What is phantom equity?
Phantom equity, which can also be referred to as phantom stock, phantom units, or phantom shares, is one of several types of equity limited liability companies (LLC) can issue—other forms include membership interests, profits interest units, unit appreciation rights, and options to acquire interests.
Like other types of equity, phantom equity is granted to employees and other recipients by LLCs. Similar to a bonus, phantom equity entitles the recipient to a cash payout when the company is acquired or goes public, or a share of annual profits when the company achieves some other milestone, such as revenue or profit goals.
How does a phantom equity plan work?
LLCs issue phantom equity as a form of employee compensation. Phantom equity is granted for free; you do not have to pay to acquire it as you do when exercising stock options in a corporation. When you receive phantom equity, you do not become a partner or member of the LLC, and you’ll retain employee status (meaning you can continue to receive company benefits and have taxes withheld by the LLC).
Phantom equity is a broad term and can be structured by LLCs in a variety of ways. It can include a share in annual profits as well as proceeds from a sale. If structured as such, you can also share in profits above your company’s threshold value set at the time of the grant.
→ Learn more about LLC equity incentive plans.
Variations on phantom equity
Unit appreciation rights, or UARs, are a type of phantom equity. Like phantom equity, UARs have the following characteristics:
-
provide a cash payout if conditions are met
-
incentivize employees to grow the company’s value
-
require no payment by the recipient to obtain
-
allow the recipient to retain employee status
However, unit appreciation rights contractually reward the recipient based on the appreciation in company value from the time of the grant to the time the grant is paid out (a structure that is not necessarily required for phantom equity). Therefore, UARs require the company’s valuation to be established at more regular intervals, potentially making it more burdensome for companies to administer than phantom equity.
Advantages & disadvantages of phantom equity
Phantom equity holds a few key overall advantages for recipients:
-
It allows them to retain employee status for benefits and tax purposes, rather than become partners or members of the LLC, so they can continue to receive a W-2 form and employee benefits.
-
It gives them a share of the company’s success or future annual profit distributions (or both)
For the LLC, phantom equity has the following advantages:
-
It can be easier to administer than other forms of equity.
-
It generally requires few, if any, changes to the LLC’s operating agreement, because unlike profits interest units or UARs, there’s no need to calculate the spread between the value of the company at the time of the equity grant and at the time of exit.
Phantom equity does hold some disadvantages:
-
Upon payout, it requires the employee to pay tax on payouts at the ordinary income rate, rather than the lower capital-gains tax rate, as they would with profits interest units.
-
Employees generally cannot sell or transfer phantom units, so liquidity can be an issue. (This can partially be countered if the LLC has strong cash flow and phantom equity is structured to provide for a share of annual distributions of profits.)
Tax treatment of phantom equity
Phantom stock unit payouts are taxable to the employee at ordinary income tax rates (generally higher than capital gains tax rates).That differs from most forms of corporate equity as well as LLC equity such as profits interest plans, which when handled correctly enable the recipient to pay capital gains tax rates.
How phantom equity differs from corporate equity
Companies organized as corporations also issue employee equity in the form of stock options, restricted stock units (RSU), and other forms. Corporate equity represents actual ownership shares, or the right to buy actual ownership shares, in the company. Typically corporate equity is based on the company’s fair market value (FMV) at the time of the grant, and requires the employee to meet certain time-based conditions to obtain the equity, based on vesting schedules.
Unlike corporate equity, phantom equity does not represent an actual ownership of the LLC; it only mimics ownership, hence the name phantom equity.
In addition, phantom equity is taxed at ordinary income tax rates, rather than capital-gains tax rates as in the case of corporate equity when certain conditions are met.
