Frequently asked questions about stock appreciation rights

Putting together an appealing compensation package can help employers attract, retain and incentivize key employees in tight labor markets. Stock appreciation rights (SARs) are an option to incentivize key employees where the value is directly tied to the increase in company value. Additionally, when designing a SAR plan, employers have the added flexibility of settling the SARs with a cash payment or the transfer of shares. Before deciding what type of executive compensation device is right for your company, here are some answers to frequently asked questions about SARs.

Q.    What is a stock appreciation right?

A.    A SAR is a promise to pay an amount based on the appreciation in value of a share of employer stock, over a stated exercise price (or threshold value), which can be settled in stock or cash. While a SAR can be designed like a stock option, the holder of the SAR receives the same net proceeds without the cash outlay associated with having to pay the exercise price of stock options.

Q.    Why might a company want to issue SARs instead of actual equity?

A.    As equity ownership does not transfer upfront, SARs allow a company to provide a promise to pay an amount in the future, which is directly linked to company value without directly diluting ownership or making employees direct owners with additional rights.

SARs are generally subject to certain time or performance-based vesting which must be satisfied prior to receiving any transfer of stock or cash. Therefore, SARs provide incentive for an employee not only to stay with the company through the vesting date, but also to contribute to increasing the company value, which will result in a higher payment value when the SAR is settled. Since SARs do not require a cash outlay (i.e., exercise price) upon exercise, they are generally viewed as creating less of a financial hardship for employees, who would otherwise need to come up with the cash required to exercise stock options.

Q.    How does a SAR plan work?

A.    SARs are similar to stock options in that they are granted at a set exercise price (or threshold value) and generally have a vesting period and expiration date. Once a SAR vests, it can be designed to allow the holder to exercise it at any time prior to the SARs expiration, which is similar to the mechanics of a stock option, or it can be designed to be payable only upon a designated event. The proceeds of the SAR, which typically equals the appreciation in value over the exercise price or threshold value, are transferred either in cash, shares, or a combination of both depending on the rules of the plan.

Q.    How is the value of a SAR determined?

A.    The value of a SAR fluctuates, based on the value of company stock, and is determined at the time of exercise by the employee. When a SAR is settled, the value awarded to the employee is based on the excess of FMV over the exercise price or threshold value (which is generally equal to the FMV at the time of grant). Unlike phantom stock, if the value declines below the value at grant, the recipient will not receive any payment.

Public companies that issue SARs will use the fair market value (FMV) as reflected on the public exchange they trade on at the time the transfer is initiated. On the other hand, private companies that issue SARs don’t have a readily ascertainable market value. Instead, they must follow the general equity compensation valuation rules for private companies and use a reasonable valuation method, such as an express written formula, or have a third-party appraisal performed to determine the FMV per share.

Q.    How are SARs treated for federal income tax purposes?

A.    SARs are not taxable at grant, and therefore, allow a recipient to defer compensation into a later year because the recipient does not pick up the value of SARs as compensation until settlement, which is typically in a year subsequent to the year of the grant.

Once SARs vest and the employee exercises or the designated payment event occurs, the company either makes a cash payment or transfers shares, depending on the rules of the plan. At the time the transfer is initiated, the excess of FMV over the exercise price or threshold value is taxable compensation to the recipient.

At the time payment becomes taxable, the company is entitled to a deduction equal to the amount of income recognized by the recipient. The timing of that deduction depends on whether the SAR is settled in shares or cash, as well as when payment is made in comparison to vesting.

Additionally, if the SARs are settled in shares, the recipient becomes an owner and the holding period of the shares begins on the date of transfer. If the shares are held longer than one year, any appreciation or depreciation after the transfer date will be characterized as long-term capital gain or loss, respectively.

Q.    What are the payroll tax consequences of SARs?

A.    SARs are subject to tax under the Federal Insurance Contributions Act (FICA), which is comprised of the old-age, survivors, and disability insurance taxes, also known as social security taxes, and the hospital insurance tax, also known as Medicare tax (collectively referred to as payroll tax), for employees with a Form W-2 reporting requirement.

SARs are subject to payroll tax withholding at the time the transfer of shares or payment is initiated if such amounts are actually or constructively received in the calendar year of the exercise.

Q.    Is a section 83(b) election available?

A.    No. With SARs, either cash is transferred (in which case section 83 does not apply) or the shares are not transferred until they are already vested; therefore, a section 83(b) election does not apply.

Q.    Are there section 409A considerations with SARs?

A.    Yes, a SARs plan can be designed to be exempt from section 409A, by using the short-term deferral or by meeting the requirements of the stock right exception.

Under the short-term deferral rules, if payment occurs within the same year of vesting or within two and a half months of the end of the year in which vesting occurred, then the SARs are not considered deferred compensation and section 409A does not apply.

SARs that satisfy the requirements to be considered a “stock right” will also not be considered deferred compensation subject to section 409A. For additional detail on the requirements, see the Stock options and section 409A: Frequently asked questions article.

If neither of the above exemptions are met, the SARs plan must either (1) be designed to conform to the requirements of section 409A and the associated regulations or (2) suffer the potential adverse tax consequences of failing section 409A if they do not conform. Generally, operating deferred compensation plans requires careful consideration of the stringent and complex section 409A rules. Employers should consult a tax advisor and review their SARs plans regularly to ensure the plan is operating as intended and does not run afoul of section 409A rules, which could result in income inclusion at vesting and a 20% penalty tax to the employee if violated.

Q.    How does the executive receive value from the SAR?

A.    The number of SARs, vesting schedule, form of payment (i.e., cash or stock), and triggering payment events are typically set forth in individual grant agreements. Actual payouts of the SARs are deferred until a future exercise date or designated payment event. It should be noted that even if payments are made after the grantee terminates service, the nature of the payment is generally still treated as compensation for tax purposes and reported on Form W-2 for individuals who were employees when they received the SARs.

Q.    Can partnerships issue SARs?

A.    Yes. It’s possible for partnerships to issue unit appreciation rights (UAR) which are economically similar to SARs. A UAR awards the recipient a right to receive a cash payment equal to the appreciation of a specified number of units of the partnership subject to specified vesting conditions. The value of a UAR is tied to partnership equity value rather than common stock value. All other aspects of the plan would be the same. Because the unit appreciation rights are not actual equity in the partnership, such a plan would not give rise to any partner as employee issues.

Q.    What should a company consider when designing a SAR plan?

A.    Companies should consider the following when formulating aspects of their written plan:

• Which key employees should receive SARs?
• When and how many SARs should be granted?
• What type of vesting conditions will most incentivize employees?
• Will the plan meet the short-term deferral or stock right exception to be exempt from section 409A?
• Will the plan be section 409A compliant? If so, what designated payment events would the company like to include that are permissible under section 409A?
• For private companies, will an express written formula or third-party appraisal be performed to determine the FMV at grant?
• Do employees have enough cash to cover the required tax upon transfer (if the SARs will be settled in shares instead of cash)?
• Will special vesting rules apply in the case of death, disability, or other events?

SARs should be compared to other incentive compensation methods to determine if they achieve the company’s goals. If they do, the plan should be reviewed with tax advisors to ensure no unintended tax consequences occur.