Phantom Stock: Profit-Sharing Plan Deep Dive 

For many private business owners, motivating and retaining top talent, particularly senior leadership, is a priority. However, offering traditional stock options may raise concerns around ownership dilution and governance. Enter phantom stock plans: a powerful tool that mirrors the benefits of equity compensation without transferring actual shares. 

If your company is aiming to drive company growth through employee engagement while protecting ownership structure, phantom stock may be the right fit. Below is a clear overview of what phantom stock is, how it works, and why it might (or might not) align with your employee benefits strategy. 

What is Phantom Stock? 

Phantom stock, sometimes referred to as synthetic equity, phantom equity, or shadow stock, is a form of long-term incentive compensation that simulates the economic benefits of actual stock ownership. Rather than granting real company stock and equity, the company issues units that track the value of company shares. After specific time and/or performance-based metrics are met, employees receive cash payouts that reflect the increase in value of those units based on either an internal formula or independent valuation. 

Phantom share payouts are typically made after a vesting period and can be timed to retirement, a liquidity event, or other key milestones which make phantom stock an effective retention and performance tool. 

While phantom stock offers considerable advantages for growing companies, there are a few additional factors to consider when determining whether this type of profit-sharing plan is the right fit for your business. 

Advantages of Phantom Stock 

There are many advantages of phantom stock over traditional stock options for both employees and businesses. Phantom stock: 

• Provides equity-like incentives to attract and retain employees, rewarding long-term retention, performance, and loyalty. 

• Avoids diluting actual ownership and keeps control with the existing shareholders. 

• Does not provide employees with voting rights. 

• Delivers various tax benefits to the employers. 

• Is flexible in that employers use it as they see fit and change the parameters at their discretion. 

Disadvantages of Phantom Stock Plans 

While there are many advantages to phantom stock plans, there are also many disadvantages that might prevent this type of employee reward from being suitable for a business. Disadvantages of phantom stock include: 

• Payouts are typically cash payments, which could create a significant strain on future cash flow. 

• Plans can be an administrative burden as you must track vesting schedules, performance metrics and share price, and annual changes in the value of the company. 

Tax Treatment 

As mentioned above, issuing phantom stock has various stock implications for both the employer and the employees receiving it. Let’s dive a bit deeper into what these implications are: 

For Employers 

• Phantom stock payouts are tax-deductible as compensation is expensed when paid. 

• The company must track accrued liabilities for earned but unpaid phantom stock on the balance sheet. 

For Employees 

• No tax is due when the phantom stock is granted. 

• Income is recognized when the phantom stock has been paid out and is taxed at ordinary income tax rates.  

• Tax filing remains the same with the income being reported on their W2 as opposed to a form K-1. 

Types of Phantom Stock Plans  

Companies have two options they must choose from regarding what type of phantom stock plan they would like to implement. 

Appreciation-Only Plans 

Also called Stock Appreciation Rights (SARs), these plans involve payments that include only the increase in value over the grant date value. For example: if an SAR is granted at $100 per share and is later fully vested and available for payout at $150 per share, the employee only receives $50 per share. 

Full Value Plans 

These plans pay the employee the full value of the stock, which includes the grant value as well as any additional appreciation. Using the same example as above, an employee would receive a payout of $150 per share at the time of vesting and payout. 

Phantom Stock Plan Creation and Implementation  

If you do wish to proceed with adding phantom stock to your employee benefits package, creating a robust plan to help ensure that both you and your team benefit from this stock option plan is crucial. Highlighted below are a few steps necessary to establish and implement this profit-sharing plan.   

1. Define Your Objectives 

Determine your company’s long-term strategic goals, such as growth, and align the plans design with those goals. 

2. Choose the Plan Structure 

Determine if an appreciation-only or full value is right for your company based on financial strategy and incentive goals. 

3. Document Plan Details 

Create a plan that addresses relevant factors such as eligibility criteria, vesting schedules, payout mechanics, and valuation methodology.   

4. Communication and Roll Out 

Inform eligible employees of the profit-sharing plan with clear communication on how the plan works, how it aligns both employee and company long-term goals, and how it creates value to the employee. 

Phantom stock offers a compelling way to incentivize performance and retain key employees without issuing actual equity or complicating your cap table. However, it’s not a one-size-fits-all solution. Companies must be prepared for the cash outlay and understand that the plan’s success hinges on continued company performance. 

For companies focused on scaling and rewarding their team driving that growth, phantom stock is an innovative and strategic solution. Read more on other profit-sharing plans, including employee stock ownership plans (ESOPs) and variable pay.  

Incentive plans and other forms of employee compensation are just part of what we do at Anders. To learn more about how we help companies like yours scale and dream big, reach out for a free consultation.