Stock Appreciation rights program with ESOP

So suppose a S-corporation has an ESOP that owns 100% of the stock. The employer is considering implementing a "SAR's" plan. Does this SAR's plan have any impact on the ESOP? What little I know about a SAR's plan is that under some circumstances, it MAY(?) be possible that they would be considered a retirement plan, and therefore issues with 404, 415, etc.? Let's assume for the moment that this isn't a problem. Seems like this could be considered compensation, which might indirectly affect the ESOP? I guess what I'm getting at is that it doesn't seem like there is a DIRECT effect on the ESOP, but that depending upon the status as to whether it represents currently taxable W-2 income or not could have indirect effects?

Would love to hear any thoughts - I'm frankly not familiar with Stock Appreciation Rights programs. Thanks.

The SARs may be considered part of a pension plan as defined in Title I of ERISA depending upon the structure, in which case that plan would have to be limited to a top hat group of employees, but it could never be a plan subject to IRC 401(a) qualification rules.  The every-day ESOP practitioners on this board may care to explain in more detail, but the SARs will need to be taken into account as synthetic equity for purposes of compliance with IRC Section 409(p).

The big one is SARs are synthetic equity for 409(p) testing so you have to make sure the SARs don't cause a failure. 

Typically when the SARs are cashed in they are not part of compensation for plan purposes.  My guess it would really be wise to have an attorney that understands both SARs and ESOPs.  I know they exist as we work with plenty. 

Thanks to you both. Question - how do these SAR's work with regards to stock - by that I mean - suppose the S-corp has 100,000 shares of stock. All are currently owned by the leveraged ESOP - either already allocated or in suspense to be released each year as the loan is repaid. So if a SAR's plan is instituted, does that mean more stock is going to be issued at a future date? Or is it essentially a cash bonus (paid at whatever time or times or conditions specified in the SAR's agreement) based upon the stock price of existing stock already in the ESOP? Etc.?

Assuming it is a cash bonus, and not an actual stock purchase right, then it still counts as synthetic equity, but may or may not be includible in current W-2 income, as it might essentially deferred compensation?

All this will go before an ESOP attorney anyway, but I'd like to have a reasonable working understanding of it. I can see I'll have to do some research, but in the meantime I greatly appreciate your expertise!

No more stock will be issued.  It merely is a right to be paid cash based on the appreciation of the stock.  For purposes of the appraisal I believe the appraiser counts them as shares to determine their fully diluted number of shares as the SARs are a future claim on the company's value.  Although most SARs are based on the value at the time of issue.  So if the stock is worth $10/shr at time of issue the person who gets the SARs share in any value increase above the $10/shr mark. 

I have never seen SARs count as compensation for allocation purposes.   They tend to be a non-qualified deferred compensation program is how I see them work. 

Thanks ESOP. Last question:

To put a number on this to see if I'm understanding properly - suppose the SAR provides that I will receive a cash payment at the end of the year, based on any appreciation in stock price for that year. There are 100 total shares, all owned by the ESOP. And for sake of simplicity, all shares have been allocated. No family members, etc. Stock price as of 1/1/2018 is $10.00 per share. My ESOP account has 9 shares.

Stock price as of 12/31/2018 rises to $20.00 per share. My 9 shares entitle me to a cash payment of $90.00. So $90.00/current stock price of $20.00 = 4.5, so my "synthetic equity" is 4.5 shares, giving me a total of 13.5 shares. Is the calculation then 13.5/100 = 13.5% so I am now a "disqualified person" or is it 13.5/(100 + 4.5) = 12.9% (still a disqualified person, but sometimes the math might work out so that I'm not)?

I agree the synthetic equity is 4.5 shares.

It is your 2nd calc on the DQP calc that is correct.  13.5/104.5=12.9%.  You put ONLY that person's synthetic equity into the numerator and denominator to determine DQP. 

Many thanks!!!

SAR awards can be payable in cash or in stock, so we're assuming that this Plan only provides for cash awards at distribution time. 

Interesting

I don't think I have ever seen a SARs plan that paid in stock.

My guess is a 100% S Corp ESOP wouldn't do it as they won't want to stop being a 100% S Corp ESOP.  But I guess I learned something new today. 

Absolutely the currency for SARs can be stock, but that kinda goes against the 100% sub s construct so I have never seen it done there.

JPOD and ESOP Guy, I'm a tax guy---not sure what you mean by the  "100% sub s construct"  in this context. Can you share with us what you mean ? Thanks. Also, not sure what the benefits of being a 100%  S Corp ESOP are--sometimes (and very often in my world), owners of private companies need to share actual ownership of stock with their top people for retention or to attract/hire a top recruit---so, when the smoke clears, the ESOP might be 90% owned----what's wrong with that ? (I have several clients in the private company space who have ESOPs and yet have shared actual ownership as well).

15 hours ago, Bob the Swimmer said:

JPOD and ESOP Guy, I'm a tax guy---not sure what you mean by the  "100% sub s construct"  in this context. Can you share with us what you mean ? Thanks. Also, not sure what the benefits of being a 100%  S Corp ESOP are--sometimes (and very often in my world), owners of private companies need to share actual ownership of stock with their top people for retention or to attract/hire a top recruit---so, when the smoke clears, the ESOP might be 90% owned----what's wrong with that ? (I have several clients in the private company space who have ESOPs and yet have shared actual ownership as well).

My guess is Jpod meant "corporation" not "construct" as I can't think of how that word applies either.

The primary benefit of a 100% S Corp ESOP is no one pays income taxes on the company's income.  The Corp doesn't as it passes its income through to the stockholders.  The stockholder in this case is a tax exempt trust.  So you will find most S Corp with an ESOP are 100% owned by the ESOP.  The cash flow freed up by this not paying taxes is simply too good to pass up.

The next issue with a partial owned S Corp ESOP is the people who own the shares besides the ESOP typically need a distribution from the company to meet their tax obligations.  The ESOP as a shareholder must gets its share of this "dividend".  Yes, I understand legally they aren't dividends but for this purposes they function like them.  Each shareholder has to get their share based on ownership.  What companies find in this situation is too much cash ends  up in the ESOP and it undoes many of the benefits the fact the ESOP doesn't pay taxes on the pass through income.  So unless the outside owners just don't want to sell most  partial S Corp ESOPs become 100% S Corp ESOPs over time. 

You are correct often times you do have to compensate the officers based on stock price/equity.  It is just S Corp ESOPs use things like SARs that pay in cash, phantom stock, warrants that once again pay cash when cashed in.  This is because the company values the tax free status too much to ever give actual shares to these people. 

So to answer your question nothing is wrong with giving shares.  I just find it very rare to allow outside equity with an S Corp ESOP.  With a C Corp ESOP you see giving shares to officers more often but not S Corps ESOPs.  Most S Corp ESOPs simply don't want to have to pay dividends most of which goes to the ESOP  for taxes it doesn't have to pay.  There are better uses for the funds in their mind. 

No, I meant "construct."  I was referring to the "construct" whereby an ESOP is the 100% owner of an s corp.  Perhaps I should have said "scenario," or not used any shorthand at all.  My apologies.   

28 minutes ago, jpod said:

No, I meant "construct."  I was referring to the "construct" whereby an ESOP is the 100% owner of an s corp.  Perhaps I should have said "scenario," or not used any shorthand at all.  My apologies.   

Sorry for putting words in your mouth. 

ESOP GUY-

I agree with most of what you said and there are a number of benefits for the ESOP transferors---loan benefits, 404(k) dividend, etc., but I'm seeing as an exit strategy, that not all 100% owners (or a combination of owners) are willing to part early on with their 100% single or combined ownership in the process. I have at least half a dozen private clients over the past 10 years that had less than 100% ESOPs for some very good reasons also. Just want to throw that out there.