For senior-level employees, phantom stock agreements have many of the same benefits as standard stock compensation agreements/plans except without the eventual right to vote the “shares” and loss of capital gains tax treatment on some income in some circumstances. For corporate entities, the benefits are also similar, but without having to dilute voting rights among the current owners.
Like traditional stock plans, phantom stock plans involve “stock” distributions or incentive “stock” options, except that no actual stock shares/certificates are issued. The “stock” remains “on-paper-only.” There are two types: “current value” and “appreciation value” plans. For the former, grants or options are provided representing the then-current value of the shares, and at the time of a defined “payment event,” the company is obligated to pay the full value of the shares at that time (which includes the value at the time of vesting and any appreciation). For the latter, the company is obligated only to pay the value of the increase in stock price from the date of vesting. In general, those receiving phantom stock are prohibited from selling, assigning, or pledging the phantom stock as collateral. However, generally, the “stock” in heritable. Phantom stock plans are very flexible and can even provide for dividends to be paid on the “stock.” Generally, the phantom stock will be granted/optioned and designated in the same manner as existing company stock/ownership shares (such as “Common Shares Class A” or “Non-Voting Shares — Dividend Receiving,” etc.).
For corporate entities like corporations and limited liability companies, phantom stock plans allow them to reward and incentivize employees in the same manner as traditional stock plans. This includes permissible deferral of taxes if the phantom stock complies with IRS rules. This is because, while the “stock” is hypothetical and “on-paper-only,” its value experiences price changes just like real stock. Thus, senior-level employees (and others) are incentivized to “grow” the company and to see the value of their phantom stock increase. As noted, the other advantage for the company is that, since the stock/shares are “on-paper-only,” there is no actual or potential grant of equity and no corresponding dilution of ownership among current owners. This eliminates any threat to the control of the company and maintains the current level of effort needed to create a collective agreement/action. Phantom stock may also be a solution for an S-corporation up against its 100-owner limitation.
In look and legal form, phantom stock agreements/plans are nearly identical to their standard counterparts. That is, they must be in writing, must be administered as deferred security plans, must meet the IRS requirements in Code section 409(a), and must comply with all security laws and regulations. As for the employee’s earnings and potential earnings, a phantom stock agreement will have the same taxable aspects as other deferred compensation plans, except that any appreciation in value that is eventually received will be taxed as ordinary income rather than as capital gains. This is understandable since the stock/ownership shares are phantom (non-existent).
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