Most explanations of phantom stock stop at the mechanics. Owners want the number. So here is a complete phantom stock plan example, run three ways, with the tax and the funding included — because the payout figure everyone quotes is not the figure the company actually experiences.
All figures below are hypothetical and for illustration only. They are not a projection, a quote, or a representation of any particular plan’s results.
The short answer
In this phantom stock plan example, a $20 million manufacturer grants its VP of Operations 200 appreciation-only phantom units, each tracking 0.01% of enterprise value, with a five-year cliff and a three-installment payout. If the company grows 8% a year to $34.3 million, the year-seven payout is $286,000 — roughly 2% of the appreciation, taxed to the employee as ordinary W-2 income and deductible to the company. A flat year pays $0. A sale in year six pays $360,000 or $234,000 depending on one sentence in the plan document. And long before any check is written, the award accrues on the P&L, reaching about $52,000 a year by year seven.
The setup for this phantom stock plan example
Meridian Fabrication is an S corporation with $28 million in revenue and an enterprise value of $20 million. The owner, Dan, is 58 and intends to sell in seven to ten years. His VP of Operations, Karen, has been with the company eleven years, runs the plant, and has been approached twice by a competitor. Dan is not giving up stock.
The plan design
| Plan type | Appreciation only |
| Units granted | 200 phantom units |
| Unit definition | Each unit tracks 0.01% of enterprise value |
| Baseline value at grant | $20,000,000 × 0.01% = $2,000 per unit ($400,000 total) |
| Valuation method | 5.0× trailing twelve-month adjusted EBITDA, determined annually |
| Vesting | Five-year cliff |
| Payment trigger | The later of vesting or separation from service; accelerated on a 409A change in control |
| Payout form | Three equal annual installments |
| Forfeiture | Unvested units forfeited on voluntary resignation or termination for cause |
Scenario 1: The company grows as expected
Meridian grows roughly 8% a year in value. At the end of year seven, enterprise value is $34.3 million.
| Amount | |
|---|---|
| Value per unit at grant | $2,000 |
| Value per unit at payout ($34,300,000 × 0.01%) | $3,430 |
| Appreciation per unit | $1,430 |
| Units | 200 |
| Gross payout to Karen | $286,000 |
| Paid as | Three installments of ~$95,333 |
| Karen’s tax treatment | Ordinary W-2 income in each installment year |
| Company deduction | $286,000, spread across the three payment years |
What it actually cost Dan
Enterprise value grew $14.3 million over seven years. Karen captured $286,000 of it — 2% of the appreciation. Dan kept 100% of the stock, 100% of the vote, and 98% of the growth. And because Meridian is a pass-through, the deduction flows to Dan personally; at a 37% marginal rate the after-tax cost of the $286,000 is roughly $180,000, spread over three years.
Set that against the alternative Dan was contemplating: a 2% equity grant. Karen would have received 2% of the whole $34.3 million company, not 2% of the growth — a $686,000 stake, plus voting rights, plus information rights, plus a permanent second shareholder in an S corporation, plus a buy-sell negotiation whenever she leaves.
Scenario 2: The company is flat
Year seven arrives and enterprise value is still $20 million. Appreciation per unit is zero.
Payout: $0.
The design worked exactly as intended — the company owes nothing because it created nothing. But read the human side. Karen stayed seven years, hit her vesting cliff, and received nothing. If Dan does not see that coming and prepare for it, he loses her in year eight and the plan will have actively damaged the relationship it was built to protect.
This is the strongest argument for a blended design: a modest full-value tranche that pays something even in a flat year, plus an appreciation tranche that pays real money if the business grows. The full-value piece says “thank you for staying.” The appreciation piece says “thank you for building.”
Scenario 3: The company is sold in year six
A strategic buyer acquires Meridian in year six at $38 million — a premium to the formula value, which is typical, since the plan formula was a conservative 5× EBITDA and the buyer paid roughly 6×.
This is where plan drafting earns its fee. Two possible outcomes from the same transaction:
| Plan says “transaction value” | Plan says “formula value” | |
|---|---|---|
| Enterprise value used | $38.0M (deal price) | $31.7M (5× EBITDA) |
| Value per unit | $3,800 | $3,170 |
| Appreciation per unit | $1,800 | $1,170 |
| Payout on 200 units | $360,000 | $234,000 |
A $126,000 difference, decided by one sentence written six years earlier. Karen’s view is that she helped build the thing the buyer paid $38 million for. Dan’s view is that the plan said 5× EBITDA. Both are reasonable, which is why the change-of-control provision has to be explicit — and why it has to use the 409A definition of a change in control rather than the phrase “sale of the company,” which is not a definition and creates a compliance problem alongside the valuation dispute.
The part the example usually leaves out: the P&L
Meridian did not experience the Scenario 1 plan as a single $286,000 event in year seven. Phantom stock is a liability-classified award, generally re-measured each reporting period, so compensation expense accrued on the income statement every year as company value rose — a non-cash charge, before any money moved.
Roughly, under the 8% growth path:
| Year | Enterprise value | Cumulative phantom liability | Approximate annual expense |
|---|---|---|---|
| 1 | $21.6M | $32,000 | $32,000 |
| 3 | $25.2M | $104,000 | ~$38,000 |
| 5 | $29.4M | $188,000 | ~$44,000 |
| 7 | $34.3M | $286,000 | ~$52,000 |
Two implications. First, if Meridian has a credit facility with an EBITDA or fixed-charge covenant, that accrual is a conversation to have with the bank before adoption, not after. Second, a buyer performing diligence in year six will see the liability on the balance sheet and will price it — so the plan reduces the headline purchase price by roughly its carrying value even though it also increases what a buyer will pay for an intact management team. Net, most owners come out ahead, but it is not free and nobody should present it as free.
And the part that decides whether the plan works: funding
Dan has to write $286,000 in cash starting in year seven, on a schedule driven by Karen’s separation rather than by Meridian’s cash position. Three ways he can handle it:
- Operating cash. Workable at $286,000 spread over three years for a company this size. Much less workable if Dan adds three more participants and the aggregate liability reaches seven figures.
- Sinking fund. Set aside roughly $30,000–$40,000 a year in taxable investments. Disciplined, but the earnings are taxed annually while the liability grows at the company’s full 8%.
- Informal funding with corporate-owned life insurance. Meridian owns a policy on Karen, is the beneficiary, and builds cash value on its own balance sheet against the future obligation. The asset stays the company’s, the death benefit is intended to recover the plan’s cost over time, and the arrangement must satisfy the IRC 101(j) notice-and-consent requirements before the policy is issued — a step that is easy to miss and cannot be fixed afterward.
More on the funding side: Corporate Owned Life Insurance: A Strategic Guide.
What this phantom stock plan example is meant to show
Four things, and none of them are the payout number:
- Appreciation-only plans cost the owner a small share of growth, not a share of the company. 2% of the increase, not 2% of the whole.
- A flat year produces a zero payout, and that is a design risk, not just a good outcome. Plan for the human consequence.
- The change-of-control language is worth more than any other sentence in the document. In this example it was worth $126,000.
- The plan is experienced as a P&L accrual for years before it is experienced as a check. Model both.
Every one of those depends on decisions made at design time, under 409A rules that make them very hard to revisit. That is the argument for modeling the plan against your actual numbers before anything is drafted.
Have your plan modeled against your real numbers →
Phantom stock plan example: common questions
How much does a phantom stock plan actually pay out?
It depends entirely on growth, because most closely held plans are appreciation-only. In this example, 200 units each tracking 0.01% of a $20 million company pay $286,000 after seven years of 8% growth — the difference between $2,000 and $3,430 of value per unit, multiplied by 200 units. The same grant pays nothing if value never rises.
How is a phantom stock payout taxed?
As ordinary W-2 compensation income to the employee in the year each installment is received, subject to income and payroll tax withholding. The company takes a compensation deduction in the same year. There is no capital gains treatment and no Section 83(b) election, because no property changes hands at grant. In a pass-through, that deduction flows to the owner personally.
What happens if the company does not grow?
An appreciation-only plan pays zero. That is the design working as intended — the company owes nothing because no value was created — but it is a retention risk, not just a good outcome. A participant who stayed through a five-year cliff and received nothing is a participant who may leave the following year. A blended design with a small full-value tranche pays something in a flat year.
What happens to phantom stock when the company is sold?
Whatever the plan document says. In this example a $38 million sale in year six pays $360,000 if the plan measures value at transaction price, or $234,000 if it measures at the 5x EBITDA formula — a $126,000 spread decided by one sentence. The provision should also use the 409A definition of a change in control rather than an undefined phrase like “sale of the company.”
How does phantom stock affect the P&L before anything is paid?
Phantom stock is a liability-classified award, generally re-measured each reporting period, so compensation expense accrues every year as company value rises — a non-cash charge well before any money moves. In this example the annual expense grows from about $32,000 in year one to roughly $52,000 by year seven, with a cumulative liability of $286,000 on the balance sheet. If the company has EBITDA or fixed-charge covenants, that is a conversation to have with the bank before adoption.
How much of the company’s growth does a phantom stock plan give away?
In this example, about 2% of the appreciation — $286,000 out of $14.3 million of value created. The owner keeps 100% of the stock, 100% of the vote and 98% of the growth. A 2% real equity grant would instead have handed over 2% of the entire $34.3 million company, plus voting and information rights and a permanent second shareholder.
Related reading
- What Is a Phantom Stock Plan? The Complete Guide
- How Is Phantom Stock Taxed?
- The Business Owner’s Setup Guide
All figures in this article are hypothetical and for illustrative purposes only. They do not reflect the results of any actual plan and are not a projection. This material is general information, not tax, legal, or investment advice. Schiff Executive Benefits does not provide tax or legal advice.