Issues in converting phantom stock plans to actual ownership

By Phillip J. Baptiste, CPA, MT, Cleveland

Editor: Anthony S. Bakale, CPA

Private companies that hope to sell their business in the intermediate term sometimes want to incentivize key executives who are not owners to grow the business's value in exchange for a piece of the growth. This is commonly structured in one of three ways: a phantom stock plan, stock options, or stock appreciation rights (SARs). Generally, under these structures, at the time of sale the plan triggers a payout to the executive that is taxed as compensation when paid. Sometimes, after these plans are in process, the executive and company wish to change the program to allow the executive to receive long-term capital gain treatment on future growth. To accomplish this, the executive would need to have actual ownership in the business rather than a phantom interest, stock option, or SAR. If the plan is changed in exchange for actual ownership, the results under Sec. 409A are vastly different for phantom stock plans, stock options, and SARs.

Before looking into this situation, it is necessary to give a brief overview of Sec. 409A. Sec. 409A was enacted in reaction to the actions of executives of some public companies that went bankrupt during the recession and stock market crash in the early 2000s. Congress was concerned that executives who were legally deferring income taxation on deferred compensation were able to accelerate the payment of the deferred compensation in advance of a company's bankruptcy. This allowed executives with inside knowledge to get paid despite the losses suffered by creditors and shareholders.

Congress sought to eliminate this abuse with Sec. 409A. Unfortunately, the legislation was not limited to public companies; it also applied to private businesses, with no exception for small businesses. As a result, privately held businesses often find themselves trapped in the web of Sec. 409A. A nonqualified deferred compensation plan that violates Sec. 409A, either in design or operation, subjects the employee to immediate income taxation on the vested balance in the plan and a 20% excise tax on the amount included in income.

To comply with Sec. 409A, the plan must be in writing, and distributions from the plan cannot be accelerated and can be made only on account of the following events:

  • Separation from service;
  • Disability;
  • Death;
  • A specified future date;
  • Change of control of the employer; or
  • An unforeseeable emergency.

The conversion of a phantom stock interest to actual ownership represents one of the many Sec. 409A traps that affect private businesses. To illustrate the issue, consider the following:

Example: The value of the company allocated to the executive's program at the inception of the program is $10,000, its value at the date of conversion to actual ownership is $100,000, and the value of the ownership interest at the time of sale is $200,000. The executive is fully vested and is paid only upon a change in control of the business. In comparing the conversion of a phantom interest with that of a stock option or SAR, assume no Sec. 83(b) election has been made. The phantom values are determined based upon a formula in the plan, which happens to track closely to the actual value of the share price.

Under a stock grant or SAR, the general concept is that the executive will be rewarded by the increase in value of the ownership shares allocated at the date of the company sale over the value on the date they were issued. Sec. 83 governs the taxation of stock options and SARs. Under Sec. 83, non-publicly traded stock options are not taxed until they are exercised, unless a Sec. 83(b) election is made to tax them on the date of grant. In the example, the options or SARs will be taxable at the time of exercise as ordinary income since a Sec. 83(b) election was not made. Therefore, at the date of conversion, the executive exercises her option and recognizes $90,000 of taxable income ($100,000 value less exercise price of $10,000). When the company sells, the executive will have capital gain income of $100,000 ($200,000 less cost basis of $100,000).

If the executive was the beneficiary of a phantom stock plan rather than a holder of stock options or SARs, the results would be the same from an income tax standpoint. The executive would have taxable income of $90,000 upon the issuance of the ownership interest and the cancellation of the phantom stock plan. Upon the sale of the company, the executive would have the same $100,000 capital gain.

The three situations seem to have the same economic interests among the parties, and the ultimate payout is based upon the company's sale value, with no seeming ability of the executive to gain an advantage over creditors or other shareholders. However, Sec. 409A penalizes the phantom stock structure but does not affect a stock option or SAR structure.

Regs. Sec. 1.409A-1(b)(5) exempts stock option grants and SARs from the definition of deferred compensation subject to Sec. 409A. Stock option grants are excluded, provided the exercise price at the time of grant is not less than the fair market value (FMV) and the number of shares subject to the option is fixed. Similarly, SARs are excluded if the amount of compensation awarded is not greater than the excess of the FMV on the date of exercise over the FMV on the date of the award. In the example, the conversion date is changed to a date earlier than the date set for exercise in the plan documents. This change does not violate the prohibition on acceleration of benefits in Sec. 409A because the program is not covered by that Code section.

Strangely, even though the phantom stock plan in the example looks and acts like the SAR program, it is treated differently for Sec. 409A purposes. The phantom stock plan provides a formula to value the benefit. Even if the formula provides a value identical to the stock's value, it is not considered a SAR, as its benefit is based upon the phantom stock agreement, not the stock's value. Under Regs. Sec. 1.409A-1(b)(1), a plan provides deferred compensation to the extent that the employee is legally entitled to the rights under the plan. The regulation further states the fact that the rights may be reduced by operation of the plan, including formula valuation, does not create a substantial risk of forfeiture to the rights of the plan and, thus, the plan is not excluded from Sec. 409A. Therefore, phantom stock plans are subject to Sec. 409A even though SARs are not. As such, in the example, the executive would incur an excise tax of $18,000 upon the conversion.

Executives and businesses stuck with this issue may try to plan using Regs. Sec. 1.409A-3(f), which says that an employee can voluntarily forfeit or relinquish his or her rights in a plan without its being deemed a payment, unless another right or payment is substituted. In the example, the issuance of ownership is includible in the executive's taxable income under Sec. 83, is deemed a payment per Regs. Sec. 1.409A-1(b)(4)(i)(B), and thus is a prohibited acceleration, as a change of control has not occurred.

But what if the timing is different for the voluntary forfeiture and the issuance of ownership? For example, the voluntary forfeiture happens before or after the issuance of the ownership interest. In either case, the employee or the employer is taking a risk that the other party will take the desired action and can argue that the ownership issuance is not a substitution for the phantom stock interest. Under the step transaction doctrine, steps in a transaction are generally not collapsed if there is no binding obligation between unrelated parties. However, the IRS will likely argue that there is a quid pro quo and try to tie the transactions together. Also, under the regulation, if the ownership interest's value is materially different from the value of the phantom interest in the plan, it would not be deemed a substitution. Given the lack of guidance in this area, any dispute with the IRS will likely be a messy facts-and-circumstances argument. However, the taxpayer and business may feel it is worth the risk if they have no alternatives.

This is one of the many headaches that Sec. 409A is causing private businesses, and it seems to be far from the intent of the law.


Anthony Bakale, CPA, is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at

Contributors are members of or associated with Cohen & Company Ltd.

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.