# Phantom Stock Plans: Benefits, Types, and How They Work

![Phantom Stock Plan](https://www.investopedia.com/thmb/4s5wNTTZz-_3dukxdufDkIko4Ns=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/phantomstock.asp-final-a7d2cd92e84646d7aa998aba19827d8a.png)

*— Investopedia / Jessica Olah*

> **Definition**
>
> A phantom stock plan is an employee benefit plan that gives select employees, typically executives, some of the benefits of stock ownership without transferring company stock.

A phantom stock plan, also known as shadow stock, lets certain employees enjoy stock ownership benefits without holding actual company stock. This plan tracks the actual stock price changes, rewarding participants with profits as if they held real shares, yet it conserves company ownership structure by not diluting equity.

With two main types—appreciation-only and full-value—phantom stocks offer flexible compensation options, typically favored by companies over large cash bonuses due to better tax treatment for employers and employees.

### Key Takeaways

*   Phantom stock plans provide employees with the financial benefits of stock ownership without actual shares.  
    
*   These plans offer two types: appreciation-only, which pays the increase in stock value, and full-value, which includes the stock's value and its appreciation.  
    
*   Phantom stock plans align employee interests with company performance, mimicking real stock behavior but without diluting ownership.  
    
*   Payouts from phantom stock are taxed as ordinary income, and these plans are often used as a retention tool for upper management.  
    
*   Introduced in the 1950s, phantom stocks are a legal and strategic alternative to traditional stock option plans offering flexibility and tax advantages.  
    

## Understanding the Mechanics of Phantom Stock Plans

[Phantom stock](https://www.investopedia.com/articles/stocks/12/introduction-phantom-stock.asp) plans are an alternative to the equity-based incentive plans typically offered by public companies, particularly stock option grants. These plans mimic whole shares, letting participants receive both returns and initial share value. Here are the two types of phantom stocks:

*   **Appreciation-only plans** do not include the value of the actual underlying shares. They may only pay out the value of any increase in the company stock price over a certain period that begins on the date the plan is granted.
*   **"Full value" plans** pay the value of the underlying stock and any appreciation.

Like restricted stock, full-value phantom shares have a higher per-share value than [stock options](https://www.investopedia.com/terms/s/stockoption.asp) at the time of grant, enabling companies to grant fewer shares while still providing competitive grant value. This approach is commonly used when employee retention is a concern.

However, in most cases, companies opt for appreciation-only grants, where awards are based only on [total share return](https://www.investopedia.com/terms/t/tsr.asp) rather than the initial value. Companies often aim to create performance and award leverage like stock options. In addition, discounted grants and grants that pay out when returns exceed a specific hurdle rate are also used.

> **Important**
>
> Phantom stock plans typically follow a vesting schedule and pay out after events like employment milestones, retirement, or termination.

Phantom and traditional nonqualified stock plans have several similarities. Companies can choose which employees participate, making these plans selective. These plans are also usually subject to a substantial risk of forfeiture, which means that the employee's right to receive the benefit is contingent upon meeting certain conditions, such as remaining with the company for a specific period. Employees recognize payouts as income, while employers can [deduct](https://www.investopedia.com/terms/d/deduction.asp) the payouts for tax purposes.

Phantom stock is notional but behaves like real stock. It pays dividends and undergoes price changes like real shares. After a set period, the cash value of the phantom stock is distributed to the participating employees.

A key advantage of phantom stock is its flexibility. There are no inherent limits, allowing organizations to structure the plan freely. Here are the key pros and cons of phantom stock:

### Advantages and Disadvantages of Phantom Stock Plans

Advantages

*   Employees can benefit from the company's growth without owning shares.
    
*   The company can offer incentives without diluting ownership or control.
    
*   Phantom stock plans can be tailored to specific performance goals or periods.
    

Disadvantages

*   Employees do not have voting rights, do not receive dividends or have actual ownership shares in the company.
    
*   Payouts are taxed as ordinary income which may be higher than long-term capital gains tax rates for actual stock.
    

Phantom stock is considered a deferred compensation plan and must follow the requirements outlined in the Internal Revenue Service (IRS) code 409(a). To ensure compliance, an attorney must thoroughly review the plan, and all relevant details must be clearly documented.

> **Fast Fact**
>
> Phantom stock plans have a lot in common with traditional nonqualified stock plans.

## Leveraging Phantom Stock for Organizational Advantages

Some organizations may use phantom stock as an incentive to upper management. Phantom stock ties a financial gain directly to a company performance metric. It can also be used as a reward or a bonus to employees who meet particular criteria. Phantom stock can be given to every employee, either across the board or distributed according to performance, seniority, or other factors.

Phantom stock also provides other organizations with a way to offer incentives tied to stock value. This can apply to a [limited liability corporation](https://www.investopedia.com/terms/l/llc.asp), a sole proprietor, or S-companies restricted by the 100-owner rule.

Here are two other common stock-related employee benefits, along with a table of similar plans:

### Exploring Stock Appreciation Rights (SARs)

[Stock appreciation rights (SARs)](https://www.investopedia.com/terms/s/sar.asp) are like a phantom stock-based program. They are a form of bonus compensation given to employees equal to the appreciation of company stock over a given period. Like [employee stock options (ESO)](https://www.investopedia.com/terms/e/eso.asp), SARs are worthwhile to the employee when company stock prices rise; the difference with SARs is that employees do not have to pay the [exercise price](https://www.investopedia.com/terms/e/exerciseprice.asp) but receive the sum of the increase in stock or cash.

Typically awarded to upper management, SARs can function as part of a retirement plan. They provide incentives that go up as the value of the company does. This can help ensure employee retention, especially in times of internal volatility, such as an ownership change or a personal emergency.

It reassures employees since phantom stock programs are generally backed in cash. This can, in turn, result in higher selling prices for a business if a prospective buyer perceives the upper management team as stable.

### Insights into Stock Option Plans

In a stock option plan, employees are granted the right to buy a specific number of company shares at a preset price (strike price) within a given time frame. Employees can exercise their options and buy the shares once they vest, typically over several years. If the company's stock price rises above the strike price, employees can profit by exercising their options and selling the shares.

### Advantages and Disadvantages of Stock Option Plans

Advantages

*   Employees can own actual shares in the company.
    
*   If the stock price increases, employees can realize significant gains.
    
*   Gains from exercising stock options may be taxed at lower long-term capital gains rates.
    

Disadvantages

*   Employees must pay the strike price to exercise their options and buy shares.
    
*   The options may be worthless if the stock price exceeds the strike price.
    
*   Stock options can be complex and require a good understanding of financial markets.
    

## Phantom Stock Plan in Action: An Example

Let's say an employee is granted 1,000 phantom shares under an appreciation-only plan when the company's stock price is $50. After a vesting period of three years, the company's stock price has risen to $75.

Under the phantom stock plan, the employee would receive a cash payout of $25,000: (1,000 shares × ($75 - 50)), but no actual shares of stock. (The total payout would have been $75,000 if it were a full-value phantom plan.)

In contrast, an employee granted 1,000 stock options with a strike price of $50 would have the right to buy 1,000 shares at $50 each. If the stock price rises to $75, the employee could exercise the options, buy the shares for $50,000, and then sell them for $75,000, realizing a profit of $25,000.

## When Was Phantom Stock First Introduced?

Phantom stock plans were introduced in the 1950s as a way for companies to provide key employees with long-term incentives tied to the company's success without granting them actual stock ownership. The concept gained popularity in the 1980s as an alternative to traditional stock option plans.

## Is Phantom Stock Legal?

Yes, phantom stock plans are legal and are commonly used by companies as a form of employee compensation. However, the specific terms and conditions of the plan must follow applicable laws and regulations, such as those related to taxation and securities.

## What Are the Tax Implications of Receiving Phantom Stock?

Phantom stock payouts are generally taxed as ordinary income for the employee when received. The company can typically deduct the payouts as a compensation expense. However, the specific tax implications depend on the structure of the plan and the jurisdiction. It's essential for both the company and the employees to consult with tax professionals to understand the tax consequences of a phantom stock plan.

## Final Thoughts on Phantom Stock Plans

Phantom stock serves as a deferred compensation plan, enabling employees to receive cash payouts related to company performance, without transferring actual stock ownership. These plans can be structured as full-value or appreciation-only, with payouts generally linked to vesting schedules and certain conditions.

By offering flexibility in design and timing, phantom stock plans can align employee and company interests effectively, mitigating equity dilution and providing competitive compensation. However, companies must ensure these plans adhere to legal and tax specifics while clearly communicating their structure and benefits to achieve the desired motivational impact.

> **Article Sources**
>
> 1.  Richard Ericson. "[The New Standards: Methods for Linking Business Performance and Executive Pay](https://www.wiley.com/en-us/The+New+Standards%3A+Methods+for+Linking+Business+Performance+and+Executive+Incentive+Pay-p-9780470559895)," Pages 241-246. John Wiley & Sons, 2010.
>     
> 2.  Dai, L., & Zhou, Q. (2015). "[The Study on Incentive Mode Design of Pay-Through Phantom Equity](https://www.scirp.org/journal/paperinformation?paperid=54798)." _Journal of Human Resource and Sustainability Studies_, vol. 3, no. 1, pp. 46-50.
>     
> 3.  National Center for Employee Ownership. "[Phantom Stock and Stock Appreciation Rights (SARs)](https://www.nceo.org/articles/phantom-stock-appreciation-rights-sars)."
>     
> 4.  Internal Revenue Service. "[Publication 5528 (6-2021): Nonqualified Deferred Compensation Audit Technique Guide](https://www.irs.gov/pub/irs-pdf/p5528.pdf)."