What Is a Phantom Stock Plan?
A Phantom Stock Plan is a form of employee compensation where the benefits of stock ownership are awarded without actual shares being given.
A phantom or shadow stock plan provides many of the benefits of stock ownership to selected personnel without actually granting them any company shares. Instead of genuine stock, the employee receives simulated stock. Typically, these schemes are awarded to key employees and senior management. Despite the fact that it is not real, the phantom stock tracks the price movement of the company’s actual shares, even paying out any profits that arise. The shares have monetary value, much like a genuine stock. Also, their value fluctuates with the company’s actual stock, or what the company is valued at if it is not publicly listed. Employees are paid out profits at the conclusion of a set period of time.
Phantom stock is also known as shadow stock, simulated stock, or phantom shares. They are given as an incentive or reward for hard work and longevity. Stock Appreciation Rights are one type of phantom stock. There is no single definition of phantom stock or how businesses use it. The phrase can refer to any type of reward that takes time to mature. Typically, the award is for a certain number of units that follow the price of the company’s genuine shares. They rise and fall in tandem as the company’s value rises and falls.
Phantom Stock Plan Charter
A plan charter exists for each phantom stock plan. This charter establishes the vesting schedule. For example, there might be goals or tasks that participants must do in order to vest. In that case, the charter details them as well as what the participants will earn. It also specifies any potential voting rights. In some cases, phantom stock can be converted to actual shares in the company upon distribution. The charter will specify how and when that is possible.
Phantom Stock Plans – A Closer Look
Phantom stock plans are classified into two sorts.
- Appreciation only – These plans do not include the value of the real underlying shares and may only pay out the value of any increase in the firm stock price over a specific time period beginning on the date the plan is issued.
- Full value plans – These plans pay both the underlying stock’s value and any appreciation.
In many ways, both types of plans are similar to traditional nonqualified plans. For instance, they can be discriminatory in nature and are typically subject to a significant risk of forfeiture. Loss of benefit only ends when the conditions are fully met and compensation is actually paid to the employee. Although the phantom stock is theoretical and contingent, it can nonetheless pay dividends and experience price fluctuations. In that regard, it can behave just like its genuine counterpart. The cash value of the phantom stock is dispersed to participating employees after the preset conditions are fully met.
Phantom stock is sometimes known as synthetic equity. It has no external criteria or constraints in its use. This allows the company to employ it however it sees fit. A phantom stock plan can also be amended at the discretion of company management. Simply stated, it is a type of deferred compensation plan. However, a phantom stock scheme must adhere to the rules of Internal Revenue Service (IRS) section 409. (a). An attorney must thoroughly review the plan, and all aspects and conditions must be established in writing. In this regard, phantom stock schemes are very similar to typical nonqualified stock plans.
Nonqualified Deferred Compensation
A nonqualified deferred compensation (NQDC) plan is an elective or non-elective plan, agreement, method, or arrangement between an employer and an employee (or service recipient and service provider) to pay the employee compensation in the future. In comparison with qualified plans, nonqualified plans do not provide employers and employees with the tax benefits associated with qualified plans because NQDC plans do not satisfy all of the requirements of IRC § 401(a). Under a nonqualified plan, employers generally only deduct expenses the employee or service provider recognizes income. In contrast, under a qualified plan, employers are entitled to deduct expenses in the year the employer makes contributions even though employees will not recognize income until the later years upon receipt of distributions. (Source: irs.gov)
Phantom Stock as an Organizational Benefit
Phantom stock may be used as an incentive to higher management in some corporations. The stock directly links a financial benefit to a firm performance statistic. It can also be utilised selectively as a bonus or reward for employees who match particular requirements. Alternatively, phantom stock can be allocated to all employees, either uniformly or based on performance, seniority, or other considerations. Used selectively, the stock allows corporations to create incentives connected to stock valuation while imposing certain limits. This can apply to a limited liability company (LLC), a single proprietorship, or S-corporations subject to the 100-owner rule.
Phantom Stock Plans vs Stock Appreciation Rights
Stock appreciation rights (SARs) are similar to phantom stock programs. SARs are a type of bonus compensation given to employees that is equal to the appreciation of the company’s shares over a set period of time. SARs, like employee stock options (ESO), benefit employees when company stock prices rise. The distinction is that employees do not have to pay the exercise price. Instead, they get the sum of the increase in stock or cash.
A stock appreciation right plan is one of the most basic types of equity compensation. They are frequently utilised by businesses to grant awards to employees. These plan shares some of the following qualities with other plans:
- Transferability – The benefits of this plan can be easily transferable to another party.
- Contingent vesting rights – SARs usually have a vesting schedule with rules. In other words, the employee has to complete certain goals within some time frame.
- Clawback provisions – The plan might have “clawback” provisions. For example, the employer might ask for the repayment of all or some of the benefits under the plan if the company goes bankrupt. Or, if the employee leaves to work for another firm before fully vested.
SARs are often made available to higher management and can operate as part of a retirement plan. It gives higher incentives as the company’s worth rises. This can also help to ensure staff retention, particularly during times of internal turmoil. For example, a change in ownership or a personal emergency. Employees benefit from it since phantom stock programs are typically backed by cash. This might lead to higher selling prices for a company. Particularly, if a prospective buyer believes the upper management team to be stable.
Phantom Stock Taxation
Employees who receive awards in either a stock appreciation right plan or a phantom stock plan are taxed when their benefits are exercised. Essentially, they will be required to pay tax on the value of the award less any money paid which is usually nothing in these plans. This sum is taxed at the employee’s ordinary income rate. As a result, the corporation is able to deduct the amount of the award from their tax return. However, if the award is issued in the form of shares rather than cash, the amount of the gains is taxable the minute they are exercised, even if the shares have not yet been sold. Thereafter, any subsequent gain on the shares is taxable as capital gain.
NQDC amounts are taken into account for FICA tax purposes at the later of when the services are performed or when there is no substantial risk of forfeiture with respect to the employee’s right to receive the deferred amounts in a later calendar year. Employers must withhold income taxes from NQDC amounts at the time the amounts are actually or constructively received by the employee. (Source: irs.gov)
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