Tax Planning CI BDF Private Wealth

An introduction to phantom stock and stock appreciation rights

Offering equity to employees 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 those of 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 don’t 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 to employees.

Two examples of these plans are “phantom stock” and “stock appreciation rights.” If you are a key employee or executive who holds these types of equity, it’s important to understand what they are, how they work, and the tax implications.

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 by the company and a valuation date is set. These shares or units emulate the actual stock value based on a specific formula. The payout is based on the total value and/or appreciation of those phantom shares or units.

There may be a vesting period and payout may depend on meeting predetermined 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.

Regarding taxation, if the plan is properly structured, there is no tax owing at the grant date. Payouts are normally made in cash and taxed as ordinary income when received.

Stock appreciation rights (often referred to as SARs)

SARs also provide the benefit of appreciation without granting actual stock. Instead, the SARs are tied to a set number of shares for a predetermined period. 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 the vesting and expiration dates. Vesting may depend on time or performance-based criteria.

At exercise (assuming the company’s stock price is higher than it was on the vesting date), the employee is paid – usually in cash – the value of appreciation in employer stock, which equals the value at the date of exercise minus the grant price.

Regarding taxation, as with phantom stock there is no tax owing at the grant date. The value of the SARs benefit is taxed as ordinary income when received. 

Strategies to consider

With phantom stock, you’re fairly limited in terms of strategy since the payout date and criteria are predetermined. With SARs, you have more options and can choose when to exercise. This feature may 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.

If you’re charitably inclined, one viable strategy is to combine gifts in the year that phantom stock or SARs payouts are received. As for the order of execution, charitable gifts first offset ordinary income and then capital gains, so you get the most favorable tax impact by gifting in years when your ordinary income is highest. It may also make sense to delay the exercising of SARs to a year where you’ll be in a lower tax bracket, or doing partial exercises over multiple years to fill lower brackets.

Running cash flow, college and retirement projections in tandem with tax projections may help you determine the optimal strategy to make smart decisions about phantom stock and SARs. We can help executives manage and transform their compensation plans to drive performance, minimize tax and achieve their goals. Feel free to contact us and let us know how we can help.


ABOUT THE AUTHOR

Gary Pattengale, CPA, CFP

Gary Pattengale, CPA, CFP

Wealth Advisor

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.




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