by Gregory S. Dowell

October 8, 2021

We recently discussed phantom stock in a previous blog.  Stock appreciation rights (SARs) are similar to phantom stock units insofar as SARs represent the right to receive the appreciation in value of corporate stock that accrues between the date the SARs are issued and the date they are exercised. The employee generally can exercise the SAR at any time before the date his employment is terminated. Typically, when the employee exercises the SAR, either the corporation pays cash to the employee based on the value of the SAR (a “naked” SAR) or, if the SARs are issued in conjunction with a stock option plan, the value of the SARs can be used to fund the employee's exercise of the stock option.

The employee does not recognize income until the taxable year in which he exercises the SAR and the corporation pays the employee the value of his SAR.  The corporation can then deduct the amount of compensation paid to the employee based on the value of the SAR.

The issuance of a naked SAR does not violate the single class of stock requirement (IRS Letter Ruling 8828029, relating to phantom stock plans). Moreover, even if the SAR is issued in conjunction with a stock option, the issuance of the SAR should not create a second class of class provided the SAR: (i) does not convey the right to vote; (ii) is an unfunded and unsecured promise to pay money or property in the future; (iii) is issued to an individual who is an employee in connection with the performance of services for the corporation; and (iv) is issued pursuant to a plan with respect to which the employee is not currently taxed on income.

If the SAR meets the above requirements, it should not be treated as outstanding stock of the corporation. Therefore, SARs should not be considered in determining whether the stock of the corporation confers different rights with respect to distribution and liquidation proceeds for purposes of applying the single class of stock rules for S corporations.