Stock options and stock ownership plans are a popular and effective method of incentivizing employees, often at a low cost to both the employer and the employee. Several types exist, including non-qualified stock options, incentive stock options, employee stock ownership plans, phantom stock, stock appreciation rights and more. In this second of a series of articles, we will look at Phantom Stock Options and Stock Appreciation Rights.

Phantom Stock Options and Stock Appreciation Rights

Under traditional stock option plans, an employee can become an owner of the company. Often, a business owner does not wish to pass along ownership. But s/he does want to incentivize key employees. Phantom stock options (“mirror stock” or “shadow stock”) and stock appreciation rights (SARs) both provide these features.

As with other stock plans, a set of milestones can be established. The “shares” are “issued” when the milestone is reached.

Phantom stock plans are tied to long-term company performance. There are advantages to both the employer and employee traditional stock plans don’t offer. Employees do not need to invest any money. Nor are they subject to corporate governance issues that may arise. They cannot be asked to personally guarantee company obligations. Most importantly, if they wish to sell shares under a traditional plan, their options may be limited. Typical smaller businesses are not traded and often do not hold any defined means for redeeming shares. This issue is not relevant for a phantom plan.

For an employer, the shares are “phantom”, the employee is NOT an owner. These employees hold no authoritative input in the management of the business. Yet, the employee can be incentivized through additional value added to the business, much like an owner. Administratively, these plans are much less complex than traditional stock option plans.

For the employer and the employee, the exercise of the option becomes an immediate taxable event. The employee reports it as ordinary income; the employer as a deduction.

With a SAR, many of the same advantages exist as with phantom stock. The key differences are in the exercise of the option and the amount of the award. A SAR can be exercised at the employee’s discretion once the vesting schedule is met. A phantom plan calls for exercise at the time the vesting schedule is met. A SAR awards the employee the amount equal to the difference between the FMV of the underlying stock at the exercise date and the grant date. The recipient of phantom options receives the full value of the share.

An attorney and a tax advisor should design the plan with your guidance to avoid any legal or tax consequences.

At JBV, we have valued many stock option plans, from ESOPs to phantom stock and SAR plans to ISOs and more. We are here to assist you.