Phantom Stock

Phantom stock is a contractual promise by an employer to pay an employee an amount tied to the value of a specified number of its shares, without transferring any shares. The units are bookkeeping entries. They rise and fall with the stock, they may be credited with dividend equivalents, and at a specified time the employer pays what they are worth, almost always in cash. Private companies use it to give employees the economics of ownership without new shareholders, a valuation event, or a change to the capitalization table.

The Securities and Exchange Commission's executive compensation rules name the instrument, listing "phantom stock, phantom stock units" among the awards a registrant reports as stock. No section of the Internal Revenue Code defines it, and the word does not appear anywhere in the section 409A regulations. The clearest official statement of what it is comes from an employment tax regulation drawing a boundary, discussed below.

The line against a stock appreciation right is drawn in a regulation, and it is the whole distinction. Under 26 CFR 31.3121(v)(2)-1(b)(4)(ii), a "stock value right" is a right entitling the employee "to a payment for each share of stock equal to the excess, or a percentage of the excess, of the value of a share of the employer's stock on the date of exercise over a specified price (greater than zero)". The regulation then says outright that "the term stock value right does not include a phantom stock or other arrangement under which an employee is awarded the right to receive a fixed payment equal to the value of a specified number of shares of employer stock". Appreciation only is one instrument; full value is a different one, and the tax rules follow the difference rather than the label on the award.

That difference decides whether the arrangement is deferred compensation, and phantom stock is. The same regulation excludes stock options, stock appreciation rights and other stock value rights from the deferral rules. Phantom stock is not among them. Example 8 of the regulation works through a plan crediting an employee each year with a dollar amount equal to the value of a fixed number of shares, payable on termination. It concludes that the plan "provides for the deferral of compensation" because the employee has a legally binding right in one year to something paid in a later one, and then explains why the exclusion does not rescue it: the plan is not a stock value right "because it provides for awards equal in value to the full fair market value of a specified number of shares ... rather than the excess of that fair market value over a specified price". The timing makes it deferred compensation; the full-value design is what keeps it there. Two consequences follow.

Consequence one: section 409A applies. Payment is confined to the events that section 409A permits, deferral elections generally have to be made before the year the services are performed, and accelerating a payment is generally prohibited. The rules, the permitted payment events and the tax cost of breaking them belong to the nonqualified deferred compensation entry, which covers them in full. What matters here is the fact that they apply at all, because employees frequently assume an award described in shares is governed like equity when it is governed like a deferred bonus.

Consequence two: the Social Security and Medicare timing is not the income tax timing. Deferred compensation is subject to a special timing rule under section 3121(v)(2) of the Internal Revenue Code, which treats the amount as Social Security and Medicare wages at the later of when the services are performed or when the amount stops being subject to a substantial risk of forfeiture, rather than when it is paid. For a phantom stock award that will usually be a much earlier year than the payment. Why that timing is generally favorable, and what the accompanying nonduplication rule does, belongs to the nonqualified deferred compensation entry, which works it through. The point here is only that an employee reading the payment date as the tax date has the employment tax half wrong.

The unsecured promise is the risk, and it is not a technicality. Until the employer pays, the participant holds a contractual claim ranking with the company's other general creditors. A shareholder in the same company at least holds an asset that survives the employer's insolvency in whatever diminished form; a phantom stock participant holds a promise. Employers sometimes set money aside informally in a trust to fund these promises, but such a trust must by design leave the assets reachable by the employer's creditors, so it changes the employer's discipline rather than the employee's protection.

Valuation is the practical question at a private company. Phantom stock only means something if there is an agreed way to value a share, and in a company with no market that method is a contract term: a formula, an independent appraisal, a multiple of earnings, or a price set at a transaction. The award is worth reading for that clause before it is worth reading for the numbers.

1. Award. The employer credits an employee with a number of phantom units, tied to the value of the same number of real shares, under a written plan.

2. Tracking. The units rise and fall with the share value. Some plans credit dividend equivalents; the plan document says whether they do.

3. Vesting and forfeiture. The plan states what has to happen before the award is earned, and what happens on an early departure.

4. Payment. At an event the plan specifies and section 409A permits, the employer pays the value of the units, normally in cash, as ordinary wages with withholding.

A hypothetical example, and the comparison that shows what "full value" means. Rosa is credited with 5,000 phantom units when the company's share value is $22. Six years later she separates from service and the plan pays out. The share value is then $37.

Her payment is the full value of 5,000 notional shares: 5,000 × $37 = $185,000, ordinary compensation in the year it is paid.

Now suppose the same company had granted her stock appreciation rights on the same 5,000 shares, with a base price of $22, the value on the grant date. Those would pay only the appreciation: 5,000 × ($37 − $22) = $75,000.

The gap is $110,000, which is exactly 5,000 × $22, the value the shares already had on the day she was granted them. That is the whole of the boundary the employment tax regulation draws, expressed in dollars: one instrument pays from zero, the other from a specified price greater than zero. All figures are illustrative.

Pros

• The employee gets the economics of ownership with no cash outlay, no exercise decision and no purchase price to fund.
• The award has value from the first dollar of share value, not only from growth, so a flat share price still pays.
• The employer issues no shares, which is why a closely held or family-owned business will often offer this when it will not offer real equity.
• Payment normally arrives as cash, so nothing has to be sold and the household does not end up holding more employer stock.

Cons

• The participant is an unsecured creditor until paid, so an employer in trouble is a risk to the award at exactly the moment the employee's job is also at risk.
• There is no ownership: no vote, no shareholder rights, no transferable asset, and no ability to sell part of the position.
• The entire payment is ordinary income, with no route to capital gain treatment however long the units are held.
• Section 409A's timing rules are rigid, and the tax consequences of a non-compliant plan fall on the employee rather than on the company that wrote it.
• At a private company the value depends on a valuation method written into the plan, which the employee does not control and may not be able to verify.