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I have been offered phantom stock in a closely held small tech corporation. Should I argue for stock options instead?

Mountain View, CA |

This is the first time I've been offered phantom stock for a key officer role and I have reservations.

Thanks for the input. So far, John P Corrigan's answer is helping me the most. Dana Shultz is correct in that arguing for stock options now will likely not be successful. I guess what I really am trying to understand, since this hasn't been the norm in my experience, is whether there are reasons why phantom stock is not in one's best interests relative to normal stock options. Am I better off looking at other opportunities with more traditional plans, or trading phantom stock for a higher salary in my negotiations? Yes, I realize it's a complicated topic (as the past hour searching via Google has made clear), so I was just looking more for the "gut check" here than anything else. I will speak to my CPA, but I do like to do a certain bit of homework with crowd-sourced wisdom. Thank you so far for the feedback.

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Attorney answers 4

Best Answer
Posted

Biggest difference I that phantom tock is nothing more than deferred compensation that is aid to you in cash, therefore is always taxed as ordinary income when received no different than wages. The company gets a compensation deduction. You never have ownership in the business albeit your earnings are ownership-like given the value of the phantom stock will mirror real stock for valuation. Stock options allow the recipient to actually become an owner if option is exercised and "real" stock issued. Moreover, if the recipient makes an IRC Sec. 83(b) election at time the options are issued then any future appreciation in the stock will be taxed at the lower capital gain tax rate.

My answer is not intended to be giving legal advice and this topic can be a complex area where the advice of a licensed attorney in your State should be obtained. Please click "helpful" or "best answer" if my answer added any value or add a "comment" if you have more info for me to help you get a better answer.

Asker

Posted

Thanks, John. So far your answer is the most helpful to me. Recognizing that each individual's overall tax situation and goals are different, I'll be happy to mark this as the answer if you can make it just make it clearer from the following perspective: is the motivation for issuing phantom stock instead of normal stock options driven by a perceived advantage for the actual shareholders? Or is there a real world advantage for the employee relative to more conventional stock options. Are there any reasons why one might regret committing time out of his or her life to a company that issued phantom stock instead of one issuing more conventional stock options, assuming all other factors to be equal?

John P Corrigan

John P Corrigan

Posted

Many times when I am advising a corporate client or LLC client in the early stages there may be only 2-3 owners so I recommend to them that they not give up real ownership because they now have fiduciary duties to a minority shareholder- employee which creates unnecessary baggage for the owners in terms of any s/h having rights under the law whereas a phantom interest is a mere contract right to compensation. Next biggest reason is that employer gets a tax deduction for compensation whereas if the employee makes the 83(b) election [as is usually warranted] to get capital gain treatment then employer gets NO tax deduction. many times an employee could care less about being a 1% owner -- but just "show me the money" and phantom stock is better than getting nothing in terms of a sharing of the success of the company. A savvy employee may negotiate for more phantom stock to cover the tax differential from not achieving capital gains down the road.

Asker

Posted

Thanks, marking this as the answer. It clearly explains the incentive to the owners, and what is being given up by the employee, whether it is a "show me the money" employee, or one who appreciates the fiduciary duties and rights under the law assumed by stock options as well as potential capital gains advantages down the road.

John P Corrigan

John P Corrigan

Posted

glad to shed some light on this for you....good luck!

Posted

You probably need an employment/business lawyer with experience in your industry up in Mountain View/Silicon Valley to review your agreement in its entirety. Both phantom stock and stock options are complex securities and have tax ramifications that need to be considered in conjunction with your overall tax picture. You seem to have prior experience in high level employment contracts in the industry and it is now time to have a ongoing CPA and lawyer on your team.

The above is general legal and business analysis. It is not "legal advice" but analysis, and different lawyers may analyse this matter differently, especially if there are additional facts not reflected in the question. I am not your attorney until retained by a written retainer agreement signed by both of us. I am only licensed in California. See also avvo.com terms and conditions item 9, incorporated as if it was reprinted here.

Posted

I agree with Attorney Doland and will add the following:

Does the corporation already have a stock option plan? If not, then arguing for options may not succeed, because a tax-qualified stock option plan is relatively expensive for a small corporation to establish and administer.

Perhaps you can successfully argue for restricted stock, rather than phantom stock or options. Please see the post at the link below.

This information does not constitute legal advice and does not establish an attorney-client relationship.

Asker

Posted

While I selected Mr. Corrigan's answer for this question, I did want to acknowledge that I came across various blog posts of yours while researching. I found these very informative as far as providing overall context of deciding how to incentivize key employees with stock-based compensation plans. Thank you.

Dana Howard Shultz

Dana Howard Shultz

Posted

Thank you for the kind words.

Posted

Your reservations are well advised.

You should consider making your case for options for the following reasons: (i) phantom rights will never afford you voting rights and you don't get the employee stockholder protections under the California Corporations Code as an equity holder (your interest can be diluted w/o consent); and (ii) options can qualify for lower tax treatment (as ISOs) and allow your to avoid income tax if the grant and your dispositions qualify (you're taxed as a capital gain vs. income tax rate). Phantom stock rights are taxed as supplemental income (bonus income) and do not have the right to vote on key changes to the company, and the company can keep granting phantom stock rights until your interests are meaningless. Be careful.

The issue is whether the company has enough underlying authorized shares to grant you options. Many times phantom stock rights are granted when a company depletes its option pool. Sometimes you can force a re-organization of the company to re-create an option pool, some times you can't.

Good luck.

For legal advice and representation, consult an attorney. This response was provided for informational and marketing purposes only, and should not be relied upon as legal advice. No communication with the author of this comment through this website can establish an attorney-client relationship, as the attorney-client relationship can only be established by the mutual understanding of its creation by both the client and the attorney, each party intending to create such a relationship.

Asker

Posted

I already selected Mr. Corrigan's response as the answer the other day, but yours is a very informative response that clearly explains the negative aspects from an employee's perspective. Much obliged.