A stock appreciation right is a method that companies can use to give their executives and other employees a bonus if the company performs well financially. The bonus payment is equal to the appreciation in the company stock between the time of the grant price of the SARs and the exercise date of the right.
Like non-qualified stock options and incentive stock options, stock appreciation rights allow employees to participate in the upside potential of the company via an appreciating stock price. Additionally, they may be issued a grant date, a vesting date, and an expiration date.
Unlike their stock option cousins, stock appreciation rights do not require the employee to purchase the shares of the stock at exercise. Upon exercising the right, employees receive the value of any price increase that is greater than the grant price, often as cash (although some plans may allow for the employee to take the value as shares of company stock).
A key difference between an stock appreciation rights and stock options is that when you exercise an SAR, the proceeds are often paid out in cash. On the other hand, when exercising a stock option, proceeds are often paid out in employee stock. This difference in payment may have a material impact on diversification and concentration risk as they pertain to a personal financial plan.
How Does an Stock Appreciation Right Work?
Stock appreciation rights are granted as part of a compensation package. Upon receipt, they are often issued with key dates and figures:
- Grant Price – This is the price that is used to determine if the shares will have value in the future. If the stock price is above the grant price, the right is “in the money.” If the stock price is below the grant price, the right is worthless.
- Vesting Date – This is the day upon which the employee can exercise the stock appreciation right. Prior to this date, any in-the-money value cannot be captured. After vesting, the employee can then exercise the right and capture the gain, if they so choose.
- Expiration Date – This is the last day upon which an employee can exercise their stock appreciation right, or they risk losing the right. For stock with a share price below the grant price, shares will likely expire as worthless. For stock with a share price that exceeds the grant price, exercising will likely make sense.
Using a hypothetical example, we can explore the details of a stock appreciation right:
- Grant date – January 1, 2014
- Grant price – $10
- Number of shares – 1,000
- Vesting date – January 1, 2017
- Expiration date – December 31, 2023
Continuing our example, let’s assume that the share price on January 1, 2017 is $25. In this example, the in-the-money value of the shares is as follows:
($25 – $10) * 1,000 = $15,000
At this time, the employee has two options: they can exercise the stock appreciation rights, pay the taxes on it, and receive the proceeds of the sale; or they can leave the SARs unexercised. Unexercised stock appreciation rights will be subject to market fluctuations. Should the stock price continue to go up, additional value can be created. However, should the stock price decrease in value, wealth can be lost.
If we change the assumption to assume the date is December 31, 2023, it would make sense for the employee to exercise the right. If they do not, the right will expire, and any value will then be forfeited.
How Are Stock Appreciation Rights Taxed?
Upon receipt, no taxes are due on stock appreciation rights. Like their non-qualified stock option cousins, tax is due at exercise rather than receipt. Specifically, gain in excess of the grant price is taxed as ordinary income and is subject to payroll tax that must be paid by the employee. The tax will likely be paid from cash (or shares) that is withheld upon exercise of the employee’s stock appreciation right.
Following our example above, the amount of taxable income (which will appear on a W-2) for the employee is $15,000. If we assume a federal tax of 25% and a payroll tax of 7.65%, we can calculate a tax liability of $4,898 for net proceeds to the employee of $10,102 (this resembles a cashless exercise).
If the employee decides to take receipt of the stock appreciation rights in shares, the cost basis of the shares will be equal to the exercise share price. Any further appreciation or loss will be taxed as a capital asset that is subject to both short-term and long-term capital gains rules.
Planning for Stock Appreciation Rights
Stock appreciation rights look similar and operate very similarly to their stock option cousins. For this reason, many of the planning considerations remain the same. However, some key questions should be asked:
- How much company stock do I own?
- When is the best time to exercise my shares?
- Do I want to take receipt of my earnings in cash or in stock?
- How does this fit into my overall financial and retirement plan?
While many of the answers to these questions will be the same as they are for stock options, a key distinction exists that should be touched on. The result of exercise stock appreciation rights is often the receipt of cash, while the result of exercising stock options is often the receipt of stock.
One risk of an employee stock option is that the accumulation of so many shares over time can lead to concentration risk. As concentration risk increases, it’s important that the employee has a strategy in place to manage this risk.
Because stock appreciation rights are often paid in cash, it takes a concerted effort on the part of the employee to buy additional shares of company stock. From a behavioral standpoint, one could suggest that using cash on hand to buy more shares of an increasingly concentrated position is more difficult. Following this assumption, stock appreciation rights may lead to a portfolio that is more diversified (assuming the cash isn’t received and spent, which is also quite possible).
On one side, there is the risk of owning too much stock in one company. On the other, the risk of spending the proceeds instead of saving them is very likely. A good financial plan can help balance these risks while developing a strategy to manage these risks equally.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.