The Basics of Equity Compensation

Phantom Stock

Like SARs, phantom stock is a type of bonus plan usually offered to a company’s leadership. The stock is not actual company stock but units that have a value tied to the price of the company stock and the payout is in the form of cash. There are two commonly used payout types:

1. A plan participant receives a certain number of units for a defined period of time. If the company’s actual stock price appreciates during that time, the payout is the amount of the gain times the number of units granted.
2. The second payout type includes the price appreciation and the value of the stock at the time of grant. This is known as a “full value” plan.

Since phantom stock is not actual company stock it is a way of granting a performance incentive that does not dilute stock held by shareholders. However, since the payout is cash, it has the same drawback as SARs in that the company must ensure it has the cash on hand at exercise.

For a private company using phantom stock, since it has no traded stock to establish a price, there is a requirement for it to have an independent 409A appraisal, a determination of the fair market value of its common stock.

Taxes

A phantom stock payout is taxed as ordinary income in the year it is received by the employee.

Employee Stock Purchase Plans

Tax-qualified, also known as a Section 423 plan, employee stock purchase plans (ESPPs) give employees of a company an option to set aside after-tax periodic payroll deductions to purchase company stock at the end of a defined time period referred to as the “offering period.” There is a $25,000 annual limit on how much an employee can set aside. The draw for employees to enter such a plan is that they can purchase the stock at a discount of up to 15% depending on how the company structures the plan. The discounted stock price may be based on the market price at the beginning of the offering period or the end of the offering period, whichever is lower. This is known as a “lookback” provision. The offering period may not be more than 27 months if the purchase price of the stock is offered at a discount, otherwise it may be up to 5 years. These plans must be approved by the company shareholders. Employees who own more than 5% of company stock are not permitted to join the plan. With some permissible exceptions, all other employees must be invited to participate. ESPPs that do not meet these requirements are non-qualified and do not receive preferential tax treatment.

A company may have multiple, even overlapping, offering periods in place to give as many employees as possible who wish to participate the opportunity to do so.

Taxes

Qualified section 423 plans

• These plans must have a holding period. Purchased shares must be held at least one year after the purchase date and two years after the grant date.
• There is no tax on the discount, the difference between the market price and the discount price, at time of purchase.
• When sold after the holding period ends, the discount is taxed as ordinary income and any gain in the stock value is taxed at the long-term capital gains rate.

Non-qualified plans

• The discount is taxed at the time of purchase as ordinary income.
• If the shares are held more than a year and then sold, the long-term capital gains tax applies, Otherwise, the shares are taxed at the short-term capital gains rate.

Tax advisors

This course is intended to provide an understanding of the kinds of equity compensation plans that are available. The tax implications can be more complex than what has been outlined. When setting up such plans or participating in a plan as an employee, a professional tax advisor should be consulted.