By Michael Torney, CFP, J.D., LL.M.
Stock appreciation rights (SARs) are a type of equity compensation award. They give an executive the right to compensation based on the difference between the company’s stock price on a certain date and a later date. After the award is made, SARs become profitable once the company’s stock price rises, after a pre-determined period. Of course, if the company’s stock does not appreciate, SARs will expire and the executive does not realize any profits.
Like other types of equity compensation, SARs are awarded as a long-term incentive to help the company grow. Unlike other kinds of stock grants, an executive will receive proceeds from stock price increases without needing to have cash to buy the company stock. SARs are often paid in cash, though it can also be paid in company stock.
Finally, the term “rights” may be confusing. SARs do not include the rights to dividends, voting rights or any other benefit besides the price appreciation.
Vesting
Like other kinds of equity compensation, SARs are usually awarded over a period of time, referred to as a vesting schedule. Once the SARs vest, the executive can exercise and receive the proceeds. A vesting schedule will vary by company, though it often ranges from two to four years.
Example of Stock Appreciation Rights
An executive is awarded 2,000 SARs when the company’s stock price is $50. The vesting schedule calls for the SARs to vest in three years.
After three years, the stock is worth $85, an increase of $35 a share. If the executive exercises the SARs, he/she will receive $70,000 before taxes (2,000 SARs x $35 = $70,000) in additional compensation.
Taxes
Like other kinds of compensation awards, employers may withhold money from the award to pay federal, state and local taxes.
However, no taxes are due when an executive initially receives the award or when it vests. When the executive decides to exercise shares of their award , the cash received is recognized as income and added to other income in that tax year.
If the SARs are awarded as company stock – and not cash – there is an additional tax consideration. In addition to the ordinary income recognized at exercise, there may be capital gains tax due once the shares are sold on any subsequent gain from the exercise date to the sale date. If the shares are sold for $95 three months after exercise, it is considered a short-term capital gain (which is taxed at ordinary income rates at the federal level).
However, if the shares received from exercise are held for at least one year , it is taxed as a long-term capital gain. The rate here can be much lower than short-term capital gain rates.
Other Items of Note
Like several other forms of stock compensation, an employer can take back the equity award under certain conditions. Known as “clawbacks,” these provisions could allow an employer to withdraw SARs if an employee goes to work for a competitor before a specified date. Check your employer’s plan rules before making any decision to leave the company.
SARs can provide an executive with a potential windfall that could have a major impact on their wealth. With a careful strategy, executives with SARs can work to maximize the profit potential of SARs and minimize the taxes owed. If you have been granted or own SARs and would like to discuss them as part of an overall financial strategy, contact our team at Duffteam@monetagroup.com. We are always available to discuss how we can help people maximize their wealth.
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