The Responsibilities of Managing a Phantom Stock Plan

A guide to successfully operating a phantom stock program

Once you have explored the benefits of a phantom stock plan and decided to implement one as part of your compensation package, it is important to remember that you also have to maintain it. The plan will not operate itself. 

Below is an overview of some the areas you will be responsible for when it comes to managing a phantom stock plan, including: 

• Documentation

• Awarding and tracking grants

• Accounting

• Tax treatment for employees

• Tax deductions for employers

There are also special circumstances you may need to consider depending on the type of company you oversee. 

Documentation—Formalizing Terms & Conditions, Keeping Documents Updated, and Different Approaches to Participant Enrollment

Before we outline the necessary documents for a phantom stock plan, it is important to note that you will need to review your phantom stock plan documents regularly in light of periodic updates to the  laws and regulations related to phantom stock. This responsibility might fall to company counsel, third-party consultants, your internal staff, or a combination of all these parties. 

Your business strategies and goals also evolve. Updating the plan documents allows you to align your phantom stock plan with current business objectives, ensuring the plan remains an effective tool for incentivizing and retaining key employees.

Two Different Approaches to Documentation

To launch your plan, you will need to create a formal document that outlines: 

• Essential plan terms and conditions, which may include language required by the Employee Retirement Income Security Act (ERISA) and Internal Revenue Code (IRC) Section 409A 

• The promises and commitments you are making to the plan participants 

• Explanation of plan terms and provisions such as vesting, valuation, and payment events

• An explanation of the valuation methodology

The initial draft of the formal plan document can be created internally or with the help of an outside consultant or legal counsel. It may be helpful for your consultant to produce the first “legal-ready” draft since they may be the one most familiar with the terms agreed upon in the design stage. Considering the legal responsibilities of a phantom stock plan, the document should be reviewed by an attorney familiar with benefits law. 

Customarily, this documentation will follow one of the two approaches:  

• A master document approach. In this instance, a single, core document describes and governs the plan. It is not specific to any one employee. Employees attest to their plan participation by signing a grant certificate or similar record, which they retain as acknowledgement and evidence of the number of phantom stock units that they’ve been granted. 
• An agreement approach. In this instance, each employee receives a full-length, individualized agreement with all the plan details, which they sign and retain. The agreement is a legal document just for them, tailored to the terms of their participation. No master document exists. 

While both approaches are acceptable and common, each has different benefits:

A master document is generally easier to maintain for administrative purposes. Afterall, you only need to update one document. You also don’t need to hand out the plan’s details to multiple employees, which could soothe any leadership fears that the plan is going to be circulated to a broader audience or even a competitor. Your employees typically can view the master document, but they only retain their grant certificate. The decision about whether to distribute the full document should be considered carefully.

With an agreement approach, you can vary information from one participant to another while keeping all employees subject to the same general plan terms. This allows you more flexibility and control over how you reward different employees. Some attorneys will advise that it is important for the employees to have access to all the terms of the agreement. 

An Employee Plan Summary

For both approaches, it is wise to provide an employee plan summary. Although it is not required, this summary is a simplified explanation of the plan features that does not overrule the governing plan document. 

It should outline:

• The purpose of the plan
• How the plan operates
• How and when units are awarded
• How units are valued
• When payments occur
• How vesting works
• Any other factors helpful to the participants 

The summary serves as a plain-English explanation of plan terms—as opposed to the legalese of the plan document or agreement. Ultimately, an employee plan summary is a communication tool that helps participants better understand the plan and its potential value.

Awarding and Tracking Phantom Stock Grants

It is essential to keep accurate records of any phantom stock grants your company makes to employees. You should save and archive all original copies of the plan documents, the employee award agreements, and even the employee plan summaries as an official record of the documentation. 

You will also need to have phantom shares revalued annually, or more frequently, in order to communicate plan values to employees and allow for the periodic issuance of new awards. The valuation will allow your company to track the plan liability over time. 

The formula valuation will set the updated share price and will enable proper recording on financial statements once it is confirmed by your company officers.

This process helps maintain the accuracy, fairness, and transparency of the phantom stock plan. It also helps reset your company’s forecasts of future payments to assure that employee rewards are in line with your financial expectations. 

What Is the Accounting Treatment for Phantom Stock? 

Assuming payments will be settled in cash, value-based phantom stock plans—like full-value and appreciation-only plans—are considered liability awards for accounting purposes. A liability award is an obligation or financial commitment you may owe to employees that creates a contingent deferred liability on your balance sheet.

Liability awards are expensed ratably over the plan vesting schedule; you don’t need to recognize the entire expense upfront. Private companies will typically value liability awards using the Fair Value Method. Public companies—and private companies that issue stock or options—may choose to use the Intrinsic Value Method instead.

Two ratable accrual schedules are available under the Fair Value Method. We can refer to them as the Separate Method and the Entire Method. 

The following guidance is offered under Accounting Standards Codification (ASC) 718-10-35-8:

An entity shall make a policy decision about whether to recognize compensation cost for an award with only service conditions that has a graded vesting schedule in either of the following ways:

• On a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in substance, multiple awards [Separate Method]

1. On a straight-line basis over the requisite service period for the entire award (that is, over the requisite service period of the last separately vesting portion of the award). [Entire Method]

The type of vesting schedule your plan follows  may drive your choice. You should consult with an advisor before making this determination.

The Fair Value Method—Treating Each Vesting Portion Separately (Separate Method)

Let’s assume you have an appreciation-only phantom stock plan with a vesting schedule spread evenly across five years. The Separate Method accrual schedule would appear as shown in the tables below for a single award made at the beginning of the first year: 

Accrual Schedule

Accrued Expenses

The Fair Value Method—Treating the Entire Service Period of the Award (Entire Method)

Given the same assumptions, the Entire Method would recognize the annual and cumulative accruals as shown in the table below:

Accrual Schedule

Accrued Expenses

How Do You Expense Performance-Based Phantom Stock Plans?

You expense performance-based phantom stock plans (i.e., those that require the achievement of predetermined performance metrics) as their performance conditions become ascertainable, regardless of any service period. Your company should recognize the full expense when it concludes that it is probable that the performance condition will be achieved.

Are There Any Accounting Treatments for Phantom Stock Specific to C Corporations? 

Since C corporations are subject to corporate income tax, under generally accepted accounting principles (GAAP), the timing difference between when the expense related to phantom stock is recognized for book purposes and when it becomes deductible for tax purposes allows for the recognition of a deferred tax asset (DTA). A DTA is a future tax benefit recorded on a company's balance sheet that represents potential reductions in future taxable income or tax liabilities. 

If C corporations are able to book a DTA for future phantom stock distributions, it helps offset the overall accrual. 

How Are Employees Taxed On Their Phantom Stock Benefits? 

Plan participants will want to understand if their phantom stock benefits will be taxed as ordinary income or capital gains. The answer is ordinary income. From a tax perspective, phantom stock is treated like a year-end bonus, and any financial benefits a participant receives is considered supplemental income.  

Participants are only taxed when they receive payouts—not at the time the phantom stock grant is awarded, or as it vests. When the grant is awarded, no compensation is being received, literally or constructively, as plan balances are subject to a substantial risk of forfeiture. 

Substantial risk of forfeiture means that employee values are not secured (i.e., the funds are not available right away). The plan promise, along with any assets set aside to fund the promise, still remains subject to the claims of creditors. In simpler terms, if an employer goes bankrupt, then the plan participants would be considered general creditors and may not receive their phantom stock benefits. Because a substantial risk of forfeiture exists, income taxes are deferred until the employee actually receives the funds.

The same tax principle applies to installment payments. Managed properly, installment payments will not be subject to income taxes until received. 

If FICA taxes were already paid by the plan participant as the phantom shares vested, no additional payroll taxes would be due when the funds are received. If FICA and related payroll taxes had not been paid as the value vested, those taxes will be owed at the time of distribution. 

In most cases, full-value shares will be subject to FICA taxation as they vest, and appreciation-only shares will incur payroll taxes when distributed.

How Are Payments Taxed for Beneficiaries? 

Most plans will pay some or all of an employee’s phantom share value to designated beneficiaries in the event of death. Many plans will even provide accelerated vesting in that event. Beneficiaries are responsible for income taxes on the full amount received. To avoid double taxation, income and estate, the income would likely qualify as “income in respect of a decedent” under IRC Section 691.

What Penalties Could Employees Incur If Their Employer Fails to Make Timely Payments Under a Phantom Stock Plan?

Phantom stock plans that are subject to must follow strict payment timing requirements. It is the responsibility of the employer to follow the rules outlined in IRC Section 409A, but it is the plan participants who could suffer severe tax penalties if the employer fails to comply. These penalties could include the following: 

• All compensation still deferred under the plan would be taxed as soon as it becomes vested, even if payable later.
• Premium interest on that tax accrues from the vesting date at the rate applicable to tax underpayments plus 1%.
• The employee is subject to a 20% additional tax on the taxable amount.
• Certain state and local income tax sanctions could arise.  

This is commonly referred to as the time and form of payment rules. They may be the primary reason you should have access to competent administrative support as you operate your plan. 

Do Employers Receive a Tax Deduction as Phantom Stock Benefits Are Paid Out? 

As we established above, phantom stock benefits are considered a form of employee compensation. Generally, you can deduct compensation expenses as ordinary and necessary business expenses.

The same timing principle that is established for the employee’s taxation also relates to your company’s tax deduction. Phantom stock benefits are deducted as compensation expenses when they are paid to the employee. Your company’s deduction and the employee’s taxation both occur at the time of payout. 

Are There Special Circumstances You Need to Consider Based on the Type of Company You Own or Oversee? 

Yes. The majority of the information above applies to private, for-profit companies subject to US tax and labor laws. (Most countries outside the US can offer phantom-stock-equivalent programs. They may utilize different names and structures, and the details will vary, but the concept of performance-based long-term incentives is valid in nearly any business environment.)

However, phantom stock plans can also be utilized by public companies and non-profit organizations. Some, but not all, considerations related to those entities are outlined below.

Public Companies

There are several issues unique to a public company’s use of phantom stock:

• IRC Section 162(m). This limits the deduction a publicly traded company may take with respect to remuneration in excess of $1 million paid to its top officers. However, the limit does not apply to performance-based compensation. Publicly traded companies need to carefully define performance-based pay in their company’s stock option and stock appreciation right (SAR) plans as well as any phantom stock structure to qualify all programs as performance-based compensation.

• Form S-8. A public company may view a phantom stock plan as a benefit that requires disclosure in an S-8 filing with the Securities and Exchange Commission (SEC).

• Accounting considerations. As described above, phantom stock plans require variable accounting. Stock option plans could produce a more favorable fixed accounting result for public companies, and a phantom stock plan could potentially result in a higher cost. 

Nonprofit Companies

Nonprofit companies often have a challenging time competing for talented executive leaders due to the specific nonqualified retirement plan rules under IRC Section 457. These rules make it more challenging to accumulate value for executives under phantom stock plans because they may impose taxation on plan values as soon as time or circumstances remove the risk of forfeiture within the plan.

However, plan advisors are often able to work within these rules and achieve similar results for nonprofit companies as they do for public and private companies. 

Often the nonprofit will offer a combination of IRC Section 457 retirement benefits, severance agreements, and performance-based deferred bonuses. Both the retirement account and the deferred bonus arrangement can be built around the organization’s financial goals or other performance benchmarks.

How to Get Started

If you are a business leader who has been struggling to develop an effective long-term compensation strategy, it might be the right time to have a conversation with a VisionLink consultant.  

To speak with one of our expert Compensation Consultants, please call us at 1-888-703-0080.