Phantom Stock Taxation
Phantom stock taxation is straight-forward, but also commonly misunderstood. Here's what you need to know!
Tax Implications of Phantom Stock
Phantom stock is a contractual obligation between a company and an employee. Companies have flexibility in how they structure phantom stock plans to meet their needs. For employees, how a company designs its phantom stock plan impacts how and when the phantom stock is taxed.
Generally, the taxation of phantom stock depends on two factors:
1. Appreciation Only or Full Value?
Appreciation-only phantom stock compensates employees for an increase in stock value over a specifies base price.
Full-value phantom stock provides the full value of the stock.
2. Single-Trigger or Double-Trigger?
Single-trigger phantom stock vests over time according to a vesting schedule
Double-trigger phantom stock requires time-vesting and an event like a liquidity event to fully vest.
Most Phantom Stock is Double-Trigger
No taxation upon grant. The employee receives no benefit at this point.
No taxation upon time-vesting. Double-trigger phantom stock does not fully vest and provide a benefit upon time-vesting alone.
Taxation upon full vesting. When double-trigger phantom stock vests by meeting both time and event criteria, it is treated as ordinary income subject to income tax withholding for employees. It is also subject to FICA taxes (Social Security and Medicare).
Forfeited phantom stock is not taxed. If an employee leaves a company and forfeits unvested phantom stock, they receive no benefit, so it is not taxed.
Income tax withholding is required once the award is paid out for employees. The amount subject to withholding taxes is the current value of the award or payment (i.e., the amount of cash or value of shares or other property payable).
Unique Items and Special Situations
83(b) Elections Are Not Available (No Property Is Transferred)
An 83(b) election applies to the transfer of restricted property. Phantom stocks are a corporate contractual obligation--not property--and as such early exercise via 83(b) is not applicable.
If Phantom Stock Is Single Trigger, Taxation Will Occur Upon Time Vesting
Single-trigger phantom stock has only one condition (time vesting). When shares vest, both (1) the company should make payment on the requisite value (if any), and (2) if a payment of value was made, it is taxable income (withholding would apply as well). This dynamic is challenging for a private company for many reasons (frequent valuations; frequent payouts) -> which is why most phantom stock grants are double-trigger.
No Capital Gains Ever Apply
When Phantom Stock is awarded, the employee has a contractual obligation linked to company stock--not the right to purchase actual stock. As such, if/when the phantom stock vests, it generates ordinary income. There is not ability to optimize for more favorable long-term capital gains tax treatment
Taxation Example
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