What are the Advantages and Disadvantages of a Phantom Equity Plan?

I was recently asked to describe the advantages and disadvantages of a phantom equity plan.

Phantom equity plans are particularly useful for private companies without publicly traded shares of stock.  Privately held companies have unique organizational traits that require a substantially different approach to executive compensation. Often, executive compensation arrangements that are appropriate in a publicly traded organization (i.e., incentive stock options) are not appropriate in privately held companies. Phantom equity plans are one of the most frequently used long-term incentives in privately held companies. Generally, a phantom equity plan grants rights to receive the value of the appreciation in a specified number of company shares. Phantom shares are typically stand-alone rights granted to executives and are not granted in tandem with stock options.

What is a privately held company?

A privately held company is a company that does not have equity securities registered under the Securities Exchange Act of 1934.  Phantom stock plans used by privately held companies can be exactly like those used by publicly traded companies, except that executives are only able sell their shares back to the company.

What is the tax treatment of a phantom equity plan?

There is no taxation upon the grant of phantom stock because the executive is not in constructive receipt of any value at that time.  Upon exercise of phantom equity, the executive recognizes ordinary income equal to the value of the phantom equity at exercise minus the value of the phantom equity at grant.  Any phantom equity appreciation payment is subject to federal and state income tax withholding.  For the company, a phantom equity appreciation payment is a compensation deduction from its computation of taxable income.

What are the advantages and disadvantages of a phantom equity plan?

One disadvantage of a phantom equity plan for a company is that phantom equity is a costly form of long-term incentive in that it requires a charge against the company’s income statement and is potentially an “uncapped liability” to the company.  For executives, phantom stock rights do not represent a true ownership position in privately held companies that do not have publicly traded shares.  Additionally, phantom equity shares do not carry voting rights or similar rights associated with stock ownership.

An advantage of a phantom equity plan is that, for a company with significant growth in net worth potential, a phantom equity plan provides a cashless alternative for receiving income as the phantom share appreciates in value.  Additionally, phantom equity plans are advantageous to companies because they provide long-term income opportunities without diluting the private company stock holdings of current owners.

Hall Benefits Law, LLC recommends that you consult ERISA legal counsel (i) to assist in determining whether a phantom equity plan is the appropriate executive compensation plan for your company and (ii) to assist with drafting, implementation and administration of a phantom equity plan that complies with all necessary legal requirements.

The following two tabs change content below.

Hall Benefits Law, LLC

HBL offers employers comprehensive legal guidance on benefits in mergers and acquisitions, Employee Stock Ownership Plans (ESOPs), executive compensation, health and welfare benefits, healthcare reform, and retirement plans. We counsel a wide spectrum of clients including small, mid-sized, and large companies, 401(k) investment advisors, health insurance brokers, accountants, attorneys, and HR consultants, just to name a few. HBL is passionate about advising clients, and we are dedicated to our mission: to provide comprehensive, personalized, and practical ERISA and benefits legal solutions that exceed client expectations.

Latest posts by Hall Benefits Law, LLC (see all)