A Detailed Overview of Employee Ownership Plan Alternatives
Restricted Stock, Phantom Stock, and Stock Appreciation Rights
Restricted StockRestricted stock plans provide employees with the right to purchase shares at fair market value or a discount, or simply grant shares to employees outright. However, the shares employees acquire are not really theirs yet-they cannot take possession of the shares until specified restrictions lapse. Most commonly, the restriction is that the employee work for the company for a certain number of years, often three to five. The time-based restrictions may pass all at once or gradually. Any restrictions could be imposed, however. The company could, for instance, restrict the shares until certain corporate, departmental, or individual performance goals are achieved. With restricted stock units (RSUs), employees do not actually buy or receive shares until the restrictions lapse. In effect, RSUs are like phantom stock settled in shares instead of cash.
While the shares are subject to restrictions, companies can choose whether to pay dividends, provide voting rights, or give the employee other benefits of being a shareholder. When employees are awarded the restricted stock, they have the right to make what is called a "Section 83(b)" election, much as they can make this election for a stock option. If they make the election, they are taxed at ordinary income tax rates on the "bargain element" of the award at the time of grant. If the shares are simply granted to the employee, then the bargain element is their full value. If some consideration is paid, then the tax is based on the difference between what is paid and the fair market value at the time of the grant. If full price is paid, there is no tax. Any future increase in the value of the shares until they are sold is then taxed as capital gains, not ordinary income. If employees do not make the election, then there is no tax until the restrictions lapse, at which time ordinary income tax is due on the difference between the grant and exercise price. Subsequent changes in value are capital gains (or losses). RSUs do not allow employees to make the Section 83(b) election.
The employer gets a tax deduction only for amounts employees pay income tax on, regardless of whether a Section 83(b) election is made or not. A Section 83(b) election carries some risk. If the employee makes the election and pays tax, but the restrictions never lapse, the employee does not get the taxes paid refunded, nor does the employee get the shares.
Restricted stock accounting parallels option accounting in most respects. If the only restriction is vesting, companies account for restricted stock by first determining the total compensation cost at the time the award is made. So if the employee is simply given 1,000 restricted shares worth $10 per share, then a $10,000 cost is incurred. If the employee buys the shares at fair value, no charge is recorded; if there is a discount, that counts as a cost. The cost is then amortized over the period of vesting until the restrictions lapse. Because the accounting is based on the initial cost, companies with a low share price will find that a vesting requirement for the award means their accounting charge will be very low even if the stock price goes up.
If the award is more contingent, such as performance vesting, the value must be adjusted each year for the current stock price, then amortized over the estimated life of the award (the time estimated to meet the performance goal). Each year, the expected cost is amortized over the estimated remaining expected life. So if the stock is awarded at $10 and goes to $15 in the first year of an expected five-year term, then $15 × 1,000 × .20 is recorded ($3,000). If the price goes to $18 the next year, the calculation is $18 × 1,000 × .40 ($7,200). The prior $3,000 is subtracted from this amount, yielding a charge of $4,200 for that year.
Phantom Stock and Stock Appreciation RightsStock appreciation rights (SARs) and phantom stock are very similar plans. Both essentially are cash bonus plans, although some plans pay out the benefits in the form of shares. SARs typically provide the employee with a cash payment based on the increase in the value of a stated number of shares over a specific period of time. Phantom stock provides a cash or stock bonus based on the value of a stated number of shares, to be paid out at the end of a specified period of time. SARs may not have a specific settlement date; like options, the employees may have flexibility in when to choose to exercise the SAR. Phantom stock may pay dividends; SARs would not. When the payout is made, it is taxed as ordinary income to the employee and is deductible to the employer. Some phantom plans condition the receipt of the award on meeting certain objectives, such as sales, profits, or other targets. These plans often refer to their phantom stock as "performance units." Phantom stock and SARs can be given to anyone, but if they are given out broadly to employees, there is a possibility that they will be considered retirement plans and will be subject to federal retirement plan rules. Careful plan structuring can avoid this problem.
Because SARs and phantom plans are essentially cash bonuses or are delivered in the form of stock that holders will want to cash in, companies need to figure out how to pay for them. Does the company just make a promise to pay, or does it really put aside the funds? If the award is paid in stock, is there a market for the stock? If it is only a promise, will employees believe the benefit is as phantom as the stock? If it is in real funds set aside for this purpose, the company will be putting after-tax dollars aside and not in the business. Many small, growth-oriented companies cannot afford to do this. The fund can also be subject to excess accumulated earnings tax. On the other hand, if employees are given shares, the shares can be paid for by capital markets if the company goes public or by acquirers if the company is sold.
If phantom stock or SARs are irrevocably promised to employees, it is possible the benefit will become taxable before employees actually receive the funds. A "rabbi trust," a segregated account to fund deferred payments to employees, may help solve the accumulated earnings problem, but if the company is unable to pay creditors with existing funds, the money in these trusts goes to them. Telling employees their right to the benefit is not irrevocable or is dependent on some condition (working another five years, for instance) may prevent the money from being currently taxable, but it may also weaken employee belief that the benefit is real.
Finally, if phantom stock or SARs are intended to benefit most or all employees and defer some or all payment until termination or later, they may be considered de facto "ERISA plans." ERISA (the Employee Retirement Income Security Act of 1974) is the federal law that governs retirement plans. It does not allow non-ERISA plans to operate like ERISA plans, so the plan could be ruled subject to all the constraints of ERISA. Similarly, if there is an explicit or implied reduction in compensation to get the phantom stock, there could be securities issues involved, most likely anti-fraud disclosure requirements. Plans designed just for a limited number of employees, or as a bonus for a broader group of employees that pays out annually based on a measure of equity, would most likely avoid these problems. Moreover, the regulatory issues are gray areas; it could be that a company could use a broad-based plan that pays over longer periods or at departure and not ever be challenged.
Phantom stock and SAR accounting is straightforward. These plans are treated in the same way as deferred cash compensation. As the amount of the liability changes each year, an entry is made for the amount accrued. A decline in value would create a negative entry. These entries are not contingent on vesting. In closely held companies, share value is often stated as book value. However, this can dramatically underrate the true value of a company, especially one based primarily on intellectual capital. Having an outside appraisal performed, therefore, can make the plans much more accurate rewards for employee contributions.