Equity Incentive Plans Beyond Stock Options: Phantom Shares, SARs, and More for Canadian Private Companies
By Bader A. Chowdry, CPA, CA, LPA | Insight Accounting CPA
# Equity Incentive Plans Beyond Stock Options: Phantom Shares, SARs, and More for Canadian Private Companies
By Bader A. Chowdry, CPA, CA, LPA | Insight Accounting CPA
For growing businesses in Mississauga, Toronto, and across the GTA, attracting and retaining top talent often requires competitive compensation beyond salary. While stock options remain popular, they’re not the only—or even the best—equity incentive tool for private companies in Ontario.
Alternative equity compensation structures like phantom shares, Stock Appreciation Rights (SARs), and restricted share units offer flexibility without diluting ownership, triggering complex valuations, or creating immediate tax liabilities for employees.
At Insight Accounting CPA, we help Ontario business owners design tax-efficient equity incentive plans that align employee interests with long-term business success while navigating CRA compliance requirements.
This comprehensive guide explores equity incentive plans beyond traditional stock options, their tax treatment in Canada, and strategic implementation considerations for private companies.
Why Private Companies Need Alternatives to Stock Options
Limitations of Traditional Stock Options
While stock options grant employees the right to purchase shares at a fixed price, they come with several challenges for private companies:
1. Ownership Dilution
- Each exercised option creates new shares, diluting existing shareholders’ equity
- Can complicate cap tables and future financing rounds
- May trigger shareholder agreements and tag-along/drag-along provisions
- Fair market value (FMV) must be established at grant for tax purposes
2. Valuation Complexity
- Independent valuations can cost $5,000-$15,000+ annually
- Valuation disputes with CRA can result in retroactive tax assessments
- Employees may lack cash to exercise options
3. Limited Liquidity
- No public market for private company shares
- Exercise creates tax liability without corresponding cash benefit
- Requires share issuance infrastructure
4. Administrative Burden
- Securities law compliance (even for private exemptions)
- Ongoing tracking of vesting, exercise windows, and tax reporting
- Employees receive “phantom” shares that mirror real share value
Advantages of Phantom Equity Plans
Alternative equity incentive structures address these limitations:
✅ No share dilution — owners maintain their equity percentage
✅ Simpler valuation — formula-based or discretionary valuations
✅ Cash settlement — no share transfer required
✅ Flexible structure — customize vesting, performance metrics, and payout timing
✅ Lower admin costs — no share issuance or securities filings
Types of Equity Incentive Plans Beyond Stock Options
1. Phantom Share Plans (Phantom Stock)
How They Work:
- At vesting or exit event, employees receive cash equal to share appreciation
- No actual shares are issued
- Payments are taxable employment income to the employee
Tax Treatment:
- Tax-deductible to the corporation as compensation expense
- Taxed only when cash is received (not at grant or vesting)
- Companies wanting to reward long-term value creation without dilution
Best For:
- Owners who want to maintain 100% control
- Businesses with predictable exit timelines (e.g., planned sale in 3-5 years)
- Employees receive right to cash payment equal to share price increase
Example:
Insight Accounting client in Mississauga’s tech sector granted 1,000 phantom shares to a senior developer in 2023 at $50/share value. At 2026 exit ($120/share), the employee receives $70,000 cash [(1,000 × $120) – (1,000 × $50)]. The company deducts this as a business expense.
2. Stock Appreciation Rights (SARs)
How They Work:
- Settlement occurs at exercise (employee-controlled) or vesting (employer-controlled)
- Can be linked to company valuation formula or third-party appraisal
- Cash payout taxed as employment income
Tax Treatment:
- Deductible to the corporation
- No tax at grant; tax only upon cash settlement
- Companies wanting employee-controlled timing (like stock options but cash-settled)
Best For:
- Businesses with annual valuation mechanisms already in place
- Sectors where employees understand equity appreciation (tech, real estate development)
- Employees receive units representing right to future share delivery (or cash equivalent)
Key Difference from Phantom Shares:
SARs typically give employees exercise discretion within a window (similar to stock options), while phantom shares usually pay out automatically at vesting or exit.
3. Restricted Share Units (RSUs)
How They Work:
- Units vest over time (e.g., 4 years with 1-year cliff)
- At vesting, employee receives shares OR cash equal to share value
- If settled in shares: Taxed as employment income at FMV on vesting date
Tax Treatment:
- If settled in cash: Taxed as employment income when cash received
- Corporation gets tax deduction equal to employee’s income inclusion
- Companies planning eventual liquidity event (IPO, acquisition)
Best For:
- Businesses wanting flexibility to settle in shares or cash
- Situations where employees want actual equity participation
- Similar to RSUs but vesting tied to performance metrics (revenue, EBITDA, customer growth)
Private Company Variation:
Many Ontario private companies use “cash-settled RSUs” (functionally similar to phantom shares) to avoid share issuance complexity while maintaining RSU terminology familiar to employees from larger firms.
4. Performance Share Units (PSUs)
How They Work:
- Units granted at target level; actual payout varies based on achievement
- Typically settled in cash for private companies
- Identical to RSUs—taxed as employment income upon settlement
Tax Treatment:
- Deductible to corporation
- Aligning incentives with specific growth targets
Best For:
- Fractional CFO or senior management compensation
- Companies with measurable, objective performance metrics
- Employees receive units representing share of future profits or distributions
Example Structure:
Target grant: 500 units
Below threshold (90% of target): 0 units vest
At target (100%): 500 units vest
Above target (120%): 750 units vest (150% payout)
5. Profit-Sharing Units
How They Work:
- Payments occur as company generates profits (not tied to exit event)
- Can be structured with vesting schedules
- Payments taxed as employment income
Tax Treatment:
- Deductible to corporation as compensation
- Established, profitable businesses with regular cash flow
Best For:
- Family businesses balancing employee incentives with owner control
- Companies not planning near-term sale
- Written plan agreement detailing vesting, valuation, and payout terms
Tax Considerations for Equity Incentive Plans in Canada
Employee Tax Treatment Summary
| Plan Type | Taxable Event | Tax Character | Timing |
|———–|————–|————–|——–|
| Phantom Shares | Cash payment | Employment income | When cash received |
| SARs | Cash settlement | Employment income | At exercise/settlement |
| Cash-Settled RSUs | Vesting/payment | Employment income | When cash received |
| Share-Settled RSUs | Vesting | Employment income | When shares vest |
| PSUs | Performance payout | Employment income | When cash/shares received |
Employer Tax Deductions
✅ All cash-settled plans are deductible as employee compensation in the year paid
✅ Share-settled RSUs: Deduction equal to income inclusion by employee
✅ No payroll tax burden until cash payment (unlike stock options, which can create deemed employment benefit before exercise)
Key Tax Advantage: No Section 7 Stock Option Benefit
Traditional stock options trigger Section 7 income inclusion (employment benefit = FMV at exercise minus exercise price). This creates tax liability even if shares remain illiquid.
Phantom plans and SARs avoid this problem—tax only when cash is received.
CRA Compliance Requirements
📋 Documentation:
- Board resolution approving plan and individual grants
- Employment agreement amendments referencing the plan
- Reasonable, defensible valuation methodology
📋 Valuation:
- Formula-based (e.g., multiple of EBITDA) or third-party appraisal
- Document assumptions and update regularly
- Report cash payments as employment income on T4 slips
📋 Reporting:
- Withhold income tax and CPP at source
- Track vesting schedules and update accruals
- Retention of key employees over 3-5 years?
Designing an Equity Incentive Plan for Your Ontario Business
Step 1: Define Objectives
What are you trying to achieve?
- Alignment with specific growth metrics (revenue, profitability)?
- Reward for long-term value creation vs. annual performance?
- Attraction of senior talent from competitors?
- Time-based: 25% per year over 4 years with 1-year cliff
Step 2: Choose Plan Structure
Decision Framework:
| If You Want… | Consider… |
|—————-|————-|
| No ownership dilution | Phantom shares or SARs |
| Employee exercise discretion | SARs |
| Performance-based vesting | PSUs |
| Ongoing profit participation | Profit-sharing units |
| Actual equity ownership (eventually) | Share-settled RSUs or restricted shares |
| Maximum tax deduction | Any cash-settled plan |
Step 3: Set Vesting Schedule
Common Vesting Structures:
- Performance-based: 100% upon achieving $10M revenue or successful exit
- Hybrid: 50% time-based, 50% tied to EBITDA milestones
- Plan document (master agreement)
GTA Best Practice:
Use 1-year cliff (no vesting in first year) to protect against early employee turnover.
Step 4: Establish Valuation Methodology
Options:
1. Formula-Based Valuation
– Example: Book value × 1.5
– Example: 5× trailing 12-month EBITDA
– Updated annually or at triggering events
2. Third-Party Appraisal
– Independent business valuator
– Typically $8,000-$15,000 per valuation
– Stronger CRA defensibility
3. Discretionary Valuation
– Board determines value each year
– Requires strong documentation and consistency
– Higher audit risk if values appear unreasonable
Step 5: Draft Legal Documentation
Required Documents:
- Individual grant agreements
- Board resolutions
- Employment agreement amendments
- Shareholder agreements (if phantom units have voting/consent rights)
- Employment lawyer for plan documentation
Work with:
- CPA for tax structuring and compliance
- Business valuator for valuation methodology
- Phantom plans create liability on balance sheet
Step 6: Financial Reporting & Accruals
ASPE Accounting:
- Expense recognized over vesting period based on estimated payout
- Adjusted each period for valuation changes
- Valuation formula: Most recent preferred share price
Example:
1,000 phantom shares granted at $50 FMV, 4-year vesting. Year 1 expense = (1,000 × $50 × 25%) = $12,500. If FMV increases to $60 in Year 2, cumulative expense adjusts upward.
Real-World Applications in Mississauga and the GTA
Case Study 1: Tech Startup Retention Plan
Client: SaaS company in Toronto, 20 employees, pre-revenue but venture-backed
Challenge: Competing with larger firms for engineering talent; founders wanted to preserve equity for future funding rounds
Solution: SAR plan with 4-year vesting, payout at next funding round or exit
- 10 employees granted SARs representing $500K total appreciation potential
- No dilution; payout funded from exit proceeds
- 5% phantom equity pool for 3 senior managers
Outcome: Retained 3 senior developers who had competing offers; exit in Year 5 generated $350K total SAR payout (tax-deductible to company)
Case Study 2: Family Manufacturing Business Succession
Client: Second-generation manufacturing company in Mississauga, $8M revenue, planning ownership transition over 10 years
Challenge: Reward non-family senior management without diluting family ownership; retain key employees during transition
Solution: Phantom share plan
- Vesting over 5 years
- Payout at family exit (planned Year 10) or earlier at discretion
- Valuation: 1.2× book value, updated annually
- Target: Maintain 25% EBITDA margin
Outcome: Two senior managers stayed through full transition; one retired early (forfeited unvested units). Total payout at exit: $420K, fully deductible.
Case Study 3: Professional Services Firm Performance Plan
Client: Engineering consulting firm in Oakville, 12 principals, $6M revenue
Challenge: Align senior staff compensation with profitability without making them partners
Solution: PSU plan tied to annual EBITDA
- Each PSU worth $1,000 if target met
- 200 PSUs granted annually per senior manager
- Cash payout in Q1 following performance year
- Cash flow modeling to ensure payout affordability
Outcome: EBITDA margin improved from 22% to 27% over 3 years; average annual payout $180K per manager. Firm retained all senior staff during aggressive growth phase.
Common Mistakes to Avoid
❌ Mistake 1: No Written Plan Document
Problem: Verbal agreements or informal emails don’t provide legal clarity or CRA defensibility.
Fix: Formalize plan with lawyer-drafted documentation before first grant.
❌ Mistake 2: Unrealistic Valuations
Problem: Inflating share value to attract employees; CRA may reassess and impose penalties.
Fix: Use conservative, defensible valuation methodology; document assumptions.
❌ Mistake 3: Failing to Accrue Liability
Problem: Phantom plans create real financial obligation; failure to accrue distorts financial statements.
Fix: Record expense and liability over vesting period; adjust for valuation changes.
❌ Mistake 4: Ignoring Cash Flow Impact
Problem: Large vested phantom share pool comes due at exit; company can’t fund payout.
Fix: Model payout scenarios; consider caps or phased settlement; ensure exit proceeds cover obligations.
❌ Mistake 5: No Change of Control Provisions
Problem: Acquisition triggers immediate vesting of all units; payout exceeds exit proceeds available.
Fix: Define vesting acceleration terms clearly; consider partial acceleration or caps.
Phantom Shares vs. Stock Options: Head-to-Head Comparison
| Factor | Stock Options | Phantom Shares / SARs |
|——–|————–|———————-|
| Ownership dilution | Yes | No |
| Employee tax timing | At exercise (even if illiquid) | Only when cash received |
| Employer tax deduction | Limited (50% deduction if CCPCs meet criteria) | 100% deductible |
| Valuation requirement | Mandatory (Section 7 FMV) | Flexible (formula-based OK) |
| Share issuance | Required | Not required |
| Securities law | May apply | Generally exempt |
| Liquidity required | Employee funds exercise | Company funds payout |
| Complexity | High | Medium |
Verdict for Private Companies in Ontario:
Phantom plans and SARs offer greater flexibility, lower admin burden, and better tax treatment for both employer and employee in most scenarios.
Integration with Other Compensation Strategies
Combining with Fractional CFO Services
At Insight Accounting CPA, we often recommend equity incentive plans alongside fractional CFO services for:
- Financial KPI dashboards to track performance metrics
- Exit readiness planning to maximize value at liquidity event
- Corporate tax deductions offset payout costs
Aligning with Tax Planning
Equity incentive plans should coordinate with overall tax planning strategies:
- Timing payouts in low-tax years for company
- Employee tax planning (RRSP contributions, income splitting)
Frequently Asked Questions (FAQs)
1. Can phantom shares have voting rights?
Generally no—phantom shares are contractual cash rights, not actual equity. However, plans can include consent or advisory rights for major decisions.
2. What happens to unvested phantom shares if an employee leaves?
Typically, unvested units are forfeited. Vested units may be paid out immediately, deferred, or forfeited depending on plan terms and reason for departure (termination vs. resignation vs. retirement).
3. Are phantom share payouts eligible for capital gains treatment?
No. All phantom share, SAR, and cash-settled RSU payments are employment income, taxed at marginal rates. Only actual share sales qualify for capital gains treatment.
4. How do I fund phantom share payouts at exit?
Most companies structure payouts as a % of exit proceeds (e.g., “5% of sale price allocated to phantom share pool”). This ensures payout is funded from the transaction itself.
5. Can I offer phantom shares to contractors or advisors?
Yes, but tax treatment may differ. Non-employees generally receive payments as business income (not employment income), affecting withholding and reporting.
6. Do phantom plans comply with CRA retirement compensation arrangement (RCA) rules?
Generally no. Phantom plans tied to employment (not retirement) and paid from operating cash avoid RCA classification. However, deferred phantom plans for retiring employees may trigger RCA rules—consult your CPA.
7. What valuation method is most CRA-defensible?
Independent third-party business valuation provides strongest CRA protection, but formula-based methods (e.g., EBITDA multiples) are acceptable if reasonable, consistent, and documented.
8. Can phantom shares be transferred or sold?
Typically no—phantom rights are non-transferable and terminate upon employment end (except for vested amounts payable).
Why Work with Insight Accounting CPA for Equity Incentive Planning
Designing and implementing equity compensation plans requires expertise across tax, accounting, valuation, and employment law. At Insight Accounting CPA, we provide:
✅ Tax-Optimized Plan Design — minimize tax burden for both employer and employees
✅ CRA Compliance — defensible documentation, valuation, and reporting
✅ Financial Modeling — cash flow impact analysis and payout scenario planning
✅ Integration with Business Strategy — align incentives with growth, exit, or succession goals
✅ Ongoing Administration Support — vesting tracking, accrual calculations, T4 reporting
Serving Mississauga, Toronto, Brampton, Oakville, Vaughan, and the Greater Toronto Area.
Take the Next Step
If you’re considering equity incentive plans beyond traditional stock options for your Ontario business, Insight Accounting CPA can help you design a tax-efficient, compliant solution tailored to your goals.
📞 Call us today: (905) 270-1873
📧 Email: info@insightscpa.ca
🌐 Visit: www.insightscpa.ca
Our team of experienced CPAs specializes in compensation planning, tax strategy, and financial advisory for growing businesses across the GTA.
Related Resources
About the Author
Bader A. Chowdry, CPA, CA, LPA is the founder of Insight Accounting CPA Professional Corporation, a leading accounting and advisory firm serving businesses across Mississauga, Toronto, and the Greater Toronto Area. With deep expertise in tax planning, financial strategy, and business advisory, Bader helps entrepreneurs and growing companies navigate complex financial decisions with confidence.
Insight Accounting CPA is recognized for innovative approaches to business challenges, including proprietary AI-powered governance frameworks (patent-pending) that enhance financial oversight and decision-making.
Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. Equity incentive plan design and implementation should be undertaken with guidance from qualified legal, accounting, and HR professionals. Tax rules and CRA interpretations are subject to change.
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