You have a successful business and want to incentivize your workforce.  Of course, you can pay bonuses or increase salaries, but you’ve also heard of other types of equity incentives; however, the different choices are very complex and none seems to be an ideal solution.  We regularly advise our clients about the advantages and disadvantages of various forms of incentives (both from the employer’s perspective and the employee’s perspective) – including with respect to regular equity, Phantom Equity, stock options, profits interests and restricted stock units.  For the purposes of this article, however, we will only focus on certain key differences between regular equity and Phantom Equity.

What Is It?

Regular Equity: “Regular equity” varies by the type of entity.  Equity in a corporation is referred to as shares of stock, and equity in partnerships or limited liability companies is often referred to as units. 

Phantom Equity: The term is used to describe a contractual right to receive payments as if the recipient owned equity in the company.  This can be structured in a variety of ways.  For example, the recipient may be entitled to a percentage of annual profits for a particular accounting period.  Phantom Equity could be structured so that the recipient is entitled to a percentage share of dividends or distributions from the company (when it declares a dividend/distribution) or a percentage share of the sales proceeds from a sale or change in control of the company.  By way of illustration, if a company grants a recipient Phantom Equity measured by 5 shares of the stock of the company, and provides that the recipient is entitled to participate in annual dividends, then when the board declares a dividend the Phantom Equity recipient would be entitled to receive a payment equal to five times the declared dividend on each share of stock just as if the recipient actually owned five shares of company stock. However, as noted above, this is simply a contractual right to receive a payment in exchange for services (e.g., akin to a formulaic bonus), and the grant of the phantom equity is not an ownership right in the company. So, for accounting purposes the payment, although it appears similar to a dividend, would be treated as compensation (and not as a dividend payment).

Is The Recipient A Shareholder/Owner Of The Company?

Regular Equity: Yes.

Phantom Equity: No

Does The Recipient Have Voting Rights?

Regular Equity: It depends, based on what type of stock is issued to the recipient (voting or non-voting).

Phantom Equity: No.  Phantom Equity can be viewed as akin to a bonus arrangement; effectively, a contractual right to receive a payment of cash that mirrors what the recipient would have received if he/she owned regular equity in the company – but, since the recipient is not an “actual” owner of the company, the recipient is not automatically entitled to any rights an “actual” owner/shareholder would have, such as voting rights.  

Can Phantom Equity Be Subject To Vesting?

“Vesting” is a term that indicates when an ownership interest has been fully transferred.  Vesting can be structured in a variety of ways.  For example, the company can grant 100 shares of stock, which vest in annual quarterly installments over 4 years (i.e., 25 shares will vest per year; this is commonly referred to as time-based vesting) or which vest upon the achievement of certain milestones (i.e., 50 shares will vest upon the design of a prototype being completed and the other 50 shares will vest upon governmental approval of such prototype; this is commonly referred to as performance-based vesting).  Vesting typically has “strings” attached to it – for example, the recipient must remain employed at the time of vesting.

Regular Equity: Yes.

Phantom Equity: Yes.

Does The Recipient Owe Taxes Upon The Issuance Or Grant?

Regular Equity: It depends on whether the grant is subject to a vesting schedule.  To the extent that the grant is vested, income is deemed to be received at the time of the grant.  Alternatively, if the entire grant is subject to a vesting schedule in the future, then there is no tax imposed at the time of grant, unless the recipient makes an election to accelerate taxation under §83(b) of the Internal Revenue Code (see below).

To the extent the grant is vested at the time of the grant, or if the recipient makes a timely §83(b) election for a future vesting grant, which must happen within 30 days of the grant, then the fair market value of the stock (minus any amounts paid by the recipient for the stock) is treated as a payment of wages to the recipient on the date of the grant. Just as with any other payment of wages to an employee, the fair market value of stock is taxed to the recipient at ordinary income rates and is also subject to Social Security and Medicare withholding taxes.  Please note that the issues surrounding whether or not to make an election under §83(b) are complex and involve weighing the likelihood of whether the stock will appreciate as well as the likelihood of whether the employee will continue his or her employment with the company throughout the duration of the vesting schedule.  For instance, if the stock declines in value over the course of the vesting schedule, then the recipient has taken a larger amount of taxable income on the grant date. Additionally, if the recipient fails to fully vest – e.g., due to termination – then he or she has recognized ordinary income on the entire amount of the stock when granted, however, the recipient has sacrificed some or all of the stock by not meeting the vesting schedule. 

Phantom Equity: No.

Is The Company Entitled To A Deduction Upon The Issuance Or Grant?

Regular Equity: Again, it depends.  The company is entitled to a deduction when the recipient includes any portion of the grant in their taxable and ordinary income.  Thus, if any portion of the grant is fully vested at the time of the grant, then the company is entitled to a deduction at the time of the grant, equal to the fair market value of such portion, and the recipient will recognize income on such portion at the time of the grant as well.  If all or some of the grant vests in the future (e.g., according to a future vesting schedule) then as each portion vests, the company will be entitled to a deduction and the recipient will have ordinary income, equal to the fair market of such portion as it vests. A good rule of thumb for the company’s tax treatment is that whenever the recipient includes a grant of equity in his or her ordinary income, then the company is also entitled to a corresponding deduction (unless precluded by another IRC section). 

Phantom Equity: No.

Does The Recipient Owe Taxes Upon Future Vesting?

Regular Equity: Yes, unless the recipient has made a timely election under §83(b) in respect of the grant.  As each portion of the grant vests, the recipient recognizes ordinary income (and withholding for Social Security and Medicare taxes is also triggered) for such portion.  Currently, the top federal ordinary income tax rate is 37%.  This can be a significant surprise for recipients and employers – many times, companies want to simply give stock to their employees as an incentive; however, the employee may be surprised (and upset) to find out that they will have a tax liability as the stock vests. 

Phantom Equity: No.

Does The Recipient Owe Taxes Upon Receipt Of Dividends or Operating Distributions (i.e., a distribution that is NOT in connection with the sale, liquidation or change in control of the company)?

Regular Equity: It depends on the type of entity of the company.  If the company is a C corporation, then distributions are usually dividends to the recipient and taxable as such.  If the company is a pass-through entity (e.g., such as a partnership, an S corporation or an LLC taxed as a partnership), then the recipient is taxed on his or her share (commonly referred to as an “allocation”) of company items (company profits and capital gains) regardless of whether a distribution is actually made. 

Phantom Equity: Yes, the recipient of a phantom equity grant is taxed at ordinary income rates as they receive distributions under the grant.

Is The Company Entitled To Make A Deduction In Connection With Such Distributions?

Regular Equity: No, distributions, allocations of income and gain and/or the payment of dividends are not deductible by a company.  Rather, the company takes a deduction when the recipient includes the regular equity in their ordinary income.   

Phantom Equity: Yes, if a phantom grant is structured so that non-liquidating distributions are paid to the recipient, then such distributions would be akin to a bonus and would be deductible by the company in computing its taxable income just like any other payment of wages.  

Does The Recipient Owe Taxes In Connection With A Sale or Change in Control of the Company?

Regular Equity: Yes; generally speaking, all gain will be capital gain and if held longer than one year will qualify as long-term capital gain (currently limited to 20% for long-term capital gains + 3.8% for the net investment income tax at the federal level). The amount of gain is measured by the appreciation of the equity from the time when the recipient included the grant in ordinary income (e.g., as it vested or upon the grant if a timely §83(b) election was made).  Please note that recipients of equity in a partnership (or LLCs taxable as a partnership) could have a portion of the gain treated as ordinary income to the extent the company has any “hot assets.” Additionally, if the partnership has any debt at the time of a change in control, then there could be additional gain as well, depending on the partner’s basis in their equity.

Phantom Equity: Yes; if a sale event that triggers a payment from the company to the recipient, then this payment will be taxed at ordinary income rates (as opposed to capital gain) (currently, the top federal ordinary income tax rate is 37%) and will also be subject to Social Security and Medicare withholding taxes. 

Is the company entitled to make a deduction upon payment of such sale event distributions?

Regular Equity: No.

Phantom Equity: Yes, as mentioned above, whenever the recipient includes a payment in ordinary income, the company is granted a corresponding deduction, and such payment is treated as compensation expense. 

The above is intended to give a general, high level summary of certain differences between grants of regular equity and Phantom Equity, and is not intended to list all of the differences or explain the differences noted above in great detail.  Both companies and recipients should engage counsel to review their specific situation and how the nuances of these different types of grants can impact them and their take home pay or deduction at the end of the day.  Please note that this article does not constitute tax advice, and each person should consult directly with their own tax advisor.