Three conditions keep the award out of section 409A, and all three are strict. Section 409A governs deferred compensation and imposes rigid rules about when payments may be made, with a punitive tax when they are broken. Treasury Regulation section 1.409A-1(b)(5)(i)(B) carves stock appreciation rights out of it, but only where three things hold. The payment cannot exceed the excess of the share's fair market value at exercise over an amount specified at grant, measured on a share count fixed at or before grant. The exercise price "may never be less than the fair market value of the underlying stock ... on the date the right is granted". And the right may include no feature deferring compensation beyond the deferral of income recognition until exercise.
That second condition means 100 percent of grant-date value, not 85 percent, and this is the point at which three separate rules that share the number 85 get mixed together. A qualified employee stock purchase plan may price its options at 85 percent of fair market value, under section 423(b)(6) of the Internal Revenue Code. A wage and hour regulation, 29 CFR 778.200(a)(8), requires an exercise price of "at least 85 percent of the fair market value of the stock at the time of grant" before a grant can be excluded from an employee's regular rate for overtime purposes. Neither of those rules touches section 409A, which permits no discount at all on a stock appreciation right. Three different regulators, three different purposes, one coincidental number.
Cash-settled and stock-settled rights differ in ways that matter to the holder. The SEC's definition covers rights "payable in cash or stock, including SARs payable in cash or stock at the election of the registrant or a named executive officer". A cash-settled right pays money and leaves the employee with no ongoing position in the stock, which is a diversification advantage rather than a drawback. A stock-settled right delivers shares worth the appreciation, so the employee ends up holding employer stock and has made an investment decision without ever choosing to make one. One narrow tax consequence follows the stock-settled form: Publication 525 states that "qualified stock" for the section 83(i) private-company deferral election cannot include stock from stock-settled stock appreciation rights.
The tax is ordinary and it arrives at exercise. The payment is compensation for the year the right is exercised, reported as wages and subject to income and payroll tax withholding. The employment tax regulations confirm the timing from the other direction: 26 CFR 31.3121(v)(2)-1(b)(4)(ii) provides that granting a stock appreciation right is not a deferral of compensation, and that amounts received on exercise are not deferred compensation "if such amounts are actually or constructively received in the calendar year of the exercise". So the special timing rule that applies to genuinely deferred pay does not apply here, and a right exercised in one year and paid in the next is worth asking about.
The overtime carve-out is real but conditional. For a non-exempt employee, income from an employer-provided grant under a stock option, stock appreciation right or bona fide employee stock purchase program is excluded from the regular rate used to compute overtime, but only where all four conditions in 29 CFR 778.200(a)(8) are met: the program's terms are communicated to participants, the grant cannot be exercisable for at least six months after grant, exercise is voluntary, and performance-based determinations meet the paragraph's own requirements. Fail one and the value comes back into the regular rate.
