Introduction To Phantom Stock And SARs

Although rewarding employees with company stock can provide numerous benefits for both employees and employers, there are times when either legal concerns or an unwillingness to issue additional shares or shift partial control of the company to an employee can cause companies to use an alternative form of compensation that does not require the issuance of actual stock shares. Phantom stock plans and stock appreciation rights (SARs) are two types of stock plans that don't really use stock at all, but still reward employees with compensation that is tied to the company's stock performance.

Phantom Stock
Also known as "shadow" stock, this type of stock plan pays a cash award to an employee that equals a set number or fraction of company shares times the current share price. The amount of the award is usually tracked in the form of hypothetical units (known as "phantom" shares) which mimic the price of the stock. These plans are typically geared for senior executives and key employees and can be very flexible in nature.

Form and Structure
There are two main types of phantom stock plans. "Appreciation only" plans do not include the value of the actual underlying shares themselves, and may only pay out the value of any increase in the company stock price over a certain period of time that begins on the date the plan is granted. "Full value" plans pay both the value of the underlying stock as well as any appreciation. Both types of plans resemble traditional nonqualified plans in many respects, as they can be discriminatory in nature and are also typically subject to a substantial risk of forfeiture that ends when the benefit is actually paid to the employee, at which time the employee recognizes income for the amount paid and the employer can take a deduction.

Phantom stock plans frequently contain vesting schedules that are based on either tenure or the accomplishment of certain goals or tasks as covered in the plan charter. This document also dictates whether participants will receive cash equivalents that match dividends or any type of voting rights. Some plans also convert their phantom units into actual stock shares at the time of payout in order to avoid paying the employee in cash. Unlike other types of stock plans, phantom stock plans do not have an exercise feature, per se; they only grant the participant into the plan according to its terms and then confer either the cash or an equivalent amount into actual stock when vesting is complete.

Advantages and Disadvantages
Phantom stock plans can appeal to employers for several reasons. As an example, employers can use them to reward employees without having to shift a portion of ownership to their participants. For this reason, these plans are used primarily by closely-held corporations, although they are used by some publicly-traded firms as well. Also, like any other type of employee stock plan, phantom plans can serve to encourage employee motivation and tenure, and can discourage key employees from leaving the company with the use of a "golden handcuff" clause.

Employees can receive a benefit that does not require an initial cash outlay of any kind and also does not cause them to become overweighted with company stock in their investment portfolios. The large cash payments that employers must make to employees, however, are always taxed as ordinary income to the recipient and may disrupt the firm's cash flow in some cases. The variable liability that comes with the normal fluctuation in the company stock price can be a drawback on the corporate balance sheet in many cases. Companies must also disclose the status of the plan to all participants on an annual basis and may need to hire an independent appraiser to periodically value the plan.

Stock Appreciation Rights (SARs)
As the name implies, this type of equity compensation gives participants the right to the appreciation in the price of their company stock, but not the stock itself. SARs resemble nonqualified stock options in many respects, such as how they are taxed, but differ in the sense that holders of stock options are actually given shares of stock that they must sell and then use a portion of the proceeds to cover the amount that was originally granted. Although SARs are also always granted in the form of actual shares of stock, the number of shares given is only equal to the dollar amount of gain that the participant has realized between the grant and exercise dates.

Like several other forms of stock compensation, SARs are transferable and are often subject to clawback provisions (conditions under which the company may take back some or all of the income received by employees under the plan, such as if the employee goes to work for a competitor within a certain time period or the company becomes insolvent). SARS are also frequently awarded according to a vesting schedule that is tied to performance goals set by the company.

Taxation
SARs essentially mirror non-qualified stock options (NSOs) in how they are taxed. There are no tax consequences of any kind on either the grant date or when they are vested. Participants must recognize ordinary income on the spread at exercise, and most employers will withhold supplemental federal income tax of 25% (or 35% for the very wealthy) along with state and local taxes, Social Security and Medicare. Many employers will also withhold these taxes in the form of shares. For example, an employer may only give a certain number of shares and withhold the remainder to cover the total payroll tax. As with NSOs, the amount of income that is recognized upon exercise then becomes the participant's cost basis for tax computation when the shares are sold.

Advantages and Disadvantages
The previous examples illustrate why SARs make it easy for employees to exercise their rights and calculate their gains. They do not have to place a sale order at exercise in order to cover the amount of their basis as with conventional stock option grants. SARs do not pay dividends, however, and holders receive no voting rights.

Employers like SARs because the accounting rules for them are now much more favorable than in the past; they receive fixed accounting treatment instead of variable and are treated in much the same manner as conventional stock option plans. But SARs require the issuance of fewer company shares and, therefore, dilute the share price less than conventional stock plans. And like all other forms of equity compensation, SARs can also serve to motivate and retain employees.

The Bottom Line
Phantom stock and SARs provide employers with a means of providing equity-linked compensation to employees without the need to materially dilute their stock. Although these programs have some limitations, industry pundits predict that both types of plans will likely become more widespread in the future. For more information on these plans, consult your HR representative or financial advisor.

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