Phantom stock is a form of compensation where a company promises to pay cash at some future date, in an amount equal to the market value of a number of shares of its stock. Thus, the payout will increase if the stock price rises, and decrease if the stock falls, but without the recipient actually receiving any stock. Like other forms of stock-based compensation plans, phantom stock broadly serves to encourage employee retention, and to align the interests of recipients and shareholders. Recipients are typically employees, but may also be directors, third-party vendors, or others.
Phantom stock is essentially a cash bonus plan, although some plans pay out the benefits in the form of shares. Phantom stock is favored by closely held or family-owned companies who want to incentivize management and other employees without granting them equity. Phantom stock grants align employees' motives with owners' motives (that is, profit growth, increased stock prices) without granting employees an actual ownership stake in the company. Phantom stock can, but usually does not, pay dividends. When the payout is made, it is taxed as ordinary income to the employee and is deductible to the employer. Generally, phantom plans require the employee to become vested, either through seniority or meeting a performance target.
Normally, phantom stock is taxable upon vesting, even if not paid out. Use of a "rabbi trust" may solve this problem in some jurisdictions; however, that subjects the payout to significant risk, such as by not being protected from the company's creditors in the event of corporate bankruptcy.
For accounting purposes, phantom stock is 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 reduce the liability. These entries are not contingent on vesting. Phantom stock payouts are taxable to the employee as ordinary income and deductible to the company. However, they are also subject to complex rules governing deferred compensation that, if not properly followed, can lead to penalty taxes.