What is phantom stock?
Perhaps you’ve heard someone talk about phantom stock. Or you read an article about phantom stock somewhere online and thought it sounded interesting. Well, let’s dive in and learn a little about this ‘ghost’ stock and why you may or may not want to use it.
Phantom Stock Defined
Let’s start at the beginning - phantom stock is the right to receive the value of stock in a cash payment instead of receiving actual equity in the company. So, if at the time of execution, the value of the 10,000 “phantom shares” of stock in XYZ, Corp. is $20,000, instead of the owner selling the shares of stock on the open market or back to the company and being reimbursed with the cash, the company just pays them the cash. The closest analogy to the way phantom stock works is like a bonus that is tied to the success of the company. The better the company is doing, the bigger a cash payout you receive.
What’s Good About It?
There are benefits to phantom stock for both the company and the stock owner. First, the company is able to give out something that holds value in the same attractive nature of equity. Contractors and employees like equity because equity can go up in value without that employee having to do anything to make it happen. If the company does amazing, the value of the equity rises and rises. Likewise, the value of the phantom stock rises and rises as the company does better (assuming there’s no cap on the value), but without having to dilute the other shareholders of the company. Our hypothetical XYZ, Corp. can give out the equivalent of millions of shares of phantom stock without one person being diluted since it’s not real equity, it’s just a promise to pay cash in an amount based upon the value of equity.
Along the same lines, the recipients get some benefit from this, as well. The receiver only has to pay taxes on the phantom stock when it’s received as actual money because it’s only a promise to pay. (There's the possibility of having taxation on phantom stock as it vests, but that's too complex for this article). Equity is something that exists and has some form of value at all times. Phantom stock is mostly a promise to pay an amount that’s calculated based upon the value of the company’s equity. Just like you don’t pay taxes on the promise of a bonus from your job, you wouldn’t pay taxes on the promise to pay the value of the phantom stock at some point when it’s exercised. So, it usually simplifies the taxes of the recipient by them not having to get valuations to list on their taxes from the portfolio of stock they have - especially if this person has done work for and received stock from numerous companies along the way.
What’s Bad About It?
For the company, there are a few ways this could go south. Number one, if the company ’oversubscribes’, as it were, and gives out way too much phantom stock, when it starts getting excercised, the company simply may not have the cash reserves to honor the contract and pay out the cash. Sure, there will be guard rails in place in the stock grant to try and prevent this, but you can only stop someone from cashing out for so long before you start to have problems when it becomes clear that nobody can cash out. Also, the company could get bad feedback from the recipients when the cashing out happens because these folks will be paying taxes at their regular income tax rate, thus rendering some of the gains from the grant date moot. Also, it’s not exactly fun to keep track of all the phantom stock grantees if you choose to use this in lieu of granting actual equity. And of course, many people simply do not want phantom stock - they want equity so they can be a part of the company, have a vote on certain issues, receive annual reports, get dividends, and attend the annual meeting of shareholders in order to know the status of the company.
Likewise, for recipients, it may not be the best thing. Number one, the tax issue discussed in the paragraph above. Equity is taxed at the more favorable capital gains tax rate once it’s held for more than one year. Since most startups require a one year cliff, almost everyone who holds actual equity in a company has held it for more than one year. But, phantom stock is not equity. Which means capital gains tax rules don’t apply, and it will be taxed as regular income during the year it was exercised. So cashing out $100,000 of phantom stock could result in a $30,000 tax bill, depending on the person’s other financial gains during the year. This is compared to the very favorable 15% capital gains tax rate that would have you paying a $15,000 tax bill, saving you 50% in taxes.
So, What Should You Do?
Well, my friend, that’s completely up to you. And the information in this article is just a set of general guidelines and observations. The situation of your company could be unique and phantom stock could be the best thing for you....or it could be the worst headache you don’t want. Either way, if you’re thinking of doing it, or are definitely wanting to set it up, reach out to an attorney who can help you get it done.
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