Specific Types of Equity Compensation: Phantom Stock and Stock Appreciation Rights

Jeff Storch | 12.06.21

This is the third in a series of posts on equity compensation. For a general overview, please see our post on equity compensation. For further information on equity compensation, please see our post on restricted stock and restricted stock units (RSUs).

The discussion below describes two types of equity-based compensation that are based on, but do not actually grant, equity (though both could be drafted to add a conversion feature to turn compensation rights into true equity). For simplicity, the discussion focuses on stock but the concepts below generally can apply to all types of equity.

Phantom Stock

Phantom stock is a type of notational equity compensation linked to employer stock, similar to RSUs. If a non-corporation uses this, then a different term such as ​“phantom equity,” ​“phantom interests,” etc. would be used.

With phantom stock, the recipient is not issued actual shares of stock on the grant date but instead receives an account credited with a certain number of hypothetical or ​“phantom” shares. The value of this account increases or decreases over time, based on the appreciation or depreciation of the employer’s stock and the crediting of phantom dividends. Phantom stock is generally granted subject to a vesting schedule and on vesting, the full value of the phantom stock account is paid to the employee in cash or stock. Phantom stock more commonly vests on a time basis rather than a performance basis.

Phantom stock is taxable to the holder on vesting, or if payment is deferred, on actual payment. However, if the phantom stock provides for a deferral of the cash or stock payment after vesting, the holder may be subject to adverse tax consequences under Internal Revenue Code Section 409A (“409A”). Issuing phantom stock (or other equity) at below its actual market value also can be subject to 409A.

Unlike stock appreciation rights (discussed below) phantom stock entitles the employee to the full value of the shares at the time of vesting, rather than only the appreciation in value from grant to vesting. In addition, phantom stock generally does not need to be exercised by the employee. Instead, it is settled on vesting without the need for exercise.

Stock Appreciation Rights

A stock appreciation right (SAR) is a contractual right that allows an employee to receive cash or stock equal to the appreciation in value of a share of employer stock from the grant date until the date the SAR is exercised. SARs differ from RSUs and phantom stock because of this built-in effective purchase or exercise price. SARs are customarily subject to a vesting period and, once vested, may be exercised at the election of the employee. When exercised, SARs are customarily settled in cash, but may also be settled in stock. SARs commonly vest on a time basis rather than a performance basis.

SARs are generally taxable to the holder when exercised, provided that both:

• The exercise price of the SAR is not less than the fair market value of the underlying stock on the grant date.
• The SAR does not include any additional deferral features.

SARs that meet these requirements are exempt from 409A (discussed above). However, SARs not meeting these requirements must comply with or meet another exemption from 409A or the holder will be subject to adverse tax consequences.