An Introduction to Phantom Stock and Stock Appreciation Rights
Providing equity is one of the best ways for companies to attract, retain and motivate top talent. Equity-based compensation can align the goals of key employees with the organization, ultimately increasing motivation, retention and results.
However, it’s not always easy to give actual ownership, especially if the shares are illiquid, cash is tight, or existing owners do not want to dilute ownership. In those situations, companies may choose to utilize synthetic ownership plans, which provide the benefit of future growth without transferring actual shares.
Two examples of these are phantom stock and stock appreciation rights (often referred to as SARs). If you are a key employee or executive that has these, it’s important to understand what they are, how they work, and the tax implications.
1. Phantom Stock
The idea of phantom stock is to provide the benefit of stock appreciation without transferring actual stock to the employee. It represents a bonus payable at a future date if certain objectives are met or if a specific event occurs, like the sale of the company.
- Phantom shares or units, which are analogous to shares, are granted and a valuation date is set. These emulate the actual stock value based on a formula. The payout is based on the total value and/or appreciation of those shares or units.
- There may be a vesting period, and payout may depend on meeting criteria such as revenue or profit goals.
- For appreciation-only plans, the employee receives payout for the difference in current value and the value on the grant date. For a full-value plan, the value of the underlying stock plus appreciation is paid.
Taxation: if properly structured, there is no tax at the grant date. Payouts are normally made in cash and taxed as ordinary income when received.
2. Stock Appreciation Rights (SARs)
SARs also provide the benefit of appreciation without giving actual stock. But unlike phantom stock, SARs tend to resemble stock options, where employees can choose when to exercise them.
- Vested SARs generally may be exercised any time between vesting and expiration.
- Vesting may be dependent on time or performance-based criteria.
- At exercise, the employee is paid the appreciation in employer stock, which equals the value at the date of exercise minus the grant price.
Taxation: Like phantom stock, there is no tax at the grant date. The value of the SARs benefit is taxed as ordinary income when received.
With phantom stock, you’re fairly limited in terms of strategy since the payout date and criteria are pre-determined. With SARs, you have more options and can choose when to exercise. This feature can be a blessing to some and a curse to others. It’s important to balance the business’s investment, tax, and prospects with your personal goals. The timing and dependency of cash needs can be just as important.
One tax strategy, if you are charitably inclined, is to combine gifts in the year phantom stock or SARs payouts are received. Charitable gifts first offset ordinary income and then capital gains in that order, so you get the most tax impact by gifting in years when your ordinary income is highest. Delaying SAR exercises to a year where you will be in a lower tax bracket or doing partial exercises over multiple years to fill lower brackets may also make sense.
Running cash flow, college, and retirement projections in tandem with tax projections can help you determine the optimal strategy to make smart decisions. With BDF’s Executive Compensation Services, we help executives manage and transform their compensation plans to drive performance, minimize tax, and achieve their goals. Please don’t hesitate to contact us and let us know how we can help.
No representation is being made that any strategy shown will or is likely to achieve results similar to those shown in this presentation. BDF does not provide legal, tax, insurance, social security, or accounting advice. Clients of BDF should obtain their own independent tax, insurance, and legal advice based on their particular circumstances. The information herein is provided solely to educate on a variety of topics, including wealth planning, tax considerations, insurance, estate, gift, and philanthropic planning.
Gary is a Wealth Manager at BDF and member of the Firm’s Investment Committee. He specializes in executive and stock-based compensation plans, including stock options, restricted stock and deferred compensation. He combines his tax knowledge, executive compensation experience and capital markets expertise to help clients reduce their tax burdens and achieve each of their unique goals.