"Phantom stock" plans allows a company to reward key employees without actually distributing shares of company stock. Phantom stock is a great way to compensate key employees without making them shareholders of the company, according to Ryan Roberts of thestartuplawyer.com.

Basics of a Phantom Stock Plan

A phantom stock plan is a formal agreement between an employer and an employee in which the company pays the equivalent dollar value of shares of stock without actually issuing the employee stock.

Payment of Phantom Stock

An employee accumulates phantom stock during her career at a company. Upon retirement, separation from the company or death of the employee, the employer pays the value of the phantom stock in cash. Some phantom stock plans have a vesting schedule that determines the number of years of service with the company for full payment of phantom stock.

Benefit to the Employer

Phantom stock plans allow the employer to reward a key employee without diluting ownership in the company. Also, because the employer does not have to pay the employee cash immediately, issuing phantom stock as compensation can increase cash flow.

Benefit to the Employee

Phantom stock plans give the employee compensation equivalant to company stock.

Taxation of Phantom Stock Plans

Employees must pay income tax on the proceeds of a phantom stock plan when they receive the benefit. Phantom stock plans are not qualified retirement plans and do not receive any special tax treatment.

Source:

The Startup Lawyer: Why A Giving Your Employees Phantom Stock Can Boost Your Company