One of the most powerful strategies for motivating and retaining key employees is to give them an equity position in the business. Tools like stock options and restricted stock incentivize employees to grow the valuation of the company — aligning their interests with those of the owners — and tie employees to the company by vesting gradually over time.

But what if you’d like to provide such incentives without sharing actual ownership? Perhaps you’d prefer not to dilute ownership of the business. Or maybe corporate or regulatory restrictions (such as an ESOP) prohibit your company from using traditional equity plans. Fortunately, there are alternatives that mimic the economic benefits of equity — notably, phantom stock and stock appreciation rights (SARs).

What They Are

Essentially, phantom stock and SARs are deferred compensation plans that award bonuses (usually cash) based on the company’s stock price. Despite the term “stock,” these tools aren’t limited to corporations. Limited liability companies (LLCs) and partnerships may offer similar “phantom unit” or “unit appreciation rights” plans.

A phantom stock plan pays a bonus based on the value of a stated number of shares of stock at a specific point in time or upon the occurrence of a specified event (such as sale of the company or termination of employment). A SARs plan pays a bonus based on the appreciation in value of a stated number of shares of stock over a specific time period.

How They Work

Either type of plan may provide for employees’ rights to vest over time or make the award contingent on the company’s achievement of certain performance goals, such as sales or earnings targets. One of the main differences is that phantom stock plans award the employee the value of stock at grant date (subject to vesting) plus the appreciation realized through execution date, whereas SARs plans award the employee only the appreciation realized from grant date through execution date.

When an award is paid out, its value is taxed as ordinary income to the employee and is deductible against ordinary business income by the employer. The accounting treatment depends on the terms of the plan, but in general the employer must recognize compensation expense on their financial statements over the vesting period.

An Effective Alternative

Although traditional equity plans offer certain tax and other advantages, phantom stock and SARs may be effective alternatives for companies that are unwilling or unable to share equity with employees. Employees become incentivized to help grow the company, thus increasing the stock’s value and their eventual payout, while employers receive the benefit of the company’s growth and an ordinary business tax deduction for the payout. Designing a plan involves a variety of tax, regulatory and funding considerations. If you’re contemplating one of these plans, contact us.