Industry Insights

From the Retention Toolbox:  Employee Stock Options, Phantom Stock & Deferred Compensation Plans

November 2014
Authors:  Tim Chitwood

Tim Chitwood



Health Care
Manufacturing & Distribution

910 E. St. Louis Street, Suite 200
P.O. Box 1190
Springfield, MO 65801-1190 (65806)


 & Gary Schafer

Gary Schafer

Managing Partner


Manufacturing & Distribution

910 E. St. Louis Street, Suite 200
P.O. Box 1190
Springfield, MO 65801-1190 (65806)


What is logistics all about?

While many people would think about the trucks, trains or planes hauling goods from point A to point B, most executives would be quick to point out the single most important element of a successful transportation company is its people.

Retaining the best and brightest employees and attracting top talent are strategic concerns for many companies in the transportation industry. Transportation companies rely on the skills and experience of this unique labor pool; as the population ages and more people move toward retirement, the situation likely will only grow more challenging. As a result of these demographic changes, companies are increasingly focused on determining how to replace key employees.

Small and midsize enterprises often have the toughest time recruiting top talent. Companies across the board will need to get compensation levels right, and this includes more than just wages. The average annual salary for a logistics professional in the U.S. increased 45 percent between 1996 and 2004 and has increased another 13 percent since 2007 after a three-year period of stagnation. A recent Delphi study reported the following list of benefits perceived as important by U.S. logistics employees:

  • Expense reimbursement (64 percent)
  • Pension plans (64 percent)
  • Variance cash bonus (58 percent)
  • Share or options (58 percent)

Employers may consider stock options or other variable compensation awards as parts of an effective compensation package for key team members. The adopted plan's specific structure can significantly affect the accounting treatment, cash flow impacts and tax implications. Consider these alternatives commonly evaluated by private companies.

Stock Options

Stock options give the recipient a temporary right to buy a number of shares at an exercise price defined at the grant date. The options become exercisable over a period of time or once the conditions specified in the grant agreement are met. Some companies set time-based vesting schedules but allow options to vest sooner if performance goals are met. Once vested, the individual can exercise the option at any time until it expires or is forfeited, which often occurs automatically when an employee is terminated.

Companies must use an option-pricing model to calculate the fair value of options on the date they are granted and show this as an expense on their income statement over the vesting period, typically with an offsetting increase to additional paid-in capital.

Options take one of two forms:  incentive stock options (ISOs) or nonqualified stock options (NSOs). While generally accepted accounting principles are similar for either type of option, the tax results differ.

When an employee exercises an NSO, the difference between the price paid for the shares and fair value of the stock as of that date is taxable to the employee as ordinary income, even if the shares are not yet sold. A corresponding amount is deductible by the company. Any gain or loss when the employee sells the stock is taxed as a capital gain or loss. Note:  If the exercise price of the NSO is less than fair market value on the date the option is granted, it is subject to the deferred compensation rules under Internal Revenue Code Section 409A vs. 409(a); it may be taxed at vesting and the option recipient subject to penalties.

By contrast, an ISO can offer tax advantages to employees; they can defer taxation on the option from the date of exercise until the date the underlying shares are sold and apply capital gain tax rates—rather than the higher ordinary income tax rates—to the proceeds. The employer may get a tax deduction corresponding to the proceeds received by the employee when the stock is sold, but may get no tax deduction in certain situations. IRS deferred compensation rules don’t apply to ISOs. Certain specific conditions must be met to qualify for ISO treatment.

Phantom Stock & Stock Appreciation Rights

Phantom or virtual stock and stock appreciation rights (SARs) are similar in many respects. Both essentially are bonus plans that grant the right to receive an award based on the value of the company’s stock. SARs typically provide the employee a cash or stock payment based on the increase in the value of a stated number of shares over a specific period. Phantom stock provides a cash bonus based on the value of a stated number of shares, to be paid out at the end of a specified period. SARs may not have a specific settlement date; as with options, the employees may have flexibility in choosing when to exercise the SAR. Phantom stock may offer dividend equivalent payments; SARs won't. The value used to determine compensation to be paid may be determined by an arbitrary formula based upon the company’s performance or derived from a third-party valuation of employer stock. When the payout is made, the value of the award is taxed as ordinary income to the employee and is deductible to the employer. Some phantom plans require the employee to meet certain objectives, such as sales, profits or other targets; these plans often refer to their phantom stock as “performance units.” If a phantom plan is broadly available to many groups of employees and is designed to pay out upon termination, the plan could be subject to federal retirement plan rules, which should be considered when structuring such programs.

Phantom stock and cash-settled SARs use liability accounting, meaning the associated accounting costs aren't settled until they pay out or expire. For phantom stock compensation, expense is calculated by period based on the underlying value and trued up through the final settlement date. The compensation expense of SARs is estimated each period using an option-pricing model and trued up when the SAR is settled.

Cashing Out

Employees who exercise stock options at some point will want to sell the shares, at least in sufficient amounts to pay their taxes. Is there a market for the stock? On one hand, allowing employees to sell shares to outside investors avoids the need for the employer to come up with the cash for that portion of their compensation. On the other hand, to control who may own stock in the company, the employer may want a first right of refusal to purchase the shares or require employees to sell the stock back to the company. Doing this may require cash payments on a schedule that are difficult to forecast.

Because phantom plans and SARs are essentially cash bonuses, they avoid many of the potential problems associated with proliferating minority shareholders and can be simpler to administer and account for. However, the entire burden of funding the compensation expense under these programs remains with the employer. Careful planning and design can help mitigate some potential problems—for example, providing the option to defer cash payments to periods when cash flow is available.

When considering which plan type may fit best, decision criteria could include:

  • Cash flow – Can the company afford to pay cash bonuses when they would be due under a phantom stock or SAR program? Can it afford to repurchase shares of stock from employees? Care should be taken to structure cash requirements to fit company needs.
  • Dilution of ownership – If the company is family-owned or closely held, what problems could arise from more individuals holding small numbers of shares? These could include increased complexity of communication, more time spent on investor relations and potential complications in making decisions about the future of the business.
  • Administrative complexity costs – Applying option-pricing models for stock options can be complex and require consultation with outside experts. If a plan is designed to require annual or periodic valuations of the company’s stock, this could be an additional cost if such valuations are not obtained for other purposes.

Contact your BKD advisor to help you put together the puzzle and structure an incentive compensation plan to effectively engage and retain your key employees. 


The transportation industry employees most frequently referenced in articles about attracting and retaining workers during the past two decades have been drivers. Since the industry was deregulated in 1980, there has been a nearly continual shortage of quality drivers. However, the authors of this article are correct that many transportation and logistics companies—especially small and midsize organizations—have difficulty attracting and retaining the best and brightest management talent.

Beginning with deregulation and fueled by consistently increasing energy costs, many shipping companies, especially large organizations, have upgraded their inventory management and distribution departments. Through the years, the title of individuals in charge of these functions has migrated from manager to vice president, or in some cases chief logistics officer. Key positions and experience requirements on the transportation company side often have required similar upgrades in quality and experience. These changes have led to the need to upgrade compensation plans for these individuals.

I have had firsthand experience with stock option, SAR and deferred compensation plans. Frequently, publicly held companies use stock option plans, and private companies utilize SAR or phantom stock programs. Deferred compensation plans seem to be a bit less common, but they are, in my opinion, one of the better alternatives for seasoned managers interested in accumulating and managing wealth.

Younger managers in the early stages of their career with growing families and increasing spending levels tend to be more interested in compensation arrangements that generate shorter-term funds. Stock option plans and cash bonus programs usually can be structured to address these shorter-term needs. More seasoned employees frequently are more interested in programs that accumulate wealth; deferred compensation and certain SAR designs can focus on this longer-term horizon.

The individual benefits of a stock option program associated with a publicly held company often are subject to timing and movements in the overall stock market and not just the results of the organization. While it's desirable for a compensation program to align personal and company goals on key factors, such as profitability, a SAR or phantom stock program that rewards managers directly for positive earnings or company net worth increases can be much more effective than a program affected by external factors like the market. Stock option programs also can offer additional income tax advantages, since employees may be able to convert some income to capital gains.

Even though deferred compensation programs typically result in income being taxed at ordinary income tax rates rather than capital gains rates, I like the flexibility of some of these programs. Stock option plans usually are associated with a fairly short time frame in order to exercise the purchasing opportunity. Deferred compensation plans usually can be structured to fund and recognize income through a period of 10 to 20 years or at retirement, when earned income and income tax rates may be lower. Deferred plan funds typically also are compounded as pre-tax and deferred tax dollars.

One additional obvious benefit:  These programs can, in many cases, be partly structured as compensation related to health and welfare. The best managers these days are extremely concerned with both their families’ current and long-term health care costs. Top management must continue to review and modify plans and programs in these areas to provide the best quality and tax-advantaged benefits the organization can afford.

About Donald

Donald G. Cope, retired, is former chief accounting officer for J. B. Hunt Transport Services, Inc. (JBHT), a publicly traded transportation and logistics company based in Lowell, Arkansas. During his 20-year tenure with JBHT, he served as vice president – controller and senior vice president and was responsible for, among other duties, the company’s budgeting, internal audit and SOX compliance and SEC reporting activities. He also was involved in developing and implementing several new financial and reporting systems and activities.

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