Phantom equity is a colorful term for a simple concept: compensation that rewards key contributors for increasing the value of the company without the immediate issuance (or even any future issuance) of equity securities. Here's a brief Q&A on how it all works:
What the heck is phantom equity?
Phantom equity is incentive compensation designed to mimic the benefits of receiving equity securities. Other fancy names for phantom equity include restricted stock units or RSUs, simulated stock, shadow stock, and synthetic equity. There is no single uniformly accepted term, nor is there one commonly used design.
How does phantom equity work?
Most phantom equity awards are a contractual promise to issue equity securities in the future if certain conditions are satisfied. Satisfaction of these conditions is commonly called vesting.
For example, Apple awards employees both time- and performance-based RSUs. Time-based RSUs vest annually over three years, so long as the employee remains employed on each vesting date. On or shortly after a vesting date, Apple issues the employee shares of Apple stock equal in number to RSUs that vest on that vesting date.
Apple's performance-based RSUs, by contrast, vest if Apple's total shareholder return hits certain targets. Once a target is hit, Apple issues shares equal in number to RSUs associated with that target.
Can private companies award phantom equity?
Yes. In fact, phantom equity is often used by corporations that need or want to limit the number of their stockholders, e.g., S corporations. Phantom equity is not limited to corporations; partnerships and LLCs can also grant phantom equity. For many private companies, vesting and payment of phantom equity awards are conditioned on a liquidity event like the sale of the company.
How are phantom equity awards different from actual equity awards?
An actual equity award like restricted stock involves an immediate stock issuance on the grant date. The stock is usually nontransferable and forfeitable until vesting conditions are satisfied. With phantom stock, by contrast, no actual stock is issued on the grant date. Put differently, a recipient of restricted stock immediately becomes a stockholder with voting and dividend rights whereas a recipient of phantom stock doesn't. This difference has important tax consequences described below.
Does phantom equity have to be paid in securities?
The term "phantom equity" is somewhat of a misnomer because there is no requirement for an award to be payable in equity securities. A phantom award can be payable in cash, gold bullion, or any other property. Cash-settled RSUs, for example, are basically cash bonuses with the payment amount calculated from the value of the underlying stock.
For example, if Apple's RSUs were settled in cash instead of shares, on each vesting date, Apple would pay the employee a cash amount equal to the number of vested RSUs times the fair market value per share of Apple stock.
Can phantom awards be granted to directors, consultants, or independent contractors?
Yes, but any payment must be treated as compensation.
How are phantom awards taxed?
The grant of a phantom award usually isn't a taxable event because no shares or other property are transferred to the award recipient. When a phantom award vests, an employee is taxed for FICA and FUTA, regardless of when the award is actually paid. When the award is paid, income tax withholding is due for employees. You can't withhold any taxes for non-employees.
Most phantom awards are paid on or soon after vesting, so FICA, FUTA, and income tax withholding are all due at once. If there's a long delay between vesting and payment, however, tricky rules on nonqualified deferred compensation might apply. So check with tax counsel when designing complicated vesting schedules.
The amount subject to withholding taxes is the current value of the award or payment, i.e., the amount of cash or value of shares or other property payable.
For an employer, the amount paid to the phantom award recipient is deductible as compensation.
Can a phantom award recipient file an 83(b) election?
No. An 83(b) election applies to the transfer of restricted property. Because no property is transferred on the grant date of a phantom award, no 83(b) election can be filed. In other words, you can file an 83(b) election for restricted stock, but not for restricted stock units.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
