Stock Appreciation Rights 101 (Part 1)
Stock appreciation rights, referred to as SARs, are a type of equity grant made at some companies. When the exercise income from SARs is settled in company stock, SARs offer you the same benefits as stock options, and with less dilution to your company's shareholders.
To help you understand SARs, this article series looks at seven key concepts. Part 1 explains what the "appreciation" part of this grant means, the role of exercises, and taxes at exercise. Part 2 discusses taxes at sale, other similarities with stock options, IRS concerns linking SARs to deferred compensation, and why companies like SARs.
1. What's The Appreciation?
SARs are a type of equity compensation that entitles you to receive the increase (i.e., the appreciation) in value on shares of company stock from the grant date. You do not receive the value of the underlying shares (e.g. stock price is $25, value per share is $25) as you do with restricted stock; rather, you receive only the increase in the value of the shares from grant, as with stock options (e.g. stock price at grant was $10 and rises to $25, so the increase is $15). These "rights" do not also include rights to dividends or voting rights, as with restricted stock.
You exercise the SAR and, depending on the plan's design and practices, receive in either cash or stock the "spread" between the SAR price at grant and the fair market value on the date of exercise. (For reasons explained in Part 2, stock-settled SARs are attracting a lot of attention.)
Example: You are granted 1,000 SARs when the stock price is $10. This $10 is your starting level for any gains. After the SARs vest, you exercise them when the market price is $25. The $25,000 value at exercise minus the $10,000 value at grant ( = $15,000) is divided by the $25 current share price. With stock-settled SARs, your company then issues you 600 shares (with cash-settled, you receive $15,000). You owe ordinary income, Social Security, and Medicare tax on the spread.
SARs offer you the same type of leveraged upside potential as stock options. You have the equivalent of a fixed purchase price throughout the term of the SARs. This also means that SARs, like options, can go underwater if the stock price drops after grant.
2. Exercise Still Important
You control the timing of exercise and thus when taxes are triggered, unlike with standard restricted stock and RSUs. Because you have no exercise cost, you do not need to put in any money to receive the appreciation spread above the grant-date value.
You exercise SARs by notifying your company according to the procedures in your stock plan or grant agreement. Before the shares are released at exercise, your company will likely require you to set up an account for the shares with a certain brokerage firm (or firms) and specify a withholding method, unless share withholding is automatically used.
At exercise, you receive in this account a payment in stock equal in value to the amount the shares have appreciated since the grant. Your company will have rules on how the fair market value at exercise and the spread are calculated, and how it handles fractional shares. For example, if you are selling all the stock at exercise, your company may use the actual sales price for this calculation. Alternatively, when you are holding the stock at exercise, it may use the closing or average price for the day.
In the example above, you receive 600 shares with a pre-tax value of $15,000 that appears on your W-2. The outcome is identical in value to a cashless exercise or sell-to-cover of 1,000 stock options, but with SARs you eliminate the need for an open-market sale to raise funds for the exercise price. With options, you would have $15,000 if you sold all the shares in a cashless exercise, after using $10,000 from the sold shares to pay the exercise price. With your SARs, you have 600 shares, as you would after a sell-to-cover option exercise (i.e., you would exercise and sell all 1,000 shares, using 400 shares at $25 to cover the $10,000 exercise cost).
Similarities between exercising 1,000 SARs and 1,000 stock options when the market price at grant / exercise price is $10 and the market price at exercise is $25 (tax withholding of shares not used in example).
|Exercise methods||1,000 stock options||1,000 SARs|
|Spread/value at exercise||$15,000||$15,000|
|Sell all shares at exercise: cash to you||$15,000||$15,000|
|Sell just enough shares to cover option exercise cost (sell-to-cover): shares you then hold||600 shares||600 shares|
|Hold all shares (cash used to exercise options)||1,000 shares||600 shares|
|Cash needed to fund exercise (not incl. taxes) when hold all shares||$10,000||$0|
|Shares company issues, regardless of exercise method for options||1,000||600|
3. Tax Rules At Exercise Sound Familiar
As with stock options, you face no taxes at grant or vesting. The spread at exercise is ordinary income to you and is taxed like the exercise spread of nonqualified stock options (NQSOs). In fact, SARs follow the same tax rules that are discussed in the NQSO sections of this website. Therefore you do not face the complications that stem from holding the stock after an exercise of incentive stock options (ISOs): alternative minimum tax (AMT), special holding periods, and potential tax benefits and complexities.
Tax is withheld at supplemental income rates, though your company may automatically "withhold" shares to cover the taxes by retaining a number of shares equal to the taxes. Alternatively, depending on your company's procedures, you may use cash, including payroll deductions, to pay withholding or you may use shares you already own.
Example: The $15 spread at exercise of 1,000 SARs gives you $15,000 in taxable income that will appear on your W-2. At exercise, your company withholds at the standard federal supplemental income rate of 22%, plus any state and local taxes, Medicare, and Social Security. If, for example, these combined taxes equal 35% of the spread value, your company holds back 210 shares (210 x $25 stock price = $5,250). It forwards this amount in money to the IRS to cover the withholding, regardless of whether it actually sells shares to fund this payment. Thus in this example, you end up with 390 shares.
Speak with your tax expert about whether you need to report these shares surrendered at exercise as a "sale" on your tax return.
Using the required withholding rates, your employer may withhold more or less federal (or state) income tax than you will eventually owe on your year-end tax return. Your company is unlikely to withhold shares that have a greater value than the statutory minimum percentage for supplemental income (22%, but 37% for yearly amounts above the level of $1 million). When a SAR exercise pushes you into a higher tax bracket, you should ensure that you put aside enough cash to pay the tax. Otherwise, by tax-return time you could be short of the money to pay taxes on SAR profits you might have spent or lost on other investments. If your gains are extremely substantial, you should consider paying estimated taxes.
Part 2 discusses the tax treatment for sales of the stock you receive at SAR exercises, along with other topics.
Bruce Brumberg is co-founder and Editor-in-Chief of myStockOptions.com.