Differences between ESOP and Stock Appreciation Rights

This article throws light on the difference between ESOP and SAR, ESOP taxation, SAR taxation, and the importance of ESOP & stock appreciation rights.

With the increase of start-ups in the economy, we observed a trend toward share-based compensation plans for employees. The most common of these are ESOP (Employee stock ownership plans) and SAR (Stock Appreciation Rights). The knowledge of many types of schemes and their accounting treatment, however, is not shared equally among specialists and corporate employees. Employee stock rights can be obtained through ESOPs and SARs. Let’s begin with an important distinction. Only an ESOP is a qualified retirement plan among the two. In addition to an ESOP, a SARs plan is a non-qualified employee benefit that can be developed to give the business seller more options for rewarding top personnel. This article throws light on the difference between ESOP and SAR, ESOP taxation, SAR taxation, and the importance of ESOP & stock appreciation rights.


Employee stock ownership plans (ESOPs), which can be stock bonus plans or stock bonus/money purchase plans, are qualified defined contribution plans under IRC section 401(a). Similar to stock options, stock appreciation rights are given at a predetermined price and often have a vesting period and expiration date. A SAR that has vested may be exercised by the employee at any time before it expires.

What is ESOP?

Employee Stock Ownership Plans (ESOPs) are defined contribution plans in the US under the terms of IRS (Internal Revenue Service) code 4975(e)(7), which became a qualified retirement plan in 1974. It is one way for employees to take part in corporate ownership. The Employee Retirement Income Security Act (ERISA), a federal legislation that establishes minimum requirements for investment programs in the private sector, regulates ESOPs. Publix Super Markets (230,000 employees), Houchens Industries (18,000 employees), W.L. Gore and Associates (12,000 employees), and Davey Tree Expert (10,500 employees) are a few of the more noteworthy majority employee-owned businesses.

How does ESOP work?

Companies establish a trust fund for employees and contribute either cash or shares directly to the plan to purchase company stock. They can also plan to borrow funds to purchase shares. The company contributes to the plan to help it pay back any loans it takes out if the plan borrows money. Tax deductions are available for plan contributions. Employees don’t pay taxes on their contributions until they receive the shares when they leave or retire. Then, they may return it to the business or sell it on the open market. Additionally, workers have the option to purchase employer shares. Companies grant employees the right to buy shares at a predetermined price for a specified number of years in the future under stock options and other specific equity schemes.

Importance of ESOP

The US ESOP concept is linked to the distinctive US system that promotes private retirement savings plans and tax laws that reflect that purpose. It is significant for the following reasons:

  • ESOPs are a tax-advantaged liquidity method that provides shareholders with fair value.
  • A “low and sluggish” ownership shift is possible with ESOPs. This is crucial for entrepreneurs who wish to remain involved and have contributed to the company.
  • By implementing an ESOP, a company can develop and protect its legacy.
  • It is essential to increase employee productivity.
  • It increases staff retention and lowers staff turnover.

How does ESOP taxation work?

Employees who participate in ESOPs do not have to pay taxes on the stock that has been assigned to their accounts until they start receiving payments. They pay taxes on their ESOP distributions, which are commonly referred to as “cashing out” an ESOP in normal terms. Employees under the age of 59 (or, in the case of ending employment, under the age of 55) are regarded to have taken distributions from an ESOP early, and as such, they are subject to the standard relevant taxes as well as an additional 10% excise tax. This additional tax is known as a penalty tax on ESOP distributions. The additional 10% ESOP payout tax penalty is not applied to the ESOP distribution if the participant’s employment ceases because of their disability or death.

The excise tax on early distributions is not applied to dividends paid by an ESOP directly to participants. Additionally, they are not subject to income tax withholding, however, dividend distributions are entirely taxable. The employee must pay income tax at ordinary tax rates on the value of the employer’s contributions to the plan, as well as capital gains tax on the increase in share value when they decide to sell their shares. This is adopted when an ESOP distributes actual shares of company stock rather than paying out the value of the shares in cash. The ESOP trustee or third-party administrator (TPA) is required to produce and file Forms 1099-R and 945 for ESOP tax reporting whenever participants receive ESOP distributions of $10 or more.

What is SAR?

A stock appreciation right (SAR) is the right to receive a payment equal to a rise in the price of the company’s common stock over a certain level. When the market value of the company’s stock rises over the option exercise price, a deferred incentive payment is made. This deferred payment is known as SAR. It grants the holder the right to receive money over and above the market value of the shares covered by the option for a specified length of time. In this way, it is similar to a stock option. Employees with stock appreciation rights (SARs) are entitled to cash payments equal to the growth of their shares of company stock that are traded on a public exchange market. Each employee’s vesting schedule is set up by the SAR program, after which it can be exercised. The agreement links SARs to the company’s established performance goals.

How does SAR work?

SARs are transferable and covered by a policy against clawbacks. An employee’s bonus or any other incentive-based compensation under a plan may be recovered by the company following the terms of a clawback policy, regardless of whether the provision is applied retrospectively or prospectively. For instance, if an employee switches to a competitor before the end of an employment term, the provision might allow a corporation to withdraw SARs. Additionally, SARs’ settlement date may not be predetermined, similar to stock options, giving employees some liberty in choosing when to exercise their rights. The majority of SAR initiatives are dependent on achieving business goals, such as profit or sales targets.

Let us understand this better with a practical example:

Assume that ABC Limited awarded stock appreciation rights on January 1, 2010, when the share price was $20, and that the vesting date, or the day on which an employee can exercise the right, is January 1, 2020.SARs of 200 shares of ABC Limited was given to Robert. The in-money value of Robert’s SAR is $10,000 [($70 – $20) x 200] if the share price of the company’s stock on the vesting date is $70. Robert has the option of having the SARs settled in cash for $10,000 or in shares of ABC’s stock worth 142 shares.

Importance of SAR

The significance of SAR is illustrated as follows:

  • Companies can inspire and reward their employees with stock appreciation rights without reducing the size of the equity pool.
  • It offers more versatility.
  • The performance of the company’s stock is reflected in SARs, which are contracts. In reality, there is no cost associated with an employee exercising their rights under a SAR contract.
  • SARs are essentially contractual documents, thus the employer has the discretion to determine whether they should be made transferable or not.

How does SAR taxation work?

The tax status of SARs is often the same as that of non-qualified stock options (NSOs). The administrative responsibility of withholding tax collection and submission to the Internal Revenue Service falls on employers. However, grantees who only receive stock options have several drawbacks, such as:

  • Having to come up with the cash to exercise the option,
  • Paying stock broker commissions on any trades,
  • Having to pay taxes on the employee benefit and gain, and
  • The possibility of a decline in the underlying stock’s market value.

If the corporation grants SAR in addition to the stock options, it can reduce the potential cash shortfall. The money required to pay for all of the outflows will be provided by these rights.

Difference between ESOP and SAR

ESOP and SAR differ in several ways, which are:

  • Payment – The money in an ESOP is paid to the employee in a single amount or equal periodic installments, depending on the plan. The corporation redistributes or cancels the shares after paying the employee and purchasing the shares. Only the cash reward is transferable for employees who leave the company voluntarily. In contrast, stock appreciation rights are given at a defined price and typically have a vesting period and expiration date, making them similar to stock options. A SAR that has vested may be exercised by the employee at any time before it expires.
  • Taxation charges – The contributions made to an ESOP are tax-free for the employees. Employees are only subject to taxation when they depart the company in some other capacity or receive a dividend from the ESOP after retirement. Gains that have accrued over time are taxed as capital gains. When you receive stock appreciation rights, there are no tax obligations at the federal level. However, you must record compensation income at the time of exercise based on the fair market value of the vested amount.
  • Protection rights – Employees who participate in an ESOP are safeguarded by ERISA (Employee Retirement Income Security Act) in addition to corporate law, the Company’s internal policies, and other shareholders. Whereas SAR is governed by section 409A of the Internal Revenue Code.
  • Nature – Employee stock ownership plan (ESOP) is an employee benefit plan that provides employees with shares of stock that represent ownership in the business. Contrastingly SARs are a sort of employee remuneration that is based on the stock price of the company over a predetermined period.

Comparison chart of ESOP and SAR

Here’s a closer look at how ESOP and SAR differ:

ESOP (Employee stock ownership plan)SAR (Stock Appreciation Rights)
Non-discrimination testing is not required.Non-discrimination testing is required.
Employers might utilize it to target and reward particular workers.An employer cannot offer to identify and reward certain employees.
Not subject to an expiry date.It possesses a time limit.
Sometimes employees hold or own shares.The employee doesn't own or hold any shares.
The spread at exercise is subject to ordinary income tax.Distributions received after termination of service are subject to taxation.
It creates Equity.SAR creates liability.

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