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A phantom stock plan refers to an employee benefit plan that gives the benefits of stock ownership to selected employees without any company stocks in the U.S. Such shares are also called shadow stocks in certain places. Here, the employee usually receives mock stock rather than getting physical stock. The phantom stock is not real, but it still follows the price movement of the company's actual stock.

Note: To learn more about a phantom stock plan, watch this video.

Types of Phantom Stock Plans

Phantom stock plans are usually divided into two categories across the United States and many other countries.

  • “Appreciation Only” Phantom Stock Plans: The plan participant in this particular stock plan receives a cash payment. This particular payment is often equal to the difference between the specific company’s stock price at redemption and the issuing price of the same phantom stock. For example, if the issuing price of the phantom stock is $10. then the company’s common share price will be $30 at redemption. Meanwhile, the cash payment per phantom stock for the same calculation would be $20.
  • “Full Value” Phantom Stock Plans: The plan participant for this phantom stock plan receives a cash payment, too. This, again, is equal to the value of the underlying asset or the common stock of the phantom stock at redemption. For example, let’s imagine the issuing price of the phantom stock is $10. Moreover, the company’s common share price was $30 at redemption. Hence, the cash payment per phantom stock in this particular case would be $30.

Note: Here is a sample phantom stock plan for your reference.

Features of Phantom Stock Plans

Now that we know what phantom stock plans are, here is a look at their important features for further understanding:

  • Granting and Vesting Schedules: Whether grants and vesting schedules should be included in the phantom stock plan is usually one of the questions that are considered. More specifically, this particular fact dictates when the employees are paid their rewards, and become eligible to benefit from dividends and their payouts. These plans are usually customized according to the needs of the employees based on performance, time, or a combination of all factors. It gives the chance to employers to develop their own contingency plans based on their specific objectives.
  • Dividend Equivalent Rights: Participants in a phantom plan obtain dividend equity rights (DER) to collect more in the absence of stock. Such is measured by the dividends declared on the stock of the company and benefits sent to the investor. This attribute serves as a factor that drives employees' goals toward shareholders in some way. Furthermore, the phantom stock plans can enhance share value over absolute participation.
  • Cash Settlement: An example of a share-based remuneration scheme is a cash settlement where each employee receives the amount due for their respective phantom stock awards in cash. It's commonly set to the number of shares involved at the time the dividend is paid. That is to say, the process is not related to authorizing any shares physically, which implies that there is no decrease in ownership for a given owner.
  • Stock Settlement: The actual disbursement of the company shares to the plan participants in stock settlement constitutes another issue in stock-based incentives. In this case, the money is withheld so that the needy person can collect it numerous times until there is no need for cash payments. This method not only provides a unique prospect for compensating employees but also empowers them with the ability to earn more. This is relevant when a stock is expected to keep growing, but it also brings about a possibility of lowering the existing shareholders' ownership percentage.
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Advantages of Phantom Stock Plans

Phantom stock plans have several advantages, which makes them the most favored employee benefit plans among professionals. So, their major benefits include:

  • Empowering Shareholder Equities: Phantom stock plans never dilute shareholder equity. For instance, somebody who is a founder will probably care about limiting the dilution of equity ownership across their respective cap table. The particular company’s other shareholders probably care about the same issue a lot, too! Hence, phantom stock plans can be a great way to give employees exposure to the rise in their stock’s price. This usually happens without granting them the required equity that would dilute the value of the shares.
  • Ensuring Employee Interests: It can help the employees feel brought to the associated company’s success. An employee who wants to own stock must purchase that same stock on the open market at many public companies. This also applies to an employee stock purchase plan (ESPP). Phantom stock is a way to give employees a “stake” in their respective company’s future in the absence of other equity compensation. It usually happens without requiring them to buy their own shares.
  • Supplementing Other Equities: Phantom Stock plans can also supplement more restrictive types of equity. It is not always considered easy to grant additional equity incentives to all the top-performing employees. Sometimes, the shares remain absent, or the regulatory requirements are too onerous. Hence, phantom stock plans may offer a more flexible and less restrictive way to reward all employees with something close to their equity.

Disadvantages of Phantom Stock Plans

Despite having the above advantages, phantom stock plans have their share of disadvantages, too. These include:

  • Affecting Company Values: The possible tax liabilities and the economic value of the entire company are the consequences of the phantom stock plans. It may increase the dues of an owner although this does not add any new liability to shareholders. It will create depreciation of the company in question. This is almost like saying that the payout is in cash and not in the shares.
  • Paying Taxes: These may usually be a pain for employees. The cash payout on a phantom stock plan is originally taxed at ordinary income tax rates. This usually happens in the year in which the phantom shares usually vest. Ordinary income rates are also higher than the long-term capital gains rates. These are the same rates at which an employee might qualify for other types of equity. It means they may be giving up more to the IRS than they otherwise would as a part of the plans.
  • Getting Lower Payouts: Less appreciation in the share value leads to lesser payouts. This usually applies to any type of equity, which also includes ordinary stock options. Still, employees with appreciation-only phantom stock plans may face issues if they make it to the end of their vesting period. They may even end up with no reward because the stock’s price didn’t rise earlier.

Key Terms for Phantom Stock Plans

  • Phantom Units: These are special units linked to a specific company's stock price. Most of them are paid out in cash when the units vest.
  • Stock Appreciation Rights (SARs): A compensatory award that most employees get during their tenure in a particular company.
  • Synthetic Equity: The specific enterprise value that is given to a person who may be an employee of some company.
  • Performance Shares: Incentive-based compensation paid to corporate managers or executives if certain benchmarks are met.
  • Notional Shares: The assumed shares of a Common Stock of the Company determined by the associated Committee to implement the purposes of the Plan.

Final Thoughts on Phantom Stock Plans

The phantom stock plans offer some of the most creative ways to share some value of the appreciation of stocks with employees. This is due to a lack of company stock ownership in the filled plans. Those strategies could be called a very powerful tool for retaining and motivating the whole staff. This is the point at which their needs concord with the respective company's success story.

The employers must develop and apply a specific set of guidelines for the eligible candidates as well as the payment terms for the phantom stocks plans into the system design. This comprises the pricing of each stock, repurchase agreements, legal and tax compliance, and certain other important elements. Besides that, they also can counsel with a lawyer's professionalism to make sure the phantom stock plans work in their best interests.

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ContractsCounsel is not a law firm, and this post should not be considered and does not contain legal advice. To ensure the information and advice in this post are correct, sufficient, and appropriate for your situation, please consult a licensed attorney. Also, using or accessing ContractsCounsel's site does not create an attorney-client relationship between you and ContractsCounsel.

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