Phantom Stock Plan Taxation for Privately Held Business Executives

As an executive at a closely held or private business, you know just how profitable and valuable a private business can be. You may want to join the ownership ranks of that business but have met resistance in becoming a formal shareholder or the firm may simply be too valuable for you to reasonably “buy-in.” Phantom Stock Plans are a way you can benefit from the growth of a company without actually becoming a shareholder.

Phantom stock plans are a type of deferred compensation plan that can be used by public and private companies. They are often used in privately held companies to provide a long-term incentive to key employees while also minimizing the number of shareholders. Avoiding minority shareholders, limits on the number of shareholders based on corporate structure, and dealing with the headache of shareholders departing from the company for new employment are a few of the reasons why companies may opt to offer a phantom stock plan instead of granting shares outright.

Phantom stock plans and stock appreciation rights are designed to reward key employees and incentivize them to continue to grow the business (golden handcuffs). When you own phantom stock you can participate in the growth of a company as a shareholder – you just don’t actually own the underlying shares. 

Unlike stock options, when you redeem your phantom stock shares you receive cash, not stock.

Phantom Stock: Stock Appreciation vs. Full Value Plans

Phantom stock can be issued via “stock appreciation” or “full value” plans. With a stock appreciation plan you get the difference between the price that the stock was granted at and what it’s worth at redemption. Full value plans give the holder just that – the full value of the share price (once vested).

Stock Appreciation Example:

Bethany is issued 500 shares of stock appreciation rights with a share price of $10. In 3 years Bethany’s shares vest and she decides to redeem them. The stock is now worth $20. Bethany will receive $5,000.

Here’s the math: ($20-$10) x 500 shares = $5,000

Full Value Example:

Bethany is issued 500 shares of company stock at $10 a share. In 3 years Bethany’s shares are vested and she decides to redeem her stock. The stock is now worth $20. Bethany will receive $10,000.

Here’s the math: $20 x 500 shares = $10,000

Things To Look For In Your Phantom Stock Grant

Always get a plan document. Yes, it may look like a lot of legalese (because it is) but your Certified Financial Planner™ will want to read it. Some of the key terms to look for when reviewing your phantom stock grant include:

• Number of shares
• Issuing Price
• Vesting terms (when can you take ownership of the shares and redeem them)
• Process of redeeming shares 
• Stock pricing mechanism
• Forfeiture Provisions
• What happens if a business is sold
• How are dividends handled
• Does the plan follow the Special Timing Rule?

Every Phantom Stock Plan is unique. It’s important to note how your shares would be handled in various situations. 

Clients of Spark Financial Advisors: Please provide us with your plan documents so we can review your specific plan and make recommendations on how to incorporate it into your personalized financial strategy.

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Phantom Stock Plans and Taxes

Odds are high that if you are participating in a Phantom Stock Plan you make enough money to pay attention to taxes. First, the good news – you do not have to pay income tax on Phantom Stock until you redeem your shares, which can potentially give you some control around timing. Unfortunately, when you redeem your Phantom Stock, that income (shares issued and any appreciation) is taxed as ordinary income, at your highest marginal tax rate.

Keep reading, it can get more complex.

Another wrinkle arises, when your phantom stock vests, you will owe payroll taxes on the value of the shares that vested, even if you don’t redeem the shares. If you’ve already exceeded the Social Security wage base ($147,000 in 2022) you will not owe Social Security taxes (6.2%) on the income but you will owe Medicare taxes (1.45% plus the Medicare surcharge of 0.9% on high income earners).

According to Alvarez and Marsal, the good news is that if your plan document allows you to take advantage of the Special Timing Rule and Non-Duplication Rule, and you decide to hold your phantom stock after it vests, you won’t have to pay FICA taxes on any potential growth when you redeem your shares. So future appreciation on the vested shares will not be subject to additional Social Security and Medicare taxes. However, your company’s plan document must elect to follow the Special Timing Rule and Non-Duplication Rule. Otherwise you may owe FICA on the appreciation of your shares when you redeem those shares.

This gets complicated fast and companies can make mistakes, so make sure you review your W-2 and understand your plan document to ensure the appropriate taxes were withheld.

Conclusion

Phantom Stock Plans can be a great way for businesses to retain key employees and incentivize those employees to grow the value of the business. However, these shares are not without risk (they may end up worthless, you may leave before your vest, etc.) and can bring some surprise tax bills, especially if your company is sold. Carefully read and understand your plan document, if you aren’t interested in the minutiae, outsource it to a fiduciary financial advisor.