So if you exercise an option to buy a stock for $1, you have to pay taxes on the stock's current value, but if you had bought the stock outright at $1, you don't have to pay capital gains until you sell? That's absurd
I think it's basically a bug in US tax law. The scenario is such an edge case for most Americans.
The other not-so-nice aspect of this is that it disproportionately affects people who aren't already relatively wealthy. Theoretically you can avoid this trap by exercising your options as soon as possible and locking yourself into long-term capital gains. But if you're joining a relatively established startup it may well be pretty expensive to immediately exercise your options. If you don't have, say, 100k lying around you have to wait until there's liquidity, thus opening yourself up to this risk.
It seems like it would be better than the worst case with traditional options but not as good as the best case. I mean, ideally you exercise your options early at a very low price and then enjoy long-term capital gains tax rates. Phantom stock means you'll always pay way more in taxes when you get your equity-based payout - 50%-60% vs 20%-30%. At the same time though you are never at risk of ending up underwater.
It seems like phantom stock would be great as an option for companies to offer employees - i.e. you could either get a traditional options structure or phantom stock. I wouldn't be surprised if there were negative accounting or tax consequences for the company though. And maybe the administrative overhead for offering phantom stock in addition to traditional options would be prohibitive for small startups.
The key here is timing. In both cases you are buying the stock for $1, but in one case it's officially worth $100. Therefore, you have a taxable gain.
That much makes sense. What doesn't make sense is treating an illiquid value the same as a liquid one.
Salary is gain paid for with labor, and it is taxed. I'm not sure I follow your point.