Accumulated Earnings and Deferred Compensation

Alternatives to stock options

We’ll now look at 3 alternatives to regular stock options:

• phantom stock
• stock appreciation rights (SARs)
• restricted stock

Phantom Stock. In some circumstances, it's impossible or undesirable to allow executives to have stock primarily because the organization is closely held and doesn't want ownership dilution. Phantom stock plans can work well in these circumstances. Phantom stock may also pay dividend equivalents. Some phantom plans condition the receipt of the award on meeting certain objectives, such as sales, profits, or other targets. These plans often refer to their phantom stock as "performance units." Phantom stock provides a cash or stock bonus based on the value of a stated number of shares, to be paid out at the end of a specified period of time.

• then-current value of the stock
• OR
• difference between the original value and current value

The award is treated as ordinary income when received.

Valuing the units: Determining the current value of the units can be a problem when the stock is not widely traded, or the company is privately held with no readily accessible market value. Sometimes a number of other financial measures are used as surrogates of the stock value, and the movement in these measures have a direct impact on the phantom stock value. Organizations may also use the services of an appraiser to make annual valuations.

Disadvantages: A phantom stock plan gives executives or key employees a strong personal interest in raising the organization's profits; however, there is a downside. Participants may be tempted to artificially inflate the stock price in the short-term to increase the value of their shares. Also, there are usually strings attached. Participants may be required to agree to remain employed by the organization for a certain number of years or until retirement. Participants may also agree not to compete with the employer or to become a competitor's employee after retirement. So, employees must carefully weigh the benefits of participating in the plan with the associated decreased career mobility.

Taxes: Phantom stock plans are treated the same as other unfunded deferred compensation plans when it comes to taxes. When a triggering event occurs (like retirement), the plan participant is usually paid compensation in installments over a period of years. The participant is not taxed until there's an actual receipt of benefit payments. Similarly, the organization will receive a deduction for the payment in the year actually paid. There is no taxable income reported or deduction taken at the time contingent credits are made to a unit-holder's account.

Stock Appreciation Rights (SARs). SARs and phantom stock are very similar plans. SARs typically provide the employee with a cash payment or equivalent shares based on the increase in the value of a stated number of shares over a specific period of time.

In addition, SARs do not require employees to make a cash outlay. Rather than having to purchase stock, the employee receives from the organization the difference between the current market value of the stock and the stated option value of the stock. This saves the employee from having to come up with the cash necessary to purchase the stock.

Taxes: The gain is taxed as ordinary income to the employee when received, but there is no tax obligation when the rights are offered. The employer can treat ordinary income to the employee as a business deduction.

(Phantom stock and SARs can be given to anyone, but if they are given out broadly to employees, there is a possibility that they will be considered retirement plans and will be subject to federal retirement plan rules. Careful plan structuring can avoid this problem.)

Restricted Stock Restricted stock is steadily replacing stock options as the long-term incentive of choice for executive level employees. The popularity of restricted stock is primarily an outcome of mandatory stock option expensing, which became effective January 1, 2006, and the complex tax laws in non-US locations as they pertain to employee equity awards.

Restricted stock awards are grants of company stock that the recipient owns on the day of the grant. They are usually outright grants, or they may be offered for purchase by the employee in full or in part. Before restricted stock may be sold, the recipient usually must meet specified vesting criteria like service or performance goals. The stock may become unrestricted, sold before vesting is accomplished, in the event of a change in control that results in the employee losing their job.

Taxes: The income gain from the award is taxed as ordinary income when received or, excluding any amount paid by the employee, the entire value of the shares when they vest. In addition, a long-term capital gains tax is assessed on any gain in value of the shares after they vest.