Phantom Stock and Stock Appreciation Rights

Quite often, employers use items like employee stock ownership plans (ESOPs), 401k plans, or stock option plans to provide incentives and benefits to employees. However, under certain circumstances, it may be desirable or necessary to use alternate forms of equity compensation. In these situations, companies can use either phantom stock or stock appreciation rights (SARs).

Why are they Used?

Certain companies may be concerned over changing the ownership structure by awarding shares of stock to employees. For example, S corporations that are worried about exceeding the 100 owner limit. Alternatively, a company may choose to use phantom stock or SARs because its owners do not want to share the equity of the company with employees, but still wish to share the economic value of that equity.

How do they Work?

Phantom stock is a promise to pay an employee a cash bonus equivalent to the value of the company shares and the increase in the value of such shares or just the increase in the value of the company shares over a fixed period of time. Typically, phantom stock plans vest based upon the employee’s tenure or the accomplishment of certain goals by the employee. Importantly, phantom stock can reflect dividends or stock splits.

A phantom stock plan that includes both the value and appreciation in value of the shares is called a “full value” plan. Alternatively, a phantom stock plan that only pays the increase in the value of the shares is called an “appreciation only” plan. Because there is no transfer of shares, phantom stock can be used to reward employees without transferring ownership interest to the employee.

SARs are similar to phantom stock in that the award is tied to the value of the stock. Specifically, SARs provide a right to the monetary equivalent of the appreciation in the price of a designated number of shares of stock over a specified period of time. The award can be paid in cash, shares of stock, or a combination of the two. By paying the award strictly in cash, a company can avoid the changes in ownership that can occur through stock transfer.

Similarly to phantom stock plans, SARs plans typically provide for vesting upon the accomplishment of specified goals set by the company. Unlike phantom stock plans, SARs do not pay dividends.

Both phantom stock and SARs are treated as ordinary income for tax purposes by the employee upon receipt of the award. The amount of the award can be used as a tax deduction by the employer.

For More Information

If you would like more information about the various forms of equity compensation, speak with a knowledgeable business and tax law attorney. At the Royse Law Firm, we have experience implementing phantom stock and SARs plans and, because we are a firm that specializes in business and tax law, we can help ensure compliance with securities laws and tax regulations when setting up these plans.

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Roger Royse

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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