10 Things to Know About Phantom Stock Before a Company Issues It | by Aysha Saifi | The Capital | Mar, 2022

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A phantom stock, sometimes known as a “shadow stock” or “ghost share,” allows employees to participate in the company’s riches and success. Private business owners are frequently on the lookout for methods to reward key employees without providing them with actual equity in the organization. A phantom stock plan is one of the most prominent of these ideas. Businesses accomplish this by providing employees with stock in the company and a retirement plan to ensure they have adequate money later in life.

We’ll explain what phantom shares are, how they vary from other stock forms, and how to set them up in this article.

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While phantom stocks may sound appealing at the moment, there are several factors to consider before providing them to your employees, including how they function and the tax ramifications.

Historically, public firms used phantom shares to create cash for executive stock option holders. In recent years, it has grown in popularity as a substitute for actual stock grants or awards in private corporations.

Understanding Phantom Stock

This program aims to provide an employee with the value of a share without actually distributing the shares. This plan is also known as equity pay plans, stock bonus plans, or phantom equity plans, which are a type of employee stock option plan (ESOP).

An employee perk entitles employees to acquire business stock at a fixed price, referred to as the “equity value.” Businesses use these options as part of their total reward strategy. Phantom stock plans are frequently a hybrid of employee stock options and a compensation program. As a result, it is a very effective technique for retaining employees.

In the business world, a phantom stock plan is an employee benefit plan that provides selected employees (usually senior management) with many of the perks of stock ownership without actually transferring any ownership interests in the company. Shadow stock is a term used to describe this type of investment strategy.

Instead of receiving physical stock, the employee will be given simulated stock to use. Despite the fact that it is not real, the phantom stock tracks the price movement of the company’s actual stock, and it pays out any profits that result from this tracking.

How does a Phantom Stock Plan work?

A phantom stock plan can be divided into two basic categories. There are ‘appreciation-only’ plans that don’t pay out on the actual value of the underlying shares, but rather on any growth in the firm stock price over a predetermined period of time. ‘Full value’ plans pay for both the underlying stock’s value and any appreciation.

Many of the characteristics of classic nonqualified plans may be found in these two types of plans, such as discriminatory nature, considerable risk of forfeiture, and the fact that they are subject to a deduction when the benefit is actually given to the employee.

The implementation of this stock strategy has various advantages for a business. As follows:

  • An ESOP is much more expensive than setting up this stock plan. That’s why phantom stock plans are a massive money-saver for a startup.
  • When phantom stock is given to employees, they do not have to pay taxes until the stock matures.
  • Employees are only paid if they meet specified criteria, which significantly streamline the procedure. This means that even if an employee resigns, the company will be able to handle half of their vested equity because the plan uses cash rather than the actual stock.
  • Even if employees aren’t able to vote, they nevertheless impact the company’s stock price.

A phantom stock plan is a bonus scheme that is referred to as a 409(a) plan by the Internal Revenue Service (IRS). As with many other IRS-regulated plans, there are some dos and don’ts that are vital before considering the phantom stock. Here are some examples:

1. Your goals/offerings

Before offering phantom equity to employees, you should consider a few things. Plan the objectives, identify the eligible individuals, and decide on the percentage of the equity to be distributed to them. Because phantom stocks are a type of deferred employee compensation plan, companies have the flexibility to amend the plan as and when necessary. Eventually, this program should be designed to match the corporate culture that you are attempting to create.

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2. Top employees

Phantom compensation is commonly referred to as a top hat scheme. This means that the plan can only be made available to the top 5 percent of your company’s compensation-paying employees. Only the top employees will be eligible to participate in the program.

3. Identify the funding

Deferred pay and deferred incentive programs can be supported in one of two ways: fully or partially. Unless the program is financially supported, your staff will not believe it is real. So, it is necessary to fund the plan.

4. Clear metrics and Legal prospects

Managers who engage in the phantom stock plan must have clearly defined parameters that must be completed before participants’ stock grants can be issued. Before launching the program, make sure that the regulations for receiving phantom stock grants are correctly defined and understood.

5. Setting up the shares

To put together the plan document and set up the shares, you will need to hire an attorney specializing in 409(a) plans to assist you. Your business will be subjected to the same regulations as major publicly traded firms due to Enron’s immoral conduct. You must retain the services of an attorney who is familiar with how these plans operate and what the applicable requirements are. The failure to adhere to the laws in their entirety might result in hefty penalties.

6. Vesting schedule

One of the primary reasons for implementing this plan is to assist in retaining key personnel who are crucial to your firm’s growth. It is preferred to use a vesting schedule that is known as a rolling vesting schedule. Until a triggering event or a specified amount of time has passed, the value of each phantom stock grant you have will be null and void.

7. The easy and clear valuation method

The value of your phantom stock fluctuates in parallel with the value of your firm. For the plan to be successful, participants must understand how their stock is valued and that they agree the valuation process is reasonable. When it comes to the effectiveness of this plan, transparency is often essential.

8. Share financial statements

Employees who engage in your phantom stock plan will be expected to know the company’s success in which they work. So the more information you share with this vital set of people, the more successful the plan will be in the long term.

9. Payout schedule

The majority of businesses arrange their phantom stock payouts on an annual basis. If you want to recognize and thank a long-term employee who is key to your business’s success, a one-time grant may be the best option. For others, this may not be good as a long-term incentive is received on annual bonuses which is over a certain number of years. However, by immediately presenting them with an equal lump payment, you may express your gratitude for everything they’ve done for your organization.

10. Phantom stock agreement

You must ensure that your employees’ legal rights are protected at all times. Phantom share arrangements must be structured in such a way that the acceptable tax treatment is achieved while also providing the required deferred remuneration for employees. Phantom stock agreements should be viewed as an extra asset within your offerings aimed to retain top personnel.

A phantom stock plan can be quite beneficial in terms of rewarding key employees for contributing to the success of your business. To ensure that the strategy succeeds, keep in mind that the more structured you are, the better your outcome is going to be. Certain organizations may use this as an “employee benefit plan” in the form of compensation for senior management. Phantom stock directly correlates a financial gain to a company’s performance statistic. Additionally, it can be utilized selectively as a bonus or reward for employees who match specified requirements. Also, this might be given uniformly or based on performance, seniority, or other considerations.

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