An overview of phantom stocks, how they work and their tax treatment.
Phantom stock options (PSO), also known as phantom shares or shadow stock, are a form of compensation whereby the recipient receives a cash bonus equal to the appreciation in the company’s share price over a specified period.
What this means is that the recipient only receives cash and not any actual ownership of the company’s shares.
Phantom stocks may have conditions attached to the agreement, typically fulfilled when milestones are reached. Like all forms of conditional equity, phantom stocks incentivise recipients to work towards achieving the business’ goals and reap the rewards later.
Each agreement will state how many phantom stocks the recipient will receive, and the exercise price for each. Then the amount the recipient receives depends on the type of phantom stock awarded.
With appreciation-only phantom stock, the recipient receives an amount equal to the appreciation in the company’s share price over a specified period.
As for full-value phantom stocks, the recipient receives value on the difference between the exercise price and the sale price.
An example agreement may look something like this: Employee X has been granted 1,000 full-value phantom shares with an exercise price of ₹50 per share. In this case, they will earn the cash equivalent of 1,000 shares, less the exercise price.
What's a phantom stock unit?
A phantom stock unit represents the value of one phantom stock, which is paid out in cash to the recipient upon vesting of that particular unit. So, if, for example, an employee is granted 100 units of phantom stock and 50 of these units vest after a particular period, then the employee receives a cash amount equivalent to the value of one unit multiplied by 50.
What's the difference between traditional Employee Stock Option Plans (ESOPs) and phantom stocks?
ESOPs grant the recipient an option to get shares of a company after the completion of the vesting period. The recipients receive shares of a company at a predetermined price and they can then sell these shares at their discretion.
Phantom stock options, on the other hand, do not give the recipients access to any shares in the company. These options only give the recipient a cash bonus at the end of the vesting period that is equal to the value of the stocks.
Why do companies issue phantom stocks?
As mentioned above, phantom stocks are a form of compensation. But they are much more flexible than simply paying cash bonuses (and potentially more cost-effective than other forms of remuneration). Also, attaching certain strings to the agreement gets everyone pulling in the same direction.
Attract and retain talent
Phantom stocks are a great way to attract employees and motivate them to stick around and earn their bonuses.
As there are not really any criteria the company needs to meet, companies of all shapes and sizes can issue phantom stocks.
Preserve cash
Of course, the cash has to be readily available to pay cash bonuses. This might not always be possible for startups or even established companies, but phantom stocks offer a way to use the equity in the company to reward people for their efforts.
Conserve equity
By issuing phantom stocks instead of actual shares, companies can conserve their equity and prevent existing shareholders from dilution.
Retain control
PSOs do not lead to any transfer of shares to the recipient. This means the company does not offer any voting rights to the recipient, thus enabling them to retain more control over the company.
Flexibility
Phantom stocks offer greater flexibility, as these can be issued to anybody, unlike traditional ESOPs, where the recipient must be a permanent employee of the organisation.
What is the tax treatment for phantom stocks?
Phantom stocks are treated as a cash bonus, so the recipient will be liable to pay income tax under the income from salaries category at their usual rate. But only once the bonus has been paid.
As nothing is actually received on the issue of phantom stocks – cash or equity – no tax liability is created on the initial award. All the recipient actually gets is the prospect of receiving a cash payment at some time in the future.
For employers, the only tax consideration is to ensure you deduct the appropriate TDS (Tax Deducted at Source) from the payout according to the applicable tax rates.
Can I issue phantom stocks through Vestd?
Absolutely! This is currently a beta service, so please contact us if you would like to issue phantom stocks and we will help you get started.
We will also provide a phantom stock option agreement template for you to use, so there is no need to get your lawyers to draft something new (though you may want them to review ours).
Once you have set the conditions of the phantom stock option scheme, you will add recipients and invite them to accept their award.
They will be prompted to join Vestd where they can view their shares and project their future value on their own My Equity page.
Sound good? Get in touch to set up your phantom stock option scheme.
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