Phantom Stock Plan: What It Is, How It Works, Types

A phantom stock or shadow stock plan is an employee benefit program that gives certain employees, typically senior managers, many of the benefits of stock ownership without actually handing over company stock.

Rather than getting physical stock, the employee receives "mock stock." Even though it's not real, the phantom stock tracks the price moves of the company's actual stock, paying out any resulting profits.

How Phantom Stock Plans Work

Phantom stock plans are an alternative to the equity-based incentive plans typically offered by public companies, particularly stock option grants. These plans can be structured to mimic whole shares of stock, allowing participants to receive accumulated returns plus the initial value per share. Here are the two types of phantom stocks:

• Appreciation-only plans do not include the value of the actual underlying shares. They may only pay out the value of any increase in the company stock price over a certain period that begins on the date the plan is granted.
• "Full value" plans pay the value of the underlying stock and any appreciation.

Like restricted stock, full-value phantom shares have a higher per-share value than stock options at the time of grant, enabling companies to grant fewer shares while still providing competitive grant value. This approach is commonly used when employee retention is a concern.

However, in most cases, companies opt for appreciation-only grants, where awards are based only on total share return rather than the initial value. Companies often aim to create performance and award leverage like stock options. In addition, discounted grants and grants that pay out when returns exceed a specific hurdle rate are also used.

Both phantom stock plans and traditional nonqualified plans share several similarities. They can be discriminatory, meaning the company can choose which employees participate in the plan. These plans are also usually subject to a substantial risk of forfeiture, which means that the employee's right to receive the benefit is contingent upon meeting certain conditions, such as remaining with the company for a specific period. Once the benefit is paid to the employee, the employee recognizes it as income, and the employer can claim a tax deduction for the amount paid.

Although the phantom stock is notional, it mimics the behavior of real stock. It can pay out dividends and experience price changes just like actual shares. After a set period, the cash value of the phantom stock is distributed to the participating employees.

A key advantage of phantom stock is its flexibility. There are no inherent requirements or restrictions on how it can be used, giving the organization the freedom to structure the plan how it wishes. Here are phantom stock's advantages and disadvantages summarized:

Phantom stock is considered a deferred compensation plan and must follow the requirements outlined in the Internal Revenue Service (IRS) code 409(a). To ensure compliance, an attorney must thoroughly review the plan, and all relevant details must be clearly documented.

Using Phantom Stock as an Organizational Benefit

Some organizations may use phantom stock as an incentive to upper management. Phantom stock ties a financial gain directly to a company performance metric. It can also be used as a reward or a bonus to employees who meet particular criteria. Phantom stock can be given to every employee, either across the board or distributed according to performance, seniority, or other factors.

Phantom stock also provides other organizations with a way to offer incentives tied to stock value. This can apply to a limited liability corporation, a sole proprietor, or S-companies restricted by the 100-owner rule.

Here are two other common stock-related employee benefits, along with a table of similar plans:

Stock Appreciation Rights

Stock appreciation rights (SARs) are like a phantom stock-based program. They are a form of bonus compensation given to employees equal to the appreciation of company stock over a given period. Like employee stock options (ESO), SARs are worthwhile to the employee when company stock prices rise; the difference with SARs is that employees do not have to pay the exercise price but receive the sum of the increase in stock or cash.

Typically awarded to upper management, SARs can function as part of a retirement plan. They provide incentives that go up as the value of the company does. This can help ensure employee retention, especially in times of internal volatility, such as an ownership change or a personal emergency.

It reassures employees since phantom stock programs are generally backed in cash. This can, in turn, result in higher selling prices for a business if a prospective buyer perceives the upper management team as stable.

Stock Option Plan

In a stock option plan, employees are granted the right to buy a specific number of company shares at a preset price (strike price) within a given time frame. Employees can exercise their options and buy the shares once they vest, typically over several years. If the company's stock price rises above the strike price, employees can profit by exercising their options and selling the shares.

Phantom Stock Example

Let's say an employee is granted 1,000 phantom shares under an appreciation-only plan when the company's stock price is $50. After a vesting period of three years, the company's stock price has risen to $75.

Under the phantom stock plan, the employee would receive a cash payout of $25,000: (1,000 shares × ($75 - 50)), but no actual shares of stock. (The total payout would have been $75,000 if it were a full-value phantom plan.)

In contrast, an employee granted 1,000 stock options with a strike price of $50 would have the right to buy 1,000 shares at $50 each. If the stock price rises to $75, the employee could exercise the options, buy the shares for $50,000, and then sell them for $75,000, realizing a profit of $25,000.

The Bottom Line

Phantom stock is a deferred compensation plan that provides employees with a cash payment based on the value of a specific number of hypothetical company shares. It's designed to align employee incentives with company performance without granting actual stock ownership. Phantom stock can be structured as either full-value or appreciation-only plans, and payouts typically have vesting periods and other criteria to meet.

While they are like stock options and SARs, phantom stock plans offer more flexibility in payouts and timing. However, it's essential for companies to carefully design and communicate these plans to ensure compliance with legal and tax regulations and to maximize their motivational effect on employees.