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paying for the privilege. If the stock increases in value, the employee will exercise the option near the
end of the option term. If the stock value does not grow, the employee will allow the option to expire,
having lost nothing. The stock option is a handy device when employees object to paying for their
piece of the action (after all, they are expecting compensation, not expense), but the employer objects
to giving them stock whose current value represents growth from the period before the employees‟
arrival. The exercise price can be more than, equal to, or less than the fair market value of the stock at
the time of the grant, depending on the extent of the incentive the employer wishes to give. Also, the
exercisability of the option will likely vest in stages over time.
Often, however, the founding entrepreneur cannot bring himself or herself to give an employee a
current or potential portion of the corporation‟s stock. Although the block of stock going to the
employee is too small to have any effect on the founder‟s control over the company, the objection may
be psychological and impossible to overcome. Or, in the case of a subchapter S corporation operating
in numerous different states, the employee may not want to have to file state income tax returns in all
those jurisdictions. The founder seeks a device that can grant the employee a growth potential similar
to that granted by stock ownership, but without the stock. Such devices are often referred to as
phantom stock or stock appreciation rights (SARs). In a phantom stock plan, employees are promised
that they may, at any time during a defined period so long as they remain employed by the
corporation, demand payment equal to the then value of a certain number of shares of the
corporation‟s stock. As the corporation grows, so does the amount available to the employees, just as
would be the case if they actually owned some stock. SARs are very similar, except that the amount
available to the employee is limited to the growth, if any, that the given number of shares has
experienced since the date of grant.
Tax Effects of Phantom Stock and SARs
Having described these devices to Morris and Brad, it is, of course, important to discuss their varying
tax impacts upon employer and employee. If Brad has been paying attention, he might immediately
object to the phantom stock and SARs as vulnerable to the constructive receipt rule. After all, if he
may claim the current value of these devices at any time he chooses, might not the IRS insist that he
include each year‟s growth in his taxable income as if he had claimed it? Although the corporation‟s
accountants will require that these devices be accounted for in that way on the corporation‟s financial
statements, the IRS has failed in its attempts to require inclusion of these amounts in taxable income,
because the monies are not unconditionally available to the taxpayer. In order to receive the money,
one must give up any right to continue to share in the growth represented by one‟s phantom stock or
SAR. If the right is not exercisable without cost, the income is not constructively received.
However, there is another good reason for Brad to object to phantom stock and SARs from a tax
point of view. Unlike stock and stock options, both of which represent a recognized form of intangible
capital asset, phantom stock and SARs are really no different from a mere promise by the corporation
to pay a bonus based on a certain formula. Since these devices are not recognized as capital assets,
they are not eligible to be taxed as long-term capital gains when redeemed. This difference is quite
meaningful, as the maximum tax rates on ordinary income and long-term capital gains in 2008 are
35% and 15%, respectively. Thus, Brad may have good reason to reject phantom stock and SARs and
insist upon the real thing.