Taxes and Business Decisions 331stock option is a handy device when the employee objects to paying for his
piece of the action (after all, he is expecting compensation, not expense) but
the employer objects to giving the employee stock whose current value repre-
sents growth from the period before the employee’s arrival. Again, 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 upon the extent of the incentive the em-
ployer wishes to give. Also, the exercisability of the option will likely vest
in stages over time.
Often, however, the founding entrepreneur cannot bring herself to give
an employee a current or potential portion of the corporation’s stock. Although
she has been assured that the block of stock going to the employee is too small
to have any effect on her control over the company, the objection may be psy-
chological and impossible to overcome. Or, in the case of a subchapter S cor-
poration operating in numerous states, the employee may not want to have to
file state income tax returns in all those jurisdictions. The founder seeks a de-
vice which 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,
the employee is promised that he may, at any time during a defined period so
long as he remains employed by the corporation, demand payment equal to the
then value of a certain number of shares of the corporation’s stock. As the cor-
poration grows, so does the amount available to the employee just as would be
the case if he 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 in-
sist 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 de-
vices 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 tax-
able income because the monies are not unconditionally available to the tax-
payer. 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