Phantom shares, also known as phantom stock, is a program whereby key employees receive ownership of a company’s stock without owning it.
In other words, phantom stock is where key employees receive the financial benefits of owning shadow shares of the company, but not actual shares.
Phantom shares are similar to the company’s actual stock as the phantom stock’s value appreciates and depreciates with the actual stock. Thus, the key employees enjoy the benefits of the stocks just like any other shareholder, but with no ownership to the actual phantom shares.
The key employees awarded these phantom shares, which are a bonus of the time, effort, and hard work they have invested in the company, receive their profits after a set period. Thus, these shares serve to compensate the company’s key employees.
What are phantom shares options?
Now that you understand the definition. You might be thinking about what phantom shares options mean to a business owner.
For entities taxed as partnerships, even though they lack a common stock, they can set up plans similar to phantom shares. In such an occurrence, however, the value of the ESOP (employee stock ownership plan) is bound to the value of the partner’s equity value and not the company’s stock value. That’s the only difference when entities taxed as partnerships use the phantom stock option plan.
Once a phantom unit is awarded to employees, they are entitled to compensation according to the number of earned or received shares.
When you have a phantom stock award, you receive dividends, bonuses, and another form of a cash bonus, just like any other shareholder. In addition, in a liquidity event, you are entitled to a payment equal to the stock’s market value at that particular time.
Therefore, a phantom stock owner receives payments and bonuses like any other shareholder who owns actual stocks.
Nevertheless,” phantom dividends” are not dividends. They are treated similarly to any other cash earned by the employees. Therefore, phantom dividends are taxable and subject to deduction by the company.
For phantom stocks to take dividends into account, it depends on how they were designed. There are different types of phantom stocks, but the most predominant ones are full value and appreciation. For the full value, an employee is paid cash according to the exact value of the shares.
For example, let’s say Joseph is an employee with 200 phantom stock awards worth $50.27 each on 8th July 2015. Then he will have for five years, for instance, so that his phantom shares mature. Fortunately, after five years, the shares increase in value up to $65.30 each; this means he will receive the total value of the shares, which is $13,060.
As for appreciation only, from the example stated above, Joseph receives the appreciation value of the phantom shares. The difference between the initial and current shares ($15.03 per share =$3006 after the maturity period).
Why is phantom stock important?
Phantom shares are essential to a company in various ways.
Primarily, phantom shares reward senior or key employees of a company. The key employees’ criteria are unique to each company, but most companies consider seniority and performance.
Phantom shares are low risk and a better stock plan option as compared to the traditional ones as they allow a company to keep its stock plan simple, avoiding conflicts with the former employees. In addition, if a family owns a company, phantom shares ensure that the company remains family-owned.
Why might a company want to use phantom equity instead of actual equity?
The most common reason a company might go for phantom equity compared to actual equity is that phantom equity has fewer disadvantages.
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For any business owner out there, anything that saves you money is good for business. Phantom shares are cheaper to set up as compared to setting up an ESOP.
The RSUs are issued after an employee meets a specific set of conditions, failure to which the phantom stock disappears. If the company uses real stocks, they have to repurchase the actual shares, compromising the actual equity.
Phantom shares are a way of investing in employees. If employees perform well, the company’s actual equity is most likely to increase; hence, both the employee and the employer win.
Phantom stockholders do not have any voting rights in the company. Consequently, companies don’t have to worry about employees down-voting their decisions, for instance, in the case of a merger.
Unlike the actual shares, phantom shares are non-taxable: They are solely taxed through bonus payments.
How does the worker gain phantom shares?
One can own the actual shares, but how does the employee own phantom shares? Employee ownership of phantom shares is slightly different.
Phantom shares are among the best ways for business owners to reward their employees. A worker is rewarded with shadow stock, also known as phantom stock, which works like the actual shares.
The phantom stockholder, therefore, enjoys the profits of the company just like any other shareholder.
Phantom stock ownership comes as compensation for the employee’s efforts. Phantom share plans are designed to be shared across all shareholders, with the value dependent on the actual stock.
How is the phantom stock plan structured?
Every phantom stock program should have a phantom plan in place before rewarding its key employees. The phantom stock plan should indicate the specific percentage of interest and number of phantom stock units to be issued to key employees.
The number and percentage interest of phantom stock units could be changed over time by a company. For example, a company could award a key worker 200 units with a 5% interest and reward them more units after five years.
When issuing phantom stock units, the value of phantom shares is not necessarily bound to the value of shares of the company at that particular period.
A company can decide its issuing prices. If the value of the phantom share is lower than the issuing price after the vesting period, the shareholder won’t receive any amount.
How is phantom stock treated for income tax purposes?
Although phantom stock bears the name “equity,” it does not imply that phantom stock should be paid in securities only. Instead, various means are used to pay phantom stocks, as long as they are legal.
For instance, RSUs can be settled in cash bonuses instead of stocks. The cash bonus is based on the fair market value of the phantom stock.
The value of the company’s actual stock determines the value of phantom stocks. There are various agreed factors to consider when choosing the value of phantom stocks.
Depending on your tax bracket and state, the amount you pay off, doubling your money in the stock market varies. However, there are few ways you can use to reduce taxes on employee stock options. For instance, you can hold and wait for long-term capital gains.
Understanding the stock appreciation rights will come in handy.
What percentage of equity should be dedicated or reserved for this plan?
Before a company settles on which percentage to use on the phantom stock plan, several factors should be considered when issuing equity awards—for example, the salary and the service length of the employers.
Regardless of the elements considered, it is always good to have a fair and straightforward procedure.
Do vesting rules apply in the case of death disability or attainment of specified normal retirement age?
Life is full of uncertainties, and one of the uncertain things that can happen to an employee is death.
What happens to the vesting schedule? In most cases, defined benefit plans provide the total vested amounts and any unpaid installments following the death of a phantom stockholder. But most vesting programs have a definite benefit plan.
It is always ideal to begin planning on your retirement as soon as possible. Of course, the first thing to think of is the retirement benefits.
Defined benefits plans are retirement plans sponsored by an employer where the benefits are calculated by considering several factors like competitiveness and the employee’s salary. These benefits cannot be withdrawn anytime; instead, an employee can withdraw the funds after the age defined by the benefit plan’s rules.
An excellent example of a defined benefit plan guarantees a particular amount of benefits after an employee retires. The employees have the option to add some funds to the benefit plan, and upon retirement, the employee can decide if they should be paid monthly or receive the total amount.
You can begin enjoying your retirement benefits at an early age, but you are entitled to receive the full benefits after you have attained the full retirement age.
To sum up
The benefits of phantom shares to the employee and the employer cannot be understated. However, it is always good for a company to consider all the factors before deciding if phantom shares are the right call.