Despite the ghostly name, phantom stock is not quite as mysterious as it sounds. In essence, phantom stock is a deferred compensation plan that gives an employee a stake in a company's success without conferring an actual ownership interest in the company.

Phantom stock provides an employee a benefit measured by, and tied to, the value of an employer's common stock. Easy, right? What makes it a “phantom” is that, unlike actual stock that conveys a piece of equity ownership in a company, phantom stock does not bestow any actual equity ownership in the company. An employee is granted units of phantom stock shares and the phantom stock plan would provide that each phantom stock unit has an equal value to each share of the company's common stock.

Once demystified, we will see phantom stock plans are not so spooky and are useful for the right employees at the right companies.

How Does Phantom Stock Work?

As mentioned, the value of phantom stock is the same as a company's common stock. A properly drafted phantom stock plan will indicate how many shares of phantom stock or a percentage interest that is to be granted to the employee. Phantom stock shares or the percentage interest can be granted to the employee upfront or over a period of time. Additionally, phantom stock shares can either vest immediately or in accordance with a vesting schedule as determined by the company.

Phantom stock value can be determined by a number of different ways, including appraisal, written formula or stated stipulation. The appropriate approach for valuation should take into account any and all adjustments the parties deem to be appropriate (for example, exclusion of certain gains or losses, or additions for dividends paid to shareholders). Year-to-year fluctuation of phantom stock value occurs when the value of the company changes. This means, just like a regular stock, if it's been a good year for the company, there will be good phantom stock value; bad year, the value drops.

The phantom stock plan should also clearly outline triggering events for valuation, meaning, those events that entitle an employee to receive the benefits under the plan. Another key consideration is the determination point as to the value of the phantom stock shares. More often than not, it is common for a valuation to be triggered upon the termination of an employee. However, it is also possible for a valuation to be determined upon a certain number of years or even a fixed date in time. After a triggering event, the company needs to decide when the value of the phantom stock is to be determined—on the triggering event date or perhaps forward or backward to the closes quarter or end-year date. This should be specified in the plan.

Finally, a phantom stock plan needs to discuss how the employee receives value from the phantom stock. Ideally, a properly structured plan will describe the following:

• When the payments will commence (thus, triggering a valuation).
• How the payments will be disbursed to the employee (i.e., lump sum or installments over a period of time).
• If the benefit is being paid in installments, how will interest, if any, be handled. This will take into consideration the company's cash flow and valuation of phantom stock when structuring the plan and provisions.

Why Would a Company Offer Phantom Stock?

An employer may not want to make an employee an actual equity shareholder in the business, as this could unintentionally provide them with voting rights or other unanticipated minority ownership rights. Furthermore, when dealing with actual equity shares in a company there is the chance that additional documentation or agreements are necessary, such as shareholder agreements, thus requiring additional complexity and potential fees. Additionally, what would happen to the employee's actual equity stock in the company upon departure of that employee? These are considerations that you don't have to worry about with phantom stock.

While phantom stock plans come with fewer complications, there are still laws to which they are subject, notably portions of the Employee Retirement Income Security Act of 1974 (ERISA). These may include limiting phantom stock offerings to management or highly compensated employees and notifying the Department of Labor within 120 days of adopting the plan. Court rulings, however, can facilitate exceptions to ERISA in some circumstances.

What About Tax Considerations?

Due to the nature of phantom stock plans being a form of deferred compensation, such plans must comply with the requirements of the Internal Revenue Code Section 409A. Assuming the plan is compliant with this section, deferred compensation attributable to such phantom stock will not be subject to income tax until it is actually paid to the employee. Once taxable to the employee, the company is generally able to deduct the corresponding amount. It is important to note that the value of the phantom stock paid to the employee is taxed as ordinary income and does not implicate any type of capital gains taxation. Compliance with IRC Section 409A is key, and any violation could potentially cause penalties relating to the income prior to the employee's receipt.

From a payroll standpoint, deferred compensation counts as wages in the latter part of the year in which the related services are performed or the year in which the deferred compensation becomes vested. As the shares of phantom stock vest, the value of such shares can be included as wages and subject to Medicare taxes and FICA taxes—notwithstanding the fact that these amounts are not subject to income tax, as discussed above, until the amounts are actually paid to the employee.

While taking into account that the proper tax considerations may be among the more complicated aspects to implementing phantom stock plans, on the whole, they are less complex than offering common stock while acting in a similar fashion. Add in the factor that phantom stock gives employees a stake in the company without making them shareholders who have equity ownership, and they may make sense for companies looking to provide an employee with a benefit tied directly to the performance of the company.

An attorney experienced in business matters can help a company determine if offering a phantom stock plans is the right decision, craft a properly structured phantom stock plan and reveal that these types of benefits aren't as mystifying as they might seem at first.

Maxwell Briskman Stanfield is also an attorney at Meyer, Unkovic & Scott. He focuses his practice on corporate, business, financial and commercial real estate law. Stanfield can be reached at [email protected].