What’s The Difference Between Phantom Stock and Traditional Stock Options?

Businesses are constantly seeking innovative ways to attract and retain top talent while aligning employee interests with organizational success. Two popular methods of doing so are phantom stock and traditional stock options. While both aim to incentivize employees and foster a sense of ownership, they operate quite differently. This blog post will explore the key differences between phantom stock and traditional stock options, helping you understand which might be more suitable for your business.

What are Traditional Stock Options?

Normal, old-school, stock options are where a company employer gives a worker-bee the option to buy company stock at a certain price. That price is set, at the time it’s granted, let’s say that option is $10.00 per stock. Then, the company (and the employee) hope that the company increases in value while the employee works there. For the sake of example, let’s say it does increase to $15.00 per stock 2 years after the option was granted. What that means, is that the employee can now sell their option to someone else who wants to buy the company stock. The market cost for that certain buyer would be $15.00 per stock, but they can instead buy the option from the employee for, let’s say $14.99. Now the Employee made $4.99 on each stock option they sold, even without actually buying any stock.

Drawbacks of Traditional Stock Options

There are a lot of drawbacks to these traditional stock options:

• If the company does NOT increase in value, then the stock options are worthless (see above example). 
• If the company is small and not publicly traded, there are not going to be a lot of buyers for the stock options, meaning that the employee would have to sell their stock options at a much lower rate, maybe just $12.00 rather than $14.99 in our above example. If the company is huge and publicly traded, there’s a rather unlimited amount of investors that want to trade that stock. But if it’s a small company with just 50 owners or something, there’s a much smaller “market” of buyers that would be interested in buying that stock. 
• All traditional stocks are just that–traditional stocks. That means that, if an employee does buy shares of actual stock in the company, and it’s a small company, they become business partners, which is quite different from being employees. These business partners will now have to pay taxes on money the company makes based on their ownership, even if they did not receive any profits from the company to pay taxes with. 
• Further, if stocks are granted to the employee, then the IRS treats that stock grant as a “taxable event,” meaning that the employee will have to pay taxes on the fair market value of those stocks, even if they never received cash. For example, if a company is worth 1 million, and an employee is given 10% stock, that means the employee will be taxed as if they received $100,000 in cash (even though they didn’t), giving them a likely tax burden of around $25,000 they have to pay to the IRS. 
• Traditional stocks allow for voting rights, and typically the ability to sell those shares/stocks to someone else. If it’s a small company, with 10 or fewer owners, that’s probably a detriment to the original stock owners (and a benefit to the employee). Now, the employee can sell those shares to anyone else, even someone the other business owners don’t know, like, or trust–effectively forcing them to become business partners with someone who’s going to harm the business. Even if the employee is fired, the traditional stock is still owned by the employee, meaning that they’re still business partners who can vote their shares, even though they no longer work with the other owners.

What is Phantom Stock?

Phantom stock is a wonderful new legal technology that fixes a lot of the drawbacks we listed above about traditional stock. 

Phantom stock is not real stock; it’s “phantom” stock because it doesn’t have all the characteristics of traditional stocks. Put simply, it’s a way to bonus an employee for the great work that they’re doing and allow them to participate in the success of the company.

What are the Main Elements of Phantom Stocks?

What does phantom stock look like in practice? There are two main elements of phantom stocks:

1. Most phantom stocks pay the employee a percentage of the profits that the company makes, so long as they remain employees.
2. Usually, phantom stocks give a portion of the business’s sales price to the phantom stock owner, if and when the company gets sold outright. If the employee-owned real stock, they would also be paid out this portion of the sales price, so phantom stock functions like real stock, but it doesn’t typically pay anything to the worker if the employee quit or was fired.

What are the Advantages of Phantom Stock?

Importantly, phantom stock does not include a lot of the drawbacks listed above, that traditional stocks have:

• Grants of phantom stocks are not taxed. If the employee gets a bonus from a profits share that the phantom stocks offered, that bonus is just taxed on their W2, as the money is paid from the employer to the employee. This is different from traditional stock, where our hypothetical worker bee was granted 10% stock in a million-dollar-valued company, and had to pay the IRS around $25,000 in taxes, even though they had not received any actual money!
• Phantom stocks do not give voting rights. In the above examples, the traditional-stock-owning-employee would have voting rights with the company, and the right to sell their shares to anyone else, causing the company owners to have to now be business partners with someone they don’t know. This is true even if the traditional stock employee quits and works for a competitor company. Differently, phantom stocks do not give any voting rights ever, and if the employee quits or is terminated, typically the phantom stock rights just “turn off,” and everyone goes their separate ways.

Three Key Differences Between Phantom Stock and Traditional Stock Options

Overall, phantom stock solves the issues that traditional stock and stock options created in three key ways. 

1. Shareholder Equity 

Phantom stock does not award actual ownership in the company. Instead, phantom stock only gives the rights to company profits sharing and (usually) a percentage of the sales price if the company is sold outright. These benefits are (usually) only given to the employee if the employee remains employed by the business; if the worker quits or is fired, they lose their phantom stock benefits. 

2. Value of the Stock

Phantom stock solves the issues with traditional stock options we listed above–remember all of that about there being a small “market” for stocks owned in a small company? With phantom stock, the employee is paid based on profits and, usually, if the company is sold. They don’t have to run around trying to find a buyer for the stock (or the stock options, for that matter). 

3. Taxes

We talked a lot about taxes, above, but I’ll reiterate it quickly here: traditional stock grants make the employee pay large amounts of taxes on the value of that stock, even if they did not receive any money. So, if a company is worth $1 million and an employee is awarded 10% of actual stock, the IRS would tax them as if they received $100,000 (which is 10% of 1 million). They are taxed on this “income” even if that employee was paid $0.00, making the employee have to come up with an extra $25,000 or so in tax liability (not a small feat). 

In contrast, phantom stockholders are only taxed on the actual money they receive. So, if the employee receives $50,000 from the profits share of phantom stock, they would have to pay taxes on that (actually received) $50,000, perhaps around $12,000 in tax liability, which would be much easier to pay since we know that the worker was actually paid the $50,000. 

Looking to Set Up Phantom Stock For Your Business?

At Sparks Law, we’ve written hundreds of phantom stock agreements in every way shape, and form that our creative clients have thought of. We’d love the opportunity to talk with you about phantom stock (and traditional stock options). Just give us a call and we can book a strategy session with you!