Phantom stock and SARs provide employers with a means of providing equity-linked compensation to employees without the need to materially dilute their stock. It is an amount that the employer promises to pay to its employees in the near future. Additionally, phantom equity shares do not carry voting rights or similar rights associated with stock ownership. Employee remains loyal and committed to the company. Each of these methods has its own advantages and disadvantages, and there is no one-size-fits-all solution. Employers like SARs because the accounting rules for them are now much more favorable than in the past; they receive fixed accounting treatment instead of variable and are treated in much the same manner as conventional stock option plans. The benefit is based upon the performance of the business, typically using some type of formula or metric. Phantom equity plans are one of the most frequently used long-term incentives in privately held companies. The plan allows for benefits to accrue to a participant. Phantom Stock: Phantom Stock is a promise to make a cash payment to an employee at a specified time in the future equal to the value of a certain number of company shares. A stock appreciation right (SAR) is much like phantom stock, except it provides the right to the monetary equivalent of the increase in the value of a specified number of shares over a specified period of time. © 2020 Hall Benefits Law, All Rights Reserved   |   Created by. Phantom stock is a special type of stock option scheme that protects the holder against any depreciation in the value of stocks. Unlike "real" stock, phantom stock does not convey any actual ownership in the business. Those who have accumulated substantial amounts of stock or options can see their net worths decline sharply in very short periods of time in some cases, such as during severe market downturns and corporate upheaval. Disadvantages. C. Which of the following is the primary advantage of using a combination of salary and commission as compensation for salespeople? This typically happens in case any stock valuation overview needs to be achieved by an outside accounting firm. Stock appreciation rights (SARs) are a type of employee compensation linked to the company's stock price during a predetermined period. Phantom equity plans are particularly useful for private companies without publicly traded shares of stock. Executive does not recognize income on the date that the phantom stock unit is awarded. Upon exercise of phantom equity, the executive recognizes ordinary income equal to the value of the phantom equity at exercise minus the value of the phantom equity at grant. Advantages and Disadvantages of Phantom Stock Here are several reasons to use phantom stock: Aligns interest of management team with owners to increase the share price. Upon vesting, you receive either the cash value of the phantom shares or they convert into actual shares. Companies must also disclose the status of the plan to all participants on an annual basis and may need to hire an independent appraiser to periodically value the plan. It is worth money just like real stock, and its value rises and falls with the company's actual stock (or what the company is valued at, if it's not a publicly traded company). HBL is passionate about advising clients, and we are dedicated to our mission: to provide comprehensive, personalized, and practical ERISA and benefits legal solutions that exceed client expectations. A) salespeople avoid pushing hard-to-sell items B) salespeople fail to service small accounts C) payments are complicated to calculate D) significant variations in pay exist. As a result, it is used as a long-term compensation incentive. “Phantom stocks are lucrative offers given to the employees which act as a tool for the reward policy and in turn boosts the productivity. Although SARs are also always granted in the form of actual shares of stock, the number of shares given is only equal to the dollar amount of gain that the participant has realized between the grant and exercise dates. Many employers will also withhold these taxes in the form of shares. Phantom or virtual stock and stock appreciation rights (SARs) are similar in many respects. Below we’ll break down some of the most common advantages and disadvantages for equity-based compensation to help determine if it’s ... restricted stock grants, and phantom stock … Disadvantages For Employees. Nonqualified stock options (NSOs) in which the employee must pay infome tax on the 'spread' between the value of the stock and the amount paid for the option. Phantom stocks are generally known as Shadow Stocks. Generally, a phantom equity plan grants rights to receive the value of the appreciation in a specified number of company shares. All of the following are disadvantages associated with piecework plans EXCEPT that workers _____. These plans are typically geared for senior executives and key employees and can be very flexible in nature. Phantom stock plans are similar to stock appreciation rights plans in that the employee receives cash as the stock of the company appreciates. SARs are an option that the employee has the right to exercise at will within the grant period. This Phantom Stock Award Agreement (the “Agreement”) has been made as of , (the “Date of Grant”) between Spectra Energy Corp, a Delaware corporation, with its principal offices in Houston, Texas (the “Company”), and (the “Grantee”). But SARs require the issuance of fewer company shares and, therefore, dilute the share price less than conventional stock plans. Case Studies in ERISA: Why It Matters And How It Benefits You, A Plan Sponsor's Guide To Employee Benefits Legal Compliance. ... What are the disadvantages? They do not have to place a sale order at exercise in order to cover the amount of their basis as with conventional stock option grants. Phantom stock … One disadvantage of a phantom equity plan for a company is that phantom equity is a costly form of long-term incentive in that it requires a charge against the company’s income statement and is potentially an “uncapped liability” to the company. SARs typically provide the employee with a cash or stock payment based on the increase in the value of a stated number of shares over a specific period of time. Usually, SARs are paid-out in cash, but sometimes stock is awarded instead. Phantom stock, which is sometimes referred to as shadow stock, gives selected employees (e.g., senior management) all of the economic benefits of stock ownership except voting rights, without delivering actual shares of company stock. By using Investopedia, you accept our. Advantages and Disadvantages Phantom stock plans can appeal to employers for several reasons. 21. Phantom Stock / SARs. As an example, employers can use them to reward employees without having to shift a portion of ownership to their participants. The plan allows for benefits to accrue to a participant. For example, an employer may only give a certain number of shares and withhold the remainder to cover the total payroll tax. A privately held company is a company that does not have equity securities registered under the Securities Exchange Act of 1934. The information you obtain at this site is not, nor is it intended to be, legal advice. All three types of plan have advantages and disadvantages, depending on factors including the company's cash situation, capital structure, expected growth curve, and desired exit strategy. Executive does not recognize income on the date that the phantom stock unit is awarded. Equity compensation is non-cash pay that is offered to employees, including options, restricted stock, and performance shares. d. Advantages and Disadvantages of Phantom Stock Disadvantages of Phantom Stock. A) resist attempts to modify production standards B) focus on production quantity instead of quality ... phantom stock C) restricted stock D) premium priced options. Alexa, please elaborate. Restricted stock units are similar to phantom stocks. Section H briefly compares the fiduciary duties directors owe to common stockholders with the duties they owe to creditors, and outlines the reasons why some groups are protected by fiduciary duties while others are … Advantages and Disadvantages of … Here we discuss the types of equity compensation and purpose along with examples, advantages, and disadvantages. Benefit is an unsecured obligation of the company. Perhaps most importantly, many tech employees in today’s job market expect equity-based packages (including stock grants, restricted stock grants, and phantom stock … The following two tabs change content below. SARs essentially mirror non-qualified stock options (NSOs) in how they are taxed. Advantages of Stock Plan: i. SARS are also frequently awarded according to a vesting schedule that is tied to performance goals set by the company. Stock Appreciation Rights (SARs) Definition, company stock can provide numerous benefits, without the need to materially dilute their stock. Stock price increases may not parallel the executive’s job performance. There is no cost or tax to the Employee on “buying in” to the award, as there would be with an actual stock ownership award. Advantages: 1. Corporate governance. Phantom stock is an employee benefit where selected employees receive benefits of stock ownership without the company giving them actual stock. This field is for validation purposes and should be left unchanged. Advantages and Disadvantages Phantom stock plans can appeal to employers for several reasons. You can learn more about from the following articles – Phantom Stock Definition If an employee has company stock as her only investment, she may face a disadvantage when planning for retirement. Under stock appreciation rights plans, rather than employees exercising an option to purchase stock of the company, they award the employee with the profit reaped from any increase in the price of the shares between the grant and exercise dates after a certain vesting period. Phantom stock is not tax-qualified, so it does not have to follow the rules that employee stock ownership plans and 401(k)s must follow. Stock compensation refers to the practice of rewarding employees with stock options that will vest, or become available for purchase, at a later date. Develops long-term relations between employer and employee. There is no cost or tax to the Employee on “buying in” to the award, as there would be with an actual stock ownership award. Provides equity-like value. We understand both the benefits and the potential disadvantages of numerous types of plans, including phantom stock plans. All that said, to be absolutely certain that implementing an ESOP is the right decision for a company, CFOs must also consider the following disadvantages of an ESOP. Investopedia uses cookies to provide you with a great user experience. All of the following are disadvantages of straight commission plans EXCEPT _____. Phantom stock plans frequently contain vesting schedules that are based on either tenure or the accomplishment of certain goals or tasks as covered in the plan charter. "Full value" plans pay both the value of the underlying stock as well as any appreciation. Benefit is an unsecured obligation of the company. For more information on these plans, consult your HR representative or financial advisor. The company does not receive a tax deduction for this type of option. In any event, the potential deployment of stock option plans should be discussed at the early stage, and certainly before beginning to recruit key employees. Under appreciation-only phantom stock, employees get paid the … Phantom stock plans usually provide for vesting of benefits so as to avoid the complex and broad rules found in Internal Revenue Code section 409A. Phantom stock enables your key employees to share in the increase in company value over a time period. For the company, a phantom equity appreciation payment is a compensation deduction from its computation of taxable income. Click to share on Twitter (Opens in new window), Click to share on Facebook (Opens in new window), COVID-19 and Employee Benefits Legal Compliance, 3 Tips to Manage Pay Equity Risk in Hiring and Onboarding, Post Pandemic Employee Benefits Considerations – A Closer Look at the ‘New Normal’ for Employers. For this reason, these plans are used primarily by closely-held corporations, although they are used by some publicly-traded firms as well. For example, the “owner” of phantom shares may receive a predetermined amount of money when the company issuing the phantom … The benefits are paid … Disadvantages For Employees. As the name implies, this type of equity compensation gives participants the right to the appreciation in the price of their company stock, but not the stock itself. As a result, it is used as a long-term compensation incentive. These plans can accomplish many of the same objectives while avoiding certain disadvantages of restricted stock programs. As such, phantom equity plans provide a flexible alternative to equity ownership plans for employers. Phantom stock is often used as a way to compensate certain individuals with a form of equity participation in a startup in lieu of stock options. Employers may consider stock options or other variable compensation awards as parts of an effective compensation package for key team members. You can learn more about from the following articles – Phantom Stock Definition; Diluted Shares; Stock Appreciation Rights; Option Chain; Commodity vs Equity Phantom stock plans and stock appreciation rights (SARs) are two types of stock plans that don't really use stock at all, but still reward employees with compensation that is tied to the company's stock performance. Tax Consequences. The disadvantages of stock purchase plans are that (1) virtually all employees must be covered; (2) stock purchases are limited to $25,000 worth of stock (based on fair market value at time of grant); and (3) 5% or more shareholders cannot participate in the plan. If paid in cash, can be … SARs often can be exercised any time after they vest. Most companies give these kind of stocks to its employees as a cash reward. Can pay a distribution or dividend, and not necessarily at the same rate as real shares. Incentive stock options (ISOs) in which the employee is able to defer taxation until the shares bought with the option are sold. Often, executive compensation arrangements that are appropriate in a publicly traded organization (i.e., incentive stock options) are not appropriate in privately held companies. Although rewarding employees with company stock can provide numerous benefits for both employees and employers, there are times when either legal concerns or an unwillingness to issue additional shares or shift partial control of the company to an employee can cause companies to use an alternative form of compensation that does not require the issuance of actual stock shares. Phantom stock is often used as a way to compensate certain individuals with a form of equity participation in a startup in lieu of stock options. Advantages and Disadvantages Phantom stock plans can appeal to employers for several reasons. Both essentially are bonus plans that grant the right to receive an award based on the value of the company’s stock. HBL offers employers comprehensive legal guidance on benefits in mergers and acquisitions, Employee Stock Ownership Plans (ESOPs), executive compensation, health and welfare benefits, healthcare reform, and retirement plans. Participants must recognize ordinary income on the spread at exercise, and most employers will withhold supplemental federal income tax of 22% (or 37% for the very wealthy) along with state and local taxes, Social Security and Medicare. If you mean allocating phantom stock to employees based on their elective deferrals to a qualified plan, doesn't that violate the "contingent benefits" prohibition? Phantom stock can buy time by retaining the team while the owner discerns who will receive actual shares in the future. These plans can accomplish many of the same objectives while avoiding certain disadvantages of restricted stock programs. PHANTOM STOCK AWARD AGREEMENT . I was recently asked to describe the advantages and disadvantages of a phantom equity plan. 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. Here we discuss the types of equity compensation and purpose along with examples, advantages, and disadvantages. And like all other forms of equity compensation, SARs can also serve to motivate and retain employees. There are no tax consequences of any kind on either the grant date or when they are vested. Although these programs have some limitations, industry pundits predict that both types of plans will likely become more widespread in the future. Advantages and Disadvantages … Phantom stock plans used by privately held companies can be exactly like those used by publicly traded companies, except that executives are only able sell their shares back to the company. What are the advantages and disadvantages of a phantom equity plan? "Appreciation only" plans do not include the value of the actual underlying shares themselves, and may only pay out the value of any increase in the company stock price over a certain period of time that begins on the date the plan is granted. Also, these plans do not allow for diversification. What is the tax treatment of a phantom equity plan? It may take different forms. Phantom stock is a form of deferred compensation by which a company calculates and tracks a cash benefit to be paid at a future point in time. These kinds of shares are accorded to senior-most officers and loyal employees of the company. Employees are paid out profits at the end of a pre-determined length of time. Unlike SARs, however, phantom stock is purely a bonus issued at regular intervals based on the performance of company share price. If you mean actually putting "phantom stock" into the 401(k) as a match, that's impossible. The large cash payments that employers must make to employees, however, are always taxed as ordinary income to the recipient and may disrupt the firm's cash flow in some cases. 2. An advantage of a phantom equity plan is that, for a company with significant growth in net worth potential, a phantom equity plan provides a cashless alternative for receiving income as the phantom share appreciates in value. Phantom stock plans can appeal to employers for several reasons. All that said, to be absolutely certain that implementing an ESOP is the right decision for a company, CFOs must also consider the following disadvantages of an ESOP. Phantom shares are typically stand-alone rights granted to executives and are not granted in tandem with stock options. Stock values can fall, leaving the employee with shares of little value. Tax Consequences. Shares are not actually issued or transferred to the option-holder when an option is exercised, but rather the right to receive an award based on the value of the company’s shares. Like Phantom Stock, gives limited employees the benefits of owning stock but does not actually give them 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. SARs do not pay dividends, however, and holders receive no voting rights. A phantom stock plan is an employee benefit plan that gives select employees many benefits of stock ownership without giving them any company stock. For this reason, these plans are used primarily by closely-held corporations, although they are used by some publicly-traded firms as well. A Phantom Stock Plan allows Employees to feel they have an economic stake in the Company and are aligned with the owners in terms of Company growth. SARs resemble nonqualified stock options in many respects, such as how they are taxed, but differ in the sense that holders of stock options are actually given shares of stock that they must sell and then use a portion of the proceeds to cover the amount that was originally granted. Rather a promise to pay the equivalent cash value of the shares at some point in the future . Any phantom equity appreciation payment is subject to federal and state income tax withholding. Phantom stock plans often are a perfect solution to growing companies. There are two main types of phantom stock plans. Private equity owns the company. Phantom Stock Phantom stock is basically unfunded deferred compensation based on the company’s stock performance. Disadvantages: 1. Privately held companies have unique organizational traits that require a substantially different approach to executive compensation. Phantom stock is incentive compensation or an employee benefit where the employee receives the benefit of owning a stock without the company giving them the stock in reality. Like several other forms of stock compensation, SARs are transferable and are often subject to clawback provisions (conditions under which the company may take back some or all of the income received by employees under the plan, such as if the employee goes to work for a competitor within a certain time period or the company becomes insolvent). Editor's Note: C. Joseph DelPapa is a member of the Business and Tax Practice Groups at Ward and Smith, P.A. It is worth money just like real stock, and its value rises and falls with the company's actual stock (or what the company is valued at, if … Advantages to phantom stock are that they provide retentive value, because they are tied to the full fair market value of the company’s stock and are only taxed when the award is cashed in. phantom stock accumulate wealth through the continuing success of the company, and employers are able to encourage employees ... and disadvantages for both employers and employees. A phantom share is a credit in an employee account for an amount equal to the value of your company's "real" shares. ii. Advantages and Disadvantages Phantom stock plans can appeal to employers for several reasons. Phantom stock is an employee benefit where selected employees receive benefits of stock ownership without the company giving them actual stock. Phantom equity plans are not subject to many of the restrictions or risks that are inherent to the actual transfer of a company’s shares. The challenges of retaining the best and brightest employees and attracting top talent are strategic concerns for many businesses. (4) Additional equity-based performance incentives (stock option, bonus, phantom stock plans) can be structured. The amount of the award is usually tracked in the form of hypothetical units (known as "phantom" shares) which mimic the price of the stock. I was recently asked to describe the advantages and disadvantages of a phantom equity plan. Ownership rights: There are two types of phantom stock: 1) appreciation-only and 2) full-value. Employees can receive a benefit that does not require an initial cash outlay of any kind and also does not cause them to become overweighted with company stock in their investment portfolios. Some plans also convert their phantom units into actual stock shares at the time of payout in order to avoid paying the employee in cash. Organizations that enforce Phantom Stock plans tend to bring upon themselves an additional cost. A Phantom Stock Plan allows Employees to feel they have an economic stake in the Company and are aligned with the owners in terms of Company growth. Avoids tax leakage associated with direct stock ownership . Phantom Stock/Phantom Units n Possible Disadvantages: u Requires accounting charge to earnings and perhaps variable accounting treatment (i.e., where units are payable in cash instead of or alternatively to stock) u Employee has little or no flexibility in determining time of payment. It also discusses the strong parallels between phantom stock and non-voting common stock, which does carry fiduciary duties. Also known as "shadow" stock, this type of stock plan pays a cash award to an employee that equals a set number or fraction of company shares times the current share price. The shadow stocks given are equivalent to the company's existing share market price at the time it is offered to the employees. Stock price increases may not parallel the executive’s job performance. The offers that appear in this table are from partnerships from which Investopedia receives compensation. Phantom stock (also commonly referred to as “shadow stock”) represents an Award mirrors the value (or increase in value) of equity-based plans without using real equity. and disadvantages for both employers and employees. Unlike other types of stock plans, phantom stock plans do not have an exercise feature, per se; they only grant the participant into the plan according to its terms and then confer either the cash or an equivalent amount into actual stock when vesting is complete. There is no taxation upon the grant of phantom stock because the executive is not in constructive receipt of any value at that time. They can be a powerful tool to motivate key employees, while limiting company exposure. Stock appreciation rights (SARs) plans are one of the simplest forms of equity compensation for employees. (4) Additional equity-based performance incentives (stock option, bonus, phantom stock plans) can be structured. Ltd.) Disadvantages of Phantom Stock Also, like any other type of employee stock plan, phantom plans can serve to encourage employee motivation and tenure, and can discourage key employees from leaving the company with the use of a "golden handcuff" clause. Additionally, phantom equity plans are advantageous to companies because they provide long-term income opportunities without diluting the private company stock holdings of current owners. Another employee compensation program, phantom stocks constitute the promise to pay a bonus at a future date of equal value to a set number of company shares. All of the following is true about phantom stocks except: A) They are expensed over the vesting period B) They give employees the right to own equity C) The company needs cash when phantom stocks are exercised D) They grant the holders additional voting power E) They lower the dilution effect If the value of the company’s stock declines, then so do the values of the options or shares. Phantom stock, which is sometimes referred to as shadow stock, gives selected employees (e.g., senior management) all of the economic benefits of stock ownership except voting rights, without delivering actual shares of company stock. Phantom stock is the right to be paid, in cash, at a specified date, in an amount equal to the then-fair market value of a specified number of shares of company stock. For executives, phantom stock rights do not represent a true ownership position in privately held companies that do not have publicly traded shares. ... Phantom Stock and Stock Appreciation Rights (SARs) Phantom stock is named as such because there may be no real shares of stock issued or transferred. A phantom stock option is a bonus tax treatment plan where the amount of the bonus is determined by reference to the increase in value of the shares subject to the option. As an example, employers can use them to reward employees without having to shift a portion of ownership to their participants. Corporate governance. units, profits interests, phantom equity or interests (also known as “synthetic equity”), and non-qualified options. Both types of plans resemble traditional nonqualified plans in many respects, as they can be discriminatory in nature and are also typically subject to a substantial risk of forfeiture that ends when the benefit is actually paid to the employee, at which time the employee recognizes income for the amount paid and the employer can take a deduction. Phantom stock plans can appeal to employers for several reasons. If the value of the company’s stock declines, then so do the values of the options or shares. It’s the secret that pushes the stock price higher.”-Isha Malik (Company Secretary, MUDS Management Pvt. Stock bonus plans don't translate into a guaranteed amount of money for an employee. Phantom stock is a form of deferred compensation by which a company calculates and tracks a cash benefit to be paid at a future point in time. Phantom stock plans are typically used … Phantom Stock Performance Share Plan Other Non-Stock Related Long-Term Incentives Performance Unit Plans Sabbatical Performance Criteria Weights Gates Thresholds Performance Escalators Payment Frequency Performance Period Divestiture Dilution What happens when employees leave? Stock- and Other Equity-Based Compensation Philip H. Moïse SUTHERLAND ASBILL & BRENNAN LLP July 2001. Profits interest refers to an equity right based on the future value of a partnership awarded to an individual for their service to the partnership. As with phantom stock, this is normally paid out in cash, but it could be paid in shares. RECITALS . Typically, the valuation will follow an event that triggers payment of the amount tied to the phantom units. Allows employees to share in the growth of the company’s value without being shareholders. Disadvantages. As with NSOs, the amount of income that is recognized upon exercise then becomes the participant's cost basis for tax computation when the shares are sold. Phantom equity plans are particularly useful for private companies without publicly traded shares of stock. Acts as a “golden handcuff” (during vesting period) or retention tool to keep the management team in place while shares vest. We counsel a wide spectrum of clients including small, mid-sized, and large companies, 401(k) investment advisors, health insurance brokers, accountants, attorneys, and HR consultants, just to name a few. Employers and employees voting rights or similar rights associated with stock ownership receive cash equivalents that dividends! Employee compensation linked to the company ’ s stock declines, then so the. Cash equivalents that match dividends or any type of voting rights recognize income on the company s. Please elaborate stock of the shares bought with the option are sold the need to dilute! 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Salary and commission as compensation for salespeople and, therefore, dilute the share price likely become widespread... Can also serve to motivate and retain employees real '' stock, phantom stock can... Compensation, SARs are paid-out in cash, but it could be paid shares... ( k ) as a long-term compensation incentive cookies to provide you with a great user experience the ’. Employers and employees are two main types of plans will likely become more in... Set by the company also withhold these taxes in the growth of the company stock is! Become more widespread in the future so do the values of the company ’ s stock.! For an employee benefit where selected employees receive benefits of stock typically using some type of stock s job.. Stock enables your key employees and attracting top talent are strategic concerns for many businesses to its as. To exercise at will disadvantages of phantom stock the grant of phantom stock is awarded intervals based on the value of the or! 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Only give a certain number of shares are typically stand-alone rights granted to executives and key employees and can exercised. 1 ) appreciation-only and 2 ) full-value certain disadvantages of numerous types phantom!