Employee ownership can be a powerful motivator, but navigating the world of stock-based compensation can be confusing. Two popular options are phantom stock plans and Employee Stock Ownership Plans (ESOPs). Let’s delve into what each entails and how they differ.
Phantom Stock vs ESOP: Quick Comparison
Both phantom stock and ESOPs aim to align employee interests with company growth. They incentivize employees to work towards the company’s success, potentially leading to a bigger payout or a more valuable ownership stake.
Here’s a table highlighting the key differences. We'll get into the details below:
What is a Phantom Stock Plan?
Imagine a stock that tracks a company’s real stock price, but you don’t actually own any shares. That’s the essence of a phantom stock plan. It’s a contractual agreement where employees receive a cash payout based on the performance of the company’s stock at a predetermined future date. Employees benefit from either the full value or appreciated value of the company, as well as owner-like benefits, without the dilution of existing shares.
How Phantom Stock Works
Here's how phantom stock plans work.
Grant
Phantom stock starts with a grant. You decide who gets it and how much. It’s not real stock, but it acts like it. You give your key people a set number of phantom shares. This used to require lawyers and months of work. We built Reins to make it easy for small business owners to set up phantom stock plans in a few clicks.
Vest
Next comes vesting. Vesting means your team earns their phantom shares over time. Most owners use a schedule—like three to five years. You can set up rules for people that leave early. This keeps your best people around.
Triggers
Phantom stock pays out when something big happens. These are called triggers. The most common trigger is a sale of the company. Sometimes, you can set other triggers—like retirement or hitting business milestones. You decide what makes sense for your business.
Cash Payout
When a trigger happens, it’s time for the cash payout. Your team receives compensation in the form of the value of their phantom shares. This is usually a lump sum. The payout is based on your most recent valuation. No ownership changes hands—just cash. Your people win, and you keep control of your company.
How Phantom Stock is Taxed
Phantom stock is simple when it comes to taxes. Your team doesn’t owe anything when you grant or vest the phantom shares. Taxes only come into play when there’s a cash payout—usually after a sale or another trigger event. At that point, the payout is treated as ordinary income for your employees, and they’ll pay income tax on it. For your business, the payout is tax-deductible, just like a bonus or salary. No ownership changes hands, and you don’t have to deal with complicated equity tax rules.
What is an ESOP (Employee Stock Ownership Plan)?
An ESOP is a type of retirement plan where a company sets aside stock for its employees. Unlike phantom stock, employees become actual shareholders in the company, often through a trust that holds the shares on their behalf. This ensures a stake in the company’s long-term success, motivating staff to work hard.
ESOPs continue to be a popular mechanism for companies to attract and retain staff. According to the National Center for Employee Ownership (NCEO), there were 6,533 ESOPs in the United States, holding total assets of over $2.1 trillion as of 2021. There were about 6,322 (5,866 private and 456 public) unique companies with an ESOP plan in place. To note, a company may sponsor multiple plans. All together, ESOPs cover 14.7 million plan participants.
How an ESOP Works
Here's how an employee stock ownership plan works.
ESOP Trusts
An ESOP starts with a trust. The company sets up a special trust to hold shares on behalf of employees. The trust is the legal owner of the stock, not the employees themselves. This setup keeps things organized and makes it easier to manage the plan.
ESOP Share Allocation
Each year, the company decides how many shares to put into the ESOP trust. These shares are then allocated to employees, usually based on their salary or years of service. The longer someone stays and the more they contribute, the more shares they get. Employees don’t buy these shares—they earn them over time.
Valuation
Because ESOP shares aren’t traded on the stock market, the company needs to figure out what they’re worth. This means getting a professional valuation every year. The value of the shares goes up or down with the business. When employees leave or retire, the company buys back their shares at the current value, giving them a real payout.
Cost & Compliance for ESOPs
The costs and compliance requirements for ESOPs are very different from phantom stocks.
ESOP ERISA Compliance
ESOPs are regulated by ERISA, a federal law that sets strict rules for retirement plans. This means you have to follow detailed guidelines for how the plan is set up, managed, and reported. ERISA compliance adds paperwork and legal steps you can’t skip.
ESOP Trustee Requirements
Every ESOP needs a trustee. The trustee’s job is to act in the best interest of your employees. They oversee the plan, make sure it’s run fairly, and handle important decisions like buying or selling company shares. You can use an internal or independent trustee, but either way, it’s a key role.
ESOP Annual Valuation
Since ESOP shares aren’t publicly traded, you need a professional valuation every year. This annual ESOP valuation sets the price for shares in the plan. It’s required by law and helps make sure employees get a fair deal when they cash out.
ESOP Audit Requirements
If your ESOP covers more than 100 participants, you’ll need an annual audit. This ESOP audit checks the plan’s financials and makes sure everything is above board. Audits add extra cost and time, but they’re required to keep your plan compliant and your employees protected.
ESOP Financing
Many ESOPs are funded through loans, known as leveraged ESOPs, where the company borrows money to buy shares for the plan and pays it back over time.
Repurchase Obligation
Repurchase obligation is a big part of running an ESOP. When employees leave or retire, the company has to buy back their shares at the current value. This means you need to plan ahead for cash flow, so you’re ready to make those payouts. The company—not the ESOP trust or the employees—pays for the repurchase. Timing matters, too. Some companies pay all at once, while others spread payments out over a few years.
It’s common to handle large payouts in installments. For example, if you owe $1 million, you might pay $200,000 per year over five years. Good planning keeps your business stable and your team happy when it’s time for them to cash out.
Phantom Stock vs ESOP: Deep Dive
Choosing between phantom stock and an ESOP isn’t just about picking a plan—it’s about what fits your business, your goals, and the flexibility your team needs. Both options help you reward and retain key people, but they work in very different ways. Here’s a closer look at how they stack up on the things that matter most to owners.
Ownership & Dilution
Phantom stock doesn’t give away any real ownership. There’s no dilution, no voting rights, and no changes to who controls the company. Employees get the value, but not the power. With an ESOP, employees actually own shares through the trust. This can mean some dilution for current owners and, in rare cases, minority shareholder rights. ESOP participants don’t usually get direct voting power, but they do have some rights under the law.
Complexity & Admin
Phantom stock is simple. You need a clear agreement and a way to track shares, but there’s no government filing or special fiduciary role. ESOPs are much more complex. They require legal documents, government filings, a trustee, and strict compliance with ERISA. You’ll need to manage annual valuations, audits, and a lot more paperwork. For small business owners, all this extra complexity can mean more time, higher costs, and a bigger headache just to keep the plan running.
Cash-Flow Impact
With an ESOP, the company must buy back shares from employees when they leave or retire. This can create big cash needs, especially if several people leave at once, because you’re required by law to repurchase those shares at their current value. Phantom stock works differently. There are no buyback requirements or ongoing payouts when someone leaves. You only pay cash when a specific trigger event happens—like the sale of the company or a pre-determined business milestone. This makes it much easier to plan for and manage your company’s cash flow.
Taxes & Accounting
Phantom stock payouts are taxed as ordinary income for employees and are deductible for the company. There’s no tax impact until a payout happens. ESOPs have more moving parts. Contributions to the ESOP are tax-deductible, and employees don’t pay tax until they get their payout. But the accounting and reporting are more involved, and you’ll need help from professionals.
Timeline to Launch and Ongoing Upkeep
Phantom stock can be set up fast. At Reins, we help businesses set up and manage phantom stock plans in just a few clicks. ESOPs take much longer to launch, often six months or more. They need ongoing attention, including annual valuations, audits, and compliance work. If you want simple and quick, phantom stock wins. If you want a full employee ownership plan, ESOPs are the way to go.
Total Cost of Ownership
Phantom stock is much more affordable to set up and maintain. You’ll pay for a simple agreement and maybe a yearly valuation, but there’s no need for ongoing legal, audit, or compliance fees. ESOPs, on the other hand, come with high upfront costs—legal work, plan documents, and setup fees—and ongoing expenses like annual valuations, trustee fees, audits, and government filings. For most small businesses, the total cost of ownership for an ESOP is significantly higher, both at launch and year after year.
When Phantom Stock Makes More Sense
Most SMBs under ~150 employees choose phantom stock for speed and control.
- Fewer than 150 employees
- Owner wants to keep full control and avoid giving up voting rights
- No interest in diluting ownership
- Need a faster rollout (weeks, not months)
- Ideal for trades and small to mid-sized businesses (HVAC, plumbing, electrical, construction, etc.)
- Want a simple, clear plan that’s easy for employees to understand
- Prefer to avoid ongoing legal, audit, and compliance headaches
Phantom stock for small business: A real-world example
Tony Cooper, owner of Cooper’s Plumbing & Air, wanted to reward and retain top talent without giving up control or dealing with complicated legal structures. After struggling to find clear advice from lawyers, Tony found Reins and quickly rolled out a phantom stock plan for his team. The process was fast and easy, and employees could finally see and trust their incentives.
"I can feel a culture shift as we have implemented this and put it right in their hands, the potential opportunity that they have in front of them." - Tony Cooper, Owner of Cooper’s Plumbing & Air
The result? A culture shift—more motivation, better employee retention, and a team that’s bought in for the long haul. This is a classic phantom stock example for small business owners who want to keep things simple and effective.
Learn more: Cooper’s Plumbing journey with phantom stock
When an ESOP Makes More Sense
ESOPs fit companies planning employee ownership succession and those able to fund repurchases.
- Owner wants to sell or transition the business to employees over time
- Company has a larger headcount (usually 50+ employees)
- Business can handle the cash flow needed for ESOP repurchase obligations
- Looking for unique ESOP tax benefits, like selling owners deferring capital gains or the company paying less in federal taxes
- Interested in building a legacy of employee ownership
- Ready to invest in ongoing compliance, audits, and annual valuations
If you’re thinking about succession and want your employees to take over, an ESOP is built for that. ESOPs let you sell all or part of your company to your team, often with big tax advantages for both you and the business. For companies with the right size and resources, ESOPs can create a strong ownership culture and a smooth path for succession—making them a smart choice for long-term planning.
Phantom Stock vs ESOP: Final Takeaways
The choice between phantom stock and ESOPs depends on the company’s goals and employee preferences. Phantom stock offers simpler administration for companies but might not be as attractive to employees due to ordinary income tax implications. ESOPs provide actual ownership with potential capital gains benefits, but come with increased administrative burdens and potential dilution for existing shareholders.
If you're interested in learning more about phantom stock plans, you can book a free call with our team. We'll get to know your business and can see if it's a good fit for you.
