Nothing Phony About Using Phantom Equity as Compensation—Part 2

In Part 1 of this article, I discussed equity grants, incentive stock options, nonstatutory stock options, and profits interests. The challenge remains of how to transfer the full value of equity—not just the appreciation from the grant date like a profits interest or an ISO—to an employee who wishes to recognize long-term capital gain treatment upon a change in control.

Phantom equity is not an actual grant of equity but is a contractual right to receive a payment, which is tied to the value of equity. So economically, it’s similar, if not identical, to equity.

For instance, suppose an employer was going to issue one share of stock to an employee. The employer could replicate this arrangement with phantom equity via a phantom equity grant, promising to pay the value of one share to the employee upon a change of control.

Generally, a phantom equity grant can be structured so that it isn’t taxable when granted and only taxable upon payout when a change in control occurs. The downside is that payouts for phantom equity are taxed as ordinary income to the recipient. However—and here’s where it gets interesting—a phantom equity payment can be grossed-up to lower the employee’s effective tax rate to equal that of long-term capital gains rates.

Specifically, the top ordinary income rate is 37% for individuals, and the top capital gains rate for individuals is 20%. Thus, the gross-up only needs to account for this 17% difference. As a result, the employee is happy because their after-tax position is equivalent to having received capital gain treatment, and they receive the full value of the equity, not just the appreciation as in an option or profits interest scenario.

Also, employers are entitled to deduct the total amount of the phantom equity payment, unlike other types of equity compensation. Since employers receive a deduction for the entire payout, they can be better off issuing phantom equity with this limited gross-up than straight equity or an option. The benefit of the deduction will depend on the rate at which the business profits are taxed. Business income of an LLC, partnership, or S corporation can be taxed as high as 37%, which weighs more in favor of using phantom equity.

On the other hand, C corporation earnings are taxed at 21% (at least for the moment), but even modeling out a gross-up for employers at this lower rate comes very close to a break even for the employer (see Figure 1). These two factors—the limited gross-up to effectuate long-term capital gains rates and the corresponding deduction by the employer for the entire payment—creates a planning opportunity that comes very close to the perfect world from a tax perspective for equity compensation.

Analysis: Employees’ payout is grossed up to equalize what would receive if LTCG; t/4 Employee is indifferent. Company deducts full payment. For each $100k paid, the company at a 21% rate loses a nominal $713 or 0.71%.

Please note, capital gains attributable to equity compensation are also subject to the net investment income tax of 3.8%, and ordinary income attributable to equity compensation is also subject to Medicare taxes of 1.9% and Social Security taxes of 6.9% on the first $147,000 for the year 2022. These taxes—net investment income, Medicare and Social Security and Medicare taxes—are considered in the modeling in Figure 1, but for simplicity aren’t included in the discussion on rate differential as they don’t significantly impact the analysis.

One issue with phantom equity is that it can be considered a deferred compensation arrangement. If a payout will be made to an employee after the employee leaves the company, IRC Section 409A could cause the employee to incur a 20% excise tax, in addition to recognizing ordinary income, and deny a deduction to the employer. However, a phantom equity grant could be structured to convert effectively into a stock appreciation right to exclude this treatment in the event that an employee leaves the company, and stock appreciation rights are not subject to Section 409A. See Treasury Regulation Section 31.3121(v)(2)-1(b)(4)(ii).

Phantom equity can also be issued to supplement the issuance of an option, whether an ISO, NSO, or a profits interest. In this fashion, the phantom equity grant would help the employee receive full economic value of the stock or provide liquidity to the employee to pay tax upon the exercise of an option.

A non-tax disadvantage to a phantom equity grant is that the employee won’t be an equity holder of the employer. However, as a minority shareholder, the potential tax benefits of phantom equity can outweigh the ability to own actual equity when such actual equity carries few if any meaningful rights.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Steve Lueker is a partner with Moses & Singer’s tax practice.

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