A share appreciation right is a right to compensation based on the increase in value of a stated number of shares over a stated base price, measured from the grant date to the date the right is exercised, and settled in cash or in shares. The holder never buys the underlying shares, and that is what separates the instrument from an option. United States federal tax law calls the same thing a stock appreciation right, usually shortened to SAR.
The Same Instrument Carries Two Names
The Treasury regulation that defines the plans section 409A covers uses the US spelling as a defined term. A right to compensation based on the appreciation in value of a specified number of shares of service recipient stock occurring between the date of grant and the date of exercise of such right is a stock appreciation right (Treasury Regulation 1.409A-1(b)(5)(i)(B)). Service recipient stock is that regulation’s name for the stock a stock right can be written on, and it has to be common stock for purposes of section 305 of a corporation that is an eligible issuer (Treasury Regulation 1.409A-1(b)(5)(iii)(A)). An eligible issuer is the corporation the holder provides direct services to on the date of grant, and any corporation above it in a chain of controlling interests, so a right written on a parent’s stock is not ruled out (Treasury Regulation 1.409A-1(b)(5)(iii)(E)(1)).
The share spelling is the international one. IFRS 2, the international standard on share-based payment, introduces share appreciation rights as its example of a cash-settled arrangement, where employees become entitled to a future cash payment rather than an equity instrument, based on the increase in the entity’s share price from a specified level over a specified period of time (IFRS 2 paragraph 31, as endorsed by Commission Regulation (EC) No 1126/2008). The US definition does not turn on settlement. It treats a right to receive cash or stock on the date of exercise as the baseline, and an added right that would let compensation be deferred beyond that date pulls the entire arrangement in (Treasury Regulation 1.409A-1(b)(5)(i)(D)).
When a Share Appreciation Right Stays Outside Section 409A
A SAR does not provide for a deferral of compensation, which is the test that decides whether section 409A reaches it, if three conditions all hold. The compensation payable under the right cannot be greater than the excess of the fair market value of the stock on the date the right is exercised over an amount specified on the date of grant, the stock appreciation right exercise price (the base price), with respect to a number of shares fixed on or before the date of grant. That exercise price may never be less than the fair market value of the underlying stock on the date the right is granted. The right must carry no feature for the deferral of compensation other than deferring recognition of income until it is exercised (Treasury Regulation 1.409A-1(b)(5)(i)(B)).
The regulation spells out the failure side as well. If the compensation payable is or could be any amount greater than the excess of the stock’s fair market value on the date of exercise over its fair market value on the date of grant, with respect to a predetermined number of shares, the grant generally will provide for the deferral of compensation, and so will a right written on stock other than service recipient stock (Treasury Regulation 1.409A-1(b)(5)(i)(C)). Where a payer reports one is set out in deferral.
A dividend right is the drafting trap. Where the right to the dividends declared on the underlying shares is contingent on exercising the SAR, it counts as an increase in the amount payable under the right and generally pulls the whole thing into section 409A (Treasury Regulation 1.409A-1(b)(5)(i)(E)).
What the Payout Looks Like
Say a plan grants a fixed number of rights at a base price equal to the share value on the grant date, and the holder exercises later at a higher value. On those inputs the payout falls out like this.
Rights exercised 5,000
Base price per share 21.00
Value per share at exercise 35.00
Appreciation per share 35.00 - 21.00 14.00
Cash settlement 5,000 x 14.00 70,000.00
Share settlement 70,000.00 / 35.00 2,000Nothing is payable if the shares are worth the base price or less on the date of exercise, because the amount is capped at the excess of value over that price and there is no excess. Share settlement hands over that same value in shares rather than cash, so the holder ends up holding stock without having paid anything for it.
Where the Tax Falls
For the holder, the payout is compensation for services, and the Code puts compensation for services, including fees, commissions, fringe benefits, and similar items, in gross income (26 U.S.C. 61(a)(1)). Income is included in gross income for the taxable year in which it is actually or constructively received, unless the taxpayer’s method of accounting puts it in a different year (Treasury Regulation 1.451-1(a)).
The FICA regulation takes these rights out of its deferred compensation timing rule by name. The grant of a stock option, stock appreciation right, or other stock value right does not constitute the deferral of compensation for purposes of section 3121(v)(2), and amounts received on exercise do not either, so long as they are actually or constructively received in the calendar year of the exercise (Treasury Regulation 31.3121(v)(2)-1(b)(4)(ii)(2)-1)). Income is constructively received once it is credited to an account, set apart, or otherwise made available to draw on, unless control of its receipt is subject to substantial limitations or restrictions (Treasury Regulation 1.451-2(a)).
That carve-out matters because of what it displaces. An amount deferred under a nonqualified deferred compensation plan is otherwise taken into account as wages for FICA at the later of the date the services creating the right are performed or the date the right stops being subject to a substantial risk of forfeiture (Treasury Regulation 31.3121(v)(2)-1(a)(2)(ii)(2)-1)). A SAR sits off that schedule, so the charge follows the payment, and whether the payment is wages in the first place runs on the statutory definitions in gross wages.
What a Share Appreciation Right Is Not
Not a Stock Option
An option is a right to purchase stock, so exercising one means paying the exercise price and taking the shares. The same regulation’s option carve-out opens on that word, an option to purchase service recipient stock (Treasury Regulation 1.409A-1(b)(5)(i)(A)). A SAR carries no purchase, so the holder needs no cash at exercise and receives the appreciation alone.
Not Phantom Stock
Phantom stock tracks the whole value of a share, while a SAR tracks only the growth above a base price. The FICA regulation draws that line in its own words. A stock value right entitles the employee to a payment for each share equal to the excess, or a percentage of the excess, of the value of a share of the employer’s stock on the date of exercise over a specified price greater than zero. The term does not include a phantom stock or other arrangement under which an employee is awarded the right to receive a fixed payment equal to the value of a specified number of shares of employer stock (Treasury Regulation 31.3121(v)(2)-1(b)(4)(ii)(2)-1)).
Common Questions
An employee stock ownership plan is a qualified retirement plan. The Code defines it as a defined contribution plan that is a stock bonus plan, or a stock bonus and money purchase plan, designed to invest primarily in qualifying employer securities (26 U.S.C. 4975(e)(7)). Participants in one hold real shares. A SAR is not a plan of that kind, conveys no shares, and pays only the appreciation on a stated number of them.
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