US Tax Return Preparation for Expats: Phantom Shares & SARs

For an American executive of a UK private company, a phantom share or cash-settled SAR payout is employment income on both returns: UK earnings through PAYE with Class 1 National Insurance, and US wages on Form 1040 when paid or made available. US tax return preparation for expats then turns on timing, sourcing, section 409A and foreign tax credits.

Phantom awards are popular with UK private companies precisely because nobody acquires a share. That simplicity is real on the UK side. On the US side it is deceptive: an unfunded promise to pay cash in a later year is deferred compensation, and the deferred compensation rules were not written with a UK plan document in mind. At Jungle Tax we prepare both returns for executives in this position, and the errors we are asked to correct are remarkably consistent: the payout reported in the wrong year, excluded when it could not be, sourced entirely to the UK when part of the vesting period was worked in the United States, or left off the US return altogether because "it was already taxed through payroll". This guide sets out how the item should be reported, and how to put matters right where it was not.

What are phantom shares and cash-settled SARs?

Both are contractual rights against the employer, measured by reference to its share value, and settled in cash.

• Phantom share units (full-value awards). The executive is credited with notional units. On a payment event - a fixed date, an exit, or leaving after a vesting period - the company pays the full value of an equivalent number of real shares, sometimes with notional dividends added.
• Cash-settled share appreciation rights (appreciation-only awards). The executive receives only the growth in share value above a base price fixed at grant. Many plans allow the holder to choose the exercise date once the right has vested; others pay automatically on an exit.

In neither case does the executive hold shares, voting rights or a securities option. The award is unfunded: nothing is set aside, and the executive is an unsecured creditor of the company until the cash arrives. Each of those features drives a specific line on one of the two returns.

How does HMRC tax a phantom share or SAR payout?

No employment-related securities are acquired

The UK regime for employment-related securities and securities options applies where an employee acquires shares, or a right to acquire them. A pure cash phantom plan confers neither. HMRC's Employment Related Securities Manual addresses the point directly under phantom scheme variants (ERSM110020): a participant in a pure cash scheme has no right to acquire shares and simply receives a cash sum calculated by reference to notional tracker shares, which is taxed as employment income. The manual also covers the variant in which the employer may deliver shares instead of cash, so the plan rules must be read before assuming the award is outside the securities regime.

Earnings through PAYE, with Class 1 National Insurance

The consequences follow from that starting point:

• Grant and vesting are not charging events. A conditional promise of future cash is not itself a payment of earnings.
• Payment is general earnings. The employer operates PAYE on the cash, so for an executive already paid above the additional-rate threshold the payout is typically taxed at 45% (Scottish rates differ).
• Class 1 NIC is due on payment. Employee contributions apply at the rate for earnings above the upper earnings limit (2% under current rates), and the employer pays secondary contributions (15% from April 2025). Whether the plan passes any employer cost to the participant is a matter for the plan rules and should be checked against the payslip.
• There is no capital gains treatment. No asset has been acquired or disposed of in the relevant sense, so no part of the payout is a capital gain and business asset disposal relief is not in point.
• UK timing follows the earnings receipt rules. Earnings are broadly treated as received at the earlier of actual payment and the time the employee becomes entitled to payment, with additional rules for directors where sums are credited in the company's accounts. For most payouts this is simply the payroll date.

Internationally mobile employees: apportionment in general terms

Where the executive was not UK resident for the whole period over which the award was earned, or performed duties outside the UK during it, the payout is treated as earnings "for" the period it rewards and is apportioned across that period, normally on a just and reasonable time basis from grant to vesting. The UK-taxable fraction then depends on residence status and where duties were performed in each part of the period, and on the reformed rules for foreign income and overseas workdays that apply from 6 April 2025. PAYE is frequently operated on the whole amount in the first instance, with the correct position settled through Self Assessment, which is why a properly prepared UK return matters even where "everything went through payroll". Our UK tax return service deals with that side.

How does the IRS tax the same payout?

Wages when paid or made available

An individual on the cash method reports compensation in the year it is actually or constructively received. A phantom or SAR payout from a UK employer is wages, reported on the wages line of Form 1040 as foreign employer compensation. No Form W-2 is issued by a UK company with no US payroll, so the figure is built from payslips and the plan statement and translated into dollars at a defensible exchange rate applied consistently.

Constructive receipt is where phantom awards begin to diverge from an ordinary bonus. Income is constructively received when it is credited, set apart or otherwise made available so that the executive could draw on it without substantial limitation. Three practical consequences follow:

• A phantom unit that has vested, with the amount fixed and payable on request, may be income in the year it became available rather than the year the cash was drawn.
• A vested but unexercised SAR is not generally treated as constructively received merely because it could be exercised, because exercising surrenders the valuable right to further appreciation. That protection falls away once the amount ceases to be at risk of market movement - for example, where the value is fixed following a sale and only the payment date is outstanding.
• The US tax year is the calendar year; the UK tax year runs from 6 April to 5 April. A payout on 20 January falls in one UK tax year and a different US year from a December payment only weeks earlier, which affects the matching of UK tax for credit purposes.

Section 409A: the design conditions that decide the year of inclusion

Section 409A applies to a US citizen or green card holder wherever the employer is located. It governs any legally binding right to compensation that is or may be payable in a later tax year, subject to stated exceptions. For phantom plans and SARs the working analysis is as follows.

• Short-term deferral. An award that must be paid, and is paid, within roughly two and a half months after the end of the year in which it vests is outside section 409A. Many UK phantom plans that pay promptly on vesting or on an exit, with continued employment required until that event, fall here.
• Exempt SARs. A share appreciation right is outside section 409A where the base price is never less than the fair market value of the underlying shares at grant, the shares are ordinary common shares of the employer or a qualifying parent, and the right carries no further deferral feature. For a UK private company, the first condition depends on a supportable valuation at the grant date, and the file should contain it.
• Compliant deferred compensation. A full-value phantom unit that vests in one year and pays in a later one is deferred compensation and must satisfy the section: payment only on a permitted event (a fixed date or schedule, separation from service, disability, a qualifying change in control, or unforeseeable emergency), no acceleration, and tightly controlled deferral elections. UK plan rules giving the board discretion over when to pay, or allowing payment on a "leaver" definition wider than a US separation from service, are the usual points of difficulty.
• Foreign-plan exceptions. The regulations contain limited exceptions for certain foreign arrangements and for amounts that would have been excludable as foreign earned income. They are narrow, fact-dependent and rarely shelter a substantial executive award in full.

What a section 409A failure means on Form 1040

If the plan fails in form or in operation, the consequences fall on the individual, not the company. All compensation deferred under the plan for the year of failure and earlier years is included in gross income as soon as it is no longer subject to a substantial risk of forfeiture - in other words at vesting, before any cash is paid. In addition, the return carries an additional tax of 20% of the amount included, together with a premium interest charge calculated at the underpayment rate plus one percentage point, running from the year the compensation was first deferred or vested. The additional tax and interest are reported with other taxes on Schedule 2, not as part of regular income tax.

The cross-border effect is harsh. The UK still taxes the cash only when it is paid, so US income arises in an earlier year than the UK tax available to credit against it, and the 20% additional tax is not an income tax that foreign tax credits offset. A preparer therefore needs the plan rules, not merely the payslip, before the first year in which an award vests.

Section 457A, where the employer is a non-US entity in a low-tax position

Section 457A is a separate rule aimed at deferred compensation owed by a "nonqualified entity": broadly, a foreign corporation unless substantially all of its income is effectively connected with a US business or is subject to a comprehensive foreign income tax, and certain partnerships with tax-indifferent partners. Where it applies, compensation is included when it vests, with a limited exception for amounts paid within twelve months after the end of the employer's tax year in which vesting occurs; if the amount cannot be determined at vesting, it is included when determinable together with a 20% additional tax and interest. An ordinary UK-resident trading company within the charge to corporation tax will generally not be a nonqualified entity, but a phantom plan operated through an offshore group entity or a tax-transparent vehicle requires the analysis. IRS guidance treats a SAR that must be settled in shares as outside section 457A; a SAR that is or may be settled in cash does not benefit from that treatment. We cover the regime in depth elsewhere in our guides.

FICA or UK National Insurance: which applies?

For work performed in the UK for a UK employer, the answer is UK National Insurance only. Services performed outside the United States by a US citizen are within FICA only where the employer is an American employer, and the US-UK totalization agreement independently assigns coverage to the country in which the work is performed, subject to its rules for temporary secondments. The IRS explains the framework on its totalization agreements page.

Three points are nevertheless relevant to the return:

• Seconded executives. An executive sent to the UK by a US group company on a temporary assignment may remain in US social security under a certificate of coverage. In that case FICA applies, and a special timing rule treats deferred compensation as FICA wages when it vests rather than when it is paid.
• US workdays. Services physically performed in the United States for a foreign employer can fall within FICA unless the agreement and a UK certificate of coverage displace it. The position should be documented rather than assumed.
• NIC is not creditable. Because a totalization agreement is in force, UK National Insurance contributions cannot be claimed as a foreign tax credit on Form 1116. Only the UK income tax counts.

How is the payout sourced between the US and the UK?

Compensation for services is sourced where the services are performed. A multi-year award is attributed to the period over which it was earned - ordinarily grant to vesting - and split between US and foreign source on a time basis, normally by workdays. An executive who spent 46 of 920 workdays in the vesting period in the United States has 5% US-source and 95% foreign-source wages, regardless of where they were living on the payment date.

The split matters because the foreign tax credit limitation is computed on foreign-source income only. The US-source slice cannot absorb UK tax under the ordinary limitation; for a US citizen resident in the UK, relief on that slice depends on the specific mechanics of the US-UK treaty's relief from double taxation article and must be computed separately. A workday calendar covering the entire vesting period is therefore a core document. Reconstructing one from travel records four years later is possible, but slow.

Foreign tax credit or foreign earned income exclusion in a large payout year?

This is a question of what each mechanism can technically reach, not of preference.

• The exclusion is capped and attributed to the year of service. The foreign earned income exclusion on Form 2555 is limited to an indexed annual amount (130,000 dollars for 2025). Income is attributed to the year in which the services were performed and tested against that year's limit, net of any exclusion already claimed for it.
• Late-paid amounts fall outside it. Amounts received after the end of the tax year following the year in which the services were performed do not qualify as foreign earned income at all. On a four-year award paid shortly after vesting, the slices attributable to the first two or three years of service are therefore not excludable.
• Excluded income carries no credit. UK tax allocable to excluded income cannot also be credited, which requires a scale-down on Form 1116.
• The credit generally does the work. UK income tax on a large payout is ordinarily claimed on Form 1116 in the general category. Because UK rates on the payout usually exceed the US rate, excess credits commonly arise and carry back one year and forward ten within the same category.
• Revocation has consequences. A taxpayer who has claimed the exclusion in earlier years and then ceases to claim it is treated as revoking the election, and is generally barred from re-electing for five years without IRS consent. The return for the payout year should be prepared with the prior years' filings on the table.
• Year matching. PAYE withheld is treated as paid when withheld, but any balancing UK liability or repayment through Self Assessment arises later. A subsequent UK repayment is a foreign tax redetermination that requires the US return to be amended.

Is an unfunded phantom award a specified foreign financial asset for Form 8938?

A phantom award is not a financial account, so it is not reported on the FBAR. Form 8938 is wider. Specified foreign financial assets include, outside any account, a financial instrument or contract held for investment with a non-US issuer or counterparty, and the IRS's published Form 8938 questions and answers expressly list an interest in a foreign deferred compensation plan as reportable.

An employment bonus right is not obviously "held for investment", and the position for an unfunded, unvested contractual promise is not free from doubt. The approach we regard as sound in return preparation is this: once the award is a vested interest in a deferred compensation arrangement with a UK company, treat it as a specified foreign financial asset and include it where the executive's aggregate specified assets exceed the filing threshold (for a single filer living abroad, more than 200,000 dollars on the last day of the year or 300,000 dollars at any time; double for joint filers). Where no reliable year-end value is available, the instructions permit the value of an interest in such a plan to be taken as the amount distributed in the year, which may be nil. The cost of reporting is a line on a form. The cost of omission is a penalty exposure and an assessment period that does not begin to run for the affected items. Related account balances can be tested with our FBAR penalty calculator.

Phantom shares and SARs vs real options vs RSUs: each return compared

Point	Phantom units / cash-settled SARs	Real share options (unapproved)	RSUs settled in shares
UK: what is acquired	Nothing; a contractual cash right	A securities option, then shares	A right to shares, then shares
UK: income charge	General earnings when paid	Employment income on exercise, under the securities option rules	Employment income when shares are delivered
UK: PAYE and NIC	Always, on the cash	Where shares are readily convertible assets	Where shares are readily convertible assets
UK: capital gains tax	None	On later sale of shares	On later sale of shares
UK: annual share scheme reporting by employer	Not for a pure cash plan	Yes	Yes
US: income event	Wages when paid or made available	Wages on exercise (spread)	Wages when shares are delivered
US: section 409A	Phantom units within it unless short-term deferral; SARs exempt only if base price is at least grant-date value	Exempt if exercise price is at least grant-date value	Usually short-term deferral
US: section 457A	Cash-settled SARs not exempt	Options at market value exempt	Depends on timing of delivery
US: later capital gain	None; no asset held	Schedule D and Form 8949 on sale	Schedule D and Form 8949 on sale
US: Form 8938	Vested deferred compensation interest: treat as reportable	Shares held directly, once acquired	Shares held directly, once acquired
US: sourcing	Workdays, grant to vesting	Workdays, grant to vesting	Workdays, grant to vesting

Worked example: a four-year phantom award

An American chief operating officer of a UK private company is granted phantom units in January 2022, vesting on 31 December 2025 subject to continued employment, with payment required within 60 days of vesting. The company pays 400,000 pounds through payroll on 20 February 2026. Over the vesting period she worked 920 days, 46 of them in the United States.

1. UK. The payment is earnings of the 2025/26 UK tax year. PAYE and Class 1 NIC are operated in the February payroll. Her UK return reports it as employment income; there is no capital gains entry.
2. US year. The payment is wages on her 2026 Form 1040. Nothing is reported for 2022 to 2025, because the award was subject to a substantial risk of forfeiture until vesting and was then paid within the short-term deferral period, so section 409A is not engaged.
3. Sourcing. 95% is foreign-source general category income; 5% is US-source.
4. Exclusion. Slices attributable to services in 2022, 2023 and 2024 were received after the end of the year following the year of service, so they are not foreign earned income. Only the 2025 slice is potentially eligible, within what remains of the 2025 limit.
5. Credit. UK income tax withheld in February 2026 is claimed on her 2026 Form 1116. NIC is not credited. Excess credits are carried back to 2025 and forward.
6. Form 8938. At 31 December 2025 the award was vested and unpaid, so it is considered for her 2025 Form 8938 alongside her other specified assets.

Change one fact - the plan pays twelve months after vesting at the board's discretion - and step 2 becomes a section 409A question with a very different return.

Catch-up: a payout reported in the wrong year or omitted from the US return

We see three recurring patterns, each with a defined route to correction.

Reported, but in the wrong year

Typically the US return followed the UK tax year, or reported at vesting when the correct year was payment (or the reverse where constructive receipt applied). Both years are corrected on Form 1040-X: income is removed from one and added to the other, with foreign tax credits re-matched. Tax and interest are due for the understated year, and the refund claim for the overstated year must be made within the ordinary limitation period - generally three years from filing or two from payment - so delay can turn a timing error into a permanent cost.

Reported, but excluded or sourced incorrectly

Where the whole payout was run through Form 2555, or treated as wholly foreign-source despite US workdays, amended returns substitute the correct exclusion and credit computations. Additional UK tax available for credit can often be claimed within a ten-year period specific to foreign tax credits.

Omitted altogether

Where the payout never reached the US return, or no US returns were filed, the route depends on conduct and on what else is outstanding. Executives living in the UK whose failure was non-wilful may be eligible for the Streamlined Foreign Offshore Procedures: three years of returns, six years of FBARs and a signed non-wilful certification, with tax and interest but without the usual failure-to-file, accuracy and information return penalties. Our IRS streamlined filing team prepares these submissions. Because UK tax on the payout usually exceeds the US tax, the net US liability is often modest once credits are properly claimed - but the credits must be claimed on a filed return to count.

Two limitation points sharpen the timetable. An omission exceeding 25% of the gross income stated on a return extends the IRS assessment period from three years to six, and a large payout readily crosses that line. Where a required Form 8938 was not filed, the assessment period for related items does not start until it is. On the UK side, if PAYE was not operated or the apportionment was wrong, the correction is made through Self Assessment, and the US amended return should follow the corrected UK figures rather than precede them.

What records does your preparer need?

• The plan rules and the individual award agreement, including leaver, exit and payment-timing clauses
• The grant-date valuation supporting any SAR base price
• Vesting and payment statements, and the payslip showing PAYE and NIC
• A workday calendar by country from grant to vesting
• Any certificate of coverage, and the group entity that actually owes the payment
• Prior US returns showing whether Form 2555 or Form 1116 was used
• UK Self Assessment returns and calculations for the payout year

Preparing both returns with confidence

Phantom shares and cash-settled SARs produce no shares and no capital gain, but they demand more care on the US return than most real equity. The year of inclusion depends on the plan rules, the exclusion reaches less than executives expect, the credit depends on sourcing, and the reporting position requires judgement. Our US-UK tax accountants prepare the US and UK returns together, so that the figures on each agree and any earlier year is corrected through the proper procedure. To have a payout reviewed before filing, or to resolve one that was reported incorrectly, please contact our cross-border team for a confidential consultation.