Photo by fauxels from PexelsPhantom stock is an excellent approach to motivate your staff and allow them to join in the company’s growth. By implementing this stock plan, you can give your employees a piece of the company’s worth without giving them the rights that generally come with stock ownership. Unlike equity shares held by employees for a specified period, which are taxable income to the firm for the whole term, it is only taxed when it matures, and the employee pays the settlement check. Let’s take a deeper look at it before you hand these out to your employees.Phantom Stock TaxationTaxes will not be collected on this stock compensation until they are sold, and the money is received. Tax deductions are also available if the plan is in accordance with 26 U.S. Code and 409A. In contrast to actual stock, the value of this stock is taxed as ordinary income. Keep reading as the concept is more clearly explained below.Understanding Phantom StockA phantom stock plan is a sort of equity-based remuneration that offers employees a few of the advantages of stock ownership without really holding the company’s stock, and these are typically offered to senior management.To put it simply, employees earn more financial rewards when the company thrives without the owner sacrificing any control over the company. For firms of all sizes, these stock plans are an excellent option, although they are more frequently used by those who are consistently cash flow positive. LLCs looking to grant stock options often turn to these stock programs as an alternative.Employees at a company with this stock plan get fictitious equity, often known as “mock stock” or “shadow stock,” but more generally known as “phantom stock.” Although the phantom stock is not real stock, it tracks the price movement of the company’s actual shares and pays out dividends to its investors.Types of Phantom StockThis stock scheme can be divided into two basic categories. There are “appreciation-only” plans that don’t pay out on the actual value of the underlying shares but rather on any growth in the firm stock price over a predetermined period of time. When a “full value” plan is used, the stockholder receives both the stock’s original value and any subsequent appreciation. Now, let’s take a close look at the two categories.Appreciation only: Stockholders who received “appreciation only” phantom shares would not be entitled to the stock’s current market value. Instead, they profit from rising stock prices as a result of their investments.Suppose that the stock’s initial price is $10. The company’s stock price was $30 at the time of redemption. The stock payment would be $20. In this case, the employee must remain with the company for at least four years before they can “sell” their shares. The term “vesting” refers to this time period.Full value: After meeting all of the terms of the “full value” phantom stock agreement, employees receive both the present value and any stock appreciation that may occur.The employee would receive a $30 per share price rise after four years in the previous scenario. However, in full value, they would also receive the current market value of the shares at the time of the deal’s inception. As a result, after the four-year vesting period ends, the employee will be entitled to receive $100,000.Benefits and Limitations of Phantom StockThe advantages of these stock deals outweigh the disadvantages, as with any financial investment strategy. Let’s analyze the positive and negative effects on your company of issuing these stocks.BenefitsFor a firm, there are numerous advantages to implementing this stock strategy. They are as follows:For both private and public corporations, phantom stock is an excellent financial tool.Setting up this stock plan is far less expensive than doing it through an ESOP. It’s a huge money saver for the company.Workers receiving these stocks have no tax obligations until the stock matures.Using this stock plan, employees are only paid if they achieve certain conditions, which considerably simplifies the process. And if an employee resigns, the corporation won’t have any problems handling half of the vested shares because the plan uses cash instead of actual stock.Even if employees aren’t allowed to vote, they’re nonetheless making a contribution to the company’s stock price growth.LimitationsAs with anything, there are drawbacks to using phantom stock, which include the following:Employees are subject to regular income tax on all benefits received. In addition, as the benefits are provided in cash, there is no exemption for capital gains on them.Phantom stock plan participants who have signed up for the “appreciate-only” option may not get any money in the event that the company’s stock price declines.If the value of the company’s stock drops, the employer can give the employees little control of the company. There are also possibilities of calling off the deal.Companies must be prepared when they are required to pay out benefits.Companies that are publicly traded are required to provide their employees with an annual report on the status of their stock plans so that the Securities and Exchange Commission (SEC) and all genuine shareholders are kept up to date.It would cost the employer a lot of money when a third-party business thoroughly reviews the stock valuation.Why Should Startups Issue Phantom Stock Shares?Phantom stock options are a helpful technique for growing startups. These stock options are a wonderful method to offer high-reward remuneration to attract the best talent even if your budget does not allow for market salaries and benefits.Keep in mind that too many options could leave you short of cash after the vesting period is through. If your startup is looking for a way to motivate your employees, this stock plan is a great option. It is possible that issuing these stocks to employees can assist your firm in achieving its goals, motivating employees, and providing your organization with the flexibility necessary to align the aims of all parties involved.How Does Phantom Stock Taxation work?The gains from these stock plans are taxed as ordinary income regardless of how the payments are paid. In addition, the tax rate applies to the final stock price. These stock plans must comply with section 409A of the Internal Revenue Code (IRC), and the bonus paid out under the plan is only taxed when it is received. During this time period, the employer might deduct the total tax from the employee’s paycheck and pay them the remaining. This is beneficial to the employee since it makes it simpler for them to pay their income taxes.When Does Phantom Stock Become Taxable?Even if no cash is received, the value of the stock could be subject to taxation upon vesting if the phantom shares are linked to other securities with monetary value. In some jurisdictions, a “rabbi trust” (Rabbi trusts are a type of trust that companies utilize to avoid taxation upon employee compensation) may be used to overcome this problem; nevertheless, the payout is subject to severe risks, such as not being shielded from the creditors of the company in the event of bankruptcy. Alternatively, one can avoid paying taxes by just paying out a portion of the rise in value that accrued from the time of vesting.Tax Treatment of Phantom Stock (Corporate and individual)Phantom stock tax treatments often have no tax consequences for the issuance of phantom options that have a strike price equal to the company’s fair market value. Phantom Options’ value increases as the company’s worth increases.Employees who receive these stock payments are taxed as ordinary income, and the corporation is taxed as a business expense. Due to a complex set of laws controlling deferred compensation, they are also subject to penalties if they aren’t observed correctly.ConclusionThe use of phantom stock options may soon emerge as one of the most successful choices for many firms to incentivize and retain personnel. These stocks can also be an employee benefit plan and would solve talent retention problems.Check out our new platform 👉 https://thecapital.io/https://twitter.com/thecapital_iohttps://medium.com/media/3b6b127891c5c8711ad105e61d6cc81f/hrefPhantom Stock: When Does It Become Taxable? was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.