite period of time afterward. Shares from either plan that are held for less than a year are counted as a short-term gain or loss, and those held for a year or more create long-term gains or losses when they are sold. The amount of gain that is reported as ordinary income at exercise then becomes the cost basis for the sale.
For example, suppose Amy sells her shares from her SARs six months later (a year from the grant date) at $50 a share. She will report a short-term gain of $10 per share for a total gain of $3,600 (360 multiplied by $10). The holding period begins on the date of exercise. It is important to note here that her cost basis equals the number of shares that she actually received after withholding, and not the pretax amount.
Advantages of SARs
The major benefits of SARs include:
- The issuance of company shares is reduced relative to other types of stock plans, such as ESPPs or NQSOs, thus reducing the company’s share dilution.
- Employers receive more favorable accounting treatment with SARs than with plans that issue actual shares – they’re classified as a fixed expense instead of variable.
- Employees do not have to place a sale trade in order to cover the amount that was granted when they exercise their shares.
- Employers can automatically withhold the appropriate amount for payroll taxes.
- The tax treatment for employees is straightforward, as they simply count the appreciation as earned income upon receipt.
- Like all other forms of equity compensation, SARs can motivate employees to improve their performance and remain with the company.
Disadvantages of SARs
There are only two real restrictions that come with SARs:
- There is no payment of dividends to participants.
- Participants do not receive voting rights.
SARs and phantom stock provide employers with two viable avenues of offering employees compensation that is tied to company stock without the need to issue large amounts of additional stock. For these reasons, many experts in the stock compensation arena are forecasting substantial growth for both types of plans over time, despite their limitations.
For more information on phantom stock and SARs, consult your financial advisor or an HR professional.