Phantom equity is a sort of compensation award that refers to equity but does not entitle the recipient to actual business ownership.
These awards are known by a variety of names, but the key to understanding them is to realize that they are essentially cash incentive schemes with cash amounts decided by a company’s shares.
Although phantom equity has tremendous value, workers may see it as less valued due to the contractual nature of the promises.
Phantom equity programs can be set up as completely discretionary bonus schemes, which are less appealing than holding stock.
Phantom stock and stock appreciation rights are two instances of phantom equity.
According to a Gallup Workforce Panel survey, slightly more than half of U.S. employees are either monitoring or actively seeking for work.
These findings could provide a huge difficulty for companies in the near future, because staff attrition or loss costs a lot of money, which is amplified when high-level or “critical personnel” leave.
Attrition of key employees can have a substantial impact on a company’s short and long-term success.
As a result, employers must discover strategies to retain and incentivize essential personnel to perform in order to avoid attrition.
Employers, fortunately, have a range of alternatives for motivating and retaining critical staff.
Employees can be given stock options, business shares, or other forms of variable pay, for example.
The specifics of the plan or package chosen by the employer, on the other hand, can have substantial repercussions for the company, such as eroding present owners’ equity, complicating corporate governance, or even imposing onerous tax liabilities on both the employer and the employee.
As a result, creating plans that offer employees with phantom equity is becoming a more attractive choice for businesses in this situation.
At its most basic level, a phantom equity plan entails a corporation pledging to pay a bonus to an employee at a specific time or upon achievement of a specific goal.
The corporation can make a cash payout or convert the phantom equity “shares” into actual stock.
Many of the restrictions and hazards associated with the actual transfer of a company’s shares are not present in phantom equity agreements.
As a result, phantom equity plans offer businesses a flexible alternative to equity ownership plans.
For example, because employees are not actually given any company shares and have no voting or consent rights, phantom equity plans eliminate the possibility of disputes over control in a company between existing ownership and new equity holders, which can occur under traditional equity ownership compensation plans.
Phantom equity programs, on the other hand, alleviate existing shareholders’ fears about immediate stock dilution.
Additionally, phantom equity schemes have lower legal and accounting costs than regular stock ownership compensation plans.
Finally, a company can circumvent the need for employees to invest cash or experience immediate taxable income as a result of shares being issued by establishing a phantom equity scheme.
As a result, a phantom equity plan can be used to simulate the benefits of providing real equity to key employees by contractually guaranteeing the employee a payout, either in cash or in shares, based on the achievement of certain benchmarks or the passage of time, while minimizing the risks and costs associated with actual equity transfers.
The payment’s value is decided on the sort of plan that the employer creates.
The “appreciation only” plan, which only pays the employee based on the increase in the company’s equity value over time, and the “full value” plan, which pays the employee based on the total worth of the company’s shares at the time of pay out, are the two most prevalent varieties.
Due to the structure of the distribution, phantom equity plans can be an effective retention factor for employers because the phantom “shares” have no actual worth prior to vesting or the employee hitting a predetermined benchmark, and the individual will receive nothing if he or she leaves the company.
Furthermore, the plans can serve as a powerful motivator for important personnel to commit time and effort in order to profit financially from any increase in the company’s worth.
As can be seen, phantom equity schemes allow firms to motivate and retain key personnel without having to pay out equity or cash right away.
When properly constructed, these programs can meet the goals of the employer while also providing the incentives needed to retain important employees from leaving or not spending time and energy into expanding the company.
However, if these programs are not properly established, an employer may unwittingly generate responsibility for the firm or cause major tax consequences for the employees.
Phantom equity plans, for example, are normally exempt from the rules of the Employee Retirement Income and Security Act of 1974 (“ERISA”), but if the plan is established wrong, the corporation may face significant ERISA obligations.
Similarly, if a plan is not properly constructed to avoid being subject to the restrictions of Internal Revenue Code Section 409A, an employer’s failure to comply with Section 409A can result in severe tax penalties for the employee (e.g., an additional 20 percent tax).
Employers should explore phantom equity plans as a flexible alternative to standard equity plans or other variable pay awards to retain and encourage key personnel, based on the prospective advantages.
Any employer considering establishing a phantom equity plan should seek legal advice to ensure that the plan is correctly crafted to suit the company’s aims and objectives while avoiding potential hazards.
Is phantom equity good?
Phantom stock is not a good idea if the company is planning on issuing them to most or all employees, especially if the shares will be paid out when the employee leaves the company or retires. In that case, phantom shares may be ruled illegal because of the Employee Retirement Income and Security Act (ERISA).
Is phantom stock the same as equity?
A phantom stock plan is a deferred compensation plan that awards the employee a unit measured by the value of a share of a company’s common stock, or, in the case of a limited liability company, by the value of an LLC unit. However, unlike actual stock, the award does not confer equity ownership in the company.
How is phantom equity calculated?
The answer involves two variables: (a) the presumed value of the company, and (b) the number of shares to be used in the plan. Once these two answers are known, the phantom share price is calculated as the former (the value) divided by the latter (the number of shares).
How are phantom shares paid out?
Phantom stock is a contractual agreement between a corporation and recipients of phantom shares that bestow upon the grantee the right to a cash payment at a designated time or in association with a designated event in the future, which payment is to be in an amount tied to the market value of an equivalent number of …
Does phantom stock pay dividends?
Dividends are periodic payments made to shareholders from profits. Because participants in phantom stock plan are not shareholders, they are not entitled to dividends per se. However, the phantom stock plan may call for phantom dividends.
Is phantom equity a security?
To the extent that phantom stock is considered a security, private companies generally rely on the exemption from registration under Rule 701 of the Securities Act of 1933, which allows a company to offer securities to employees under a written compensatory plan if certain disclosure requirements are met.
What is the meaning of phantom shares?
Definition and Example of Phantom Stock Phantom stock is a form of employee compensation that gives employees access to stock ownership without actually owning the stock.
How is phantom stock accounted for?
In conjunction with generally accepted accounting standards, a phantom stock plan is accounted for as a deferred cash compensation plan because the employee receives the increase in the value of an underlying number of shares or units over a specific period of time in the form of a cash payment on a specified date.
Can an LLC issue phantom stock?
LLCs do not issue stock. Rather, they issue membership “units” as equity. If an LLC has “checked the box” to be taxed as a corporation for Federal tax purposes, it generally can sponsor the equivalent of an employee stock ownership plan and can issue the equivalent of incentive stock options.
Can an S Corp issue phantom stock?
Consequently, an S corporation may have a phantom stock plan without terminating its S corporation election. To avoid losing the “S election,” the phantom stock plan must be structured carefully. Some of the criteria for an effective phantom stock plan for an S corporation includes liquidation rights must be limited.
Can phantom stock be issued to non-employees?
Phantom stocks are only given to a small percentage of employees. RSUs are allowed, by law, to be granted to employees and non-employees alike. This means they can be used for contractors and outside directors. From an individual income and tax perspective they are also similar to RSUs given to employees.
How are phantom shares taxed in Canada?
Phantom stock and similar plans A phantom stock plan is not defined for income tax purposes. It generally refers to a plan that rewards employees in cash, and the amount of the reward is directly tied to the value of the shares of the company.
What is the difference between SARS and phantom stock?
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. As with phantom stock, this is normally paid out in cash, but it could be paid in shares.
What happens to phantom stock when a company goes public?
The phantom stock becomes a liability that the company must eventually convert to either cash or company stock. In privately held businesses, company stock is rarely an option. employees like these plans as any phantom stock they receive is not taxable until converted into cash by the company.
Is phantom stock subject to Erisa?
Qualified plans, such as 401(k) programs, are subject to all of the rules and restrictions of ERISA. Nonqualified plans, including most phantom stock plans, are not. Thus, most phantom stock plans are exempt from the portions of ERISA pertaining to participation, vesting, funding and fiduciary responsibilities.
Do phantom shares dilute?
Phantom stock plans do not result in shareholder dilution because actual shares are not being transferred. Employees do not become owners. Instead, they are potential cash beneficiaries in the underlying company value.
What is phantom income?
Phantom income is typically an investment gain that has not yet been realized through a cash sale or a distribution. Phantom income can complicate the process of tax planning because, even though it has not been realized, it is income that is attributed to one’s tax liability.
Is phantom stock a second class?
For example, phantom stock plans are not considered a second class of stock, provided only employees are covered by the plan.
Do you pay tax when shares vest?
Vesting is not a taxable event and so you owe no tax on vesting. You only have to pay tax on the gain when you sell the shares. In contrast, if you do not file a Section 83(b) election, you effectively defer being taxed until vesting.
Do stock grants count as income?
If you’re granted a restricted stock award, you have two choices: you can pay ordinary income tax on the award when it’s granted and pay long-term capital gains taxes on the gain when you sell, or you can pay ordinary income tax on the whole amount when it vests.
