We’ve come to the last post in my series on compensation beyond your paycheck. In the past few weeks, I’ve explored different forms of equity compensation including restricted stock units (RSUs), Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs) and Employee Stock Purchase Plans (ESPP). For this last post, I wanted to go over Stock Appreciation Rights (SARs). Like other forms of equity compensation, SARs are a little complicated. You’ll have to learn the ins and outs of this program to make the most of it.
What are SARs?
As you might guess from the name, SARs allow you to benefit from a rise in the value of your company’s stock. But unlike most other forms of equity compensation — RSUs, NSOs, ISOs and ESPPs — they do this without requiring you to ever own the underlying stock.
How does that work? SARs are granted at one price, usually the market price on the day of the grant. They vest over a certain time frame (usually one to two years) and expire at some point in the future (e.g., five years from the grant date). You can exercise your rights any time after the vesting date and before they expire.
For example, let’s say you’re granted SARs representing 1000 shares today when your company’s stock closes at $20/share. You have a one-year vesting period — that is, you can’t exercise your SARs for a whole year — and a five-year expiration period. At the end of the first year, the stock is worth $30/share. If you exercise all of your rights at that point, you have a gain of $10,000 (($30/share – $20/share) * 1000). Now about that gain — depending on the type of SARs that you have, you may get this bonus in company stock (Stock-Settled Stock Appreciation Rights or SSARs) or cash (Cash-Settled Stock Appreciation Rights or CSARs).
If you’re awarded your gain in stock, that $10,000 gain is divided by the current stock price (in our example $30/share). You’re awarded 333 shares of your company stock in a brokerage account, minus the amount withheld for income and employment taxes (more on the taxes below). If you have CSARs, you receive the $10,000 in cash, again minus the amount withheld for taxes.
You’ll notice here the key difference between SARs and the other forms of equity compensation that I’ve discussed. When you exercise SARs you won’t receive the value of the underlying shares of stock, only the amount of the appreciation. In other words, you don’t get 1,000 shares of company stock at $30/share. You just get the difference in amount between the $20/share and $30/share. This form of compensation works in your favor because you don’t have to pay for the cost of the shares when you exercise as you do with the other forms of equity compensation. Simply put, you don’t have to purchase anything to receive the proceeds.
In this way, SARs most closely resemble phantom stock plans. Both types of plans award cash bonuses. The main difference being phantom stock is typically paid out at the end of a specific period of time. You don’t get to decide when and whether you want to exercise your options. Also, phantom stock plans often set conditions for exercising shares. You might have to meet a sales target or the company might need to make a certain amount of profit, for instance; SARs don’t usually have these kinds of restrictions. Lastly, phantom stock also tends to reflect stock splits and dividends, unlike SARs. I’ve recently seen a client’s company provide her with PSARs (Phantom Stock Appreciation Rights), which is a combination of the two.
Keep in mind that your SARs may become “under water,” if the stock price drops below the fair market value on its grant date. That makes it essentially worthless. For this reason, it’s important to keep track of the grant, exercise and expiration dates to ensure you don’t miss out on an opportunity to exercise while in the red.
SARs don’t create a tax liability when your company grants them to you. However, when you exercise your SARs you owe ordinary income and employment taxes on your gains, that is, the difference between the set price and the fair market value of your stock when you exercise. This is also known as “the spread.”
Your company will report that as ordinary income amount on the W-2 from your company. Note that with SSARs, the taxable amount at exercise doesn’t change whether you sell the shares you receive immediately or hold on to them. If you hold on to your shares after exercise, you have to pay any short- or long-term gain or loss when you do sell them.
It’s also good to remember that your employer is generally obligated to withhold taxes, whether the bonus is given in cash or stock. So while your gain may be $10,000, you won’t receive that entire amount. You just receive the net proceeds in your specified brokerage account. You may find that your company also allows you to use cash, including payroll deductions, to pay withholding or you may use shares you already own.
The great thing about SARs is that you get to determine when you exercise them, and thus, you can control when the taxation occurs. Because large increases an income can have a significant affect on your ability to take certain deductions (student loans, child tax credit, itemized deductions, etc.), it’s especially important that you take into consideration the effect of exercising some or all of your SARs will have on your overall tax situation.
Many people don’t think about this until they begin to prepare their tax return – and it can be a nasty surprise. Your company will likely only withhold the minimum percentage required for supplemental income (22%, but 37% for yearly amounts above the level of $1 million). However, if your marginal tax bracket is 35%, you still have a large gap between what was withheld and what you’ll actually owe. So it’s especially important to know how much the exercise of the SARs will increase your marginal tax rate. I highly recommend seeing a tax professional to help you project how much additional tax will be due and the estimated taxes you’ll need to make when you exercise your SARs.
Unlike the other forms of equity compensation, you won’t need to decide whether to participate in a SAR plan. Your employer makes most of the decisions when it comes to the structure of the compensation. Even so, it’s important that you take into consideration a few things to make the most of this benefit:
- Hold on to your grant agreement: As with all equity compensation, the devil is in the details. So make sure to take special care in holding onto your grant agreement and/or summary page. This will have your important time frames such as the vesting period, exercise dates and expiration dates, as well as how the grant price and exercise price are calculated.
- Get familiar with your brokerage account: When you exercise, your company will likely require that you set up a brokerage account (think E*trade). It’s important that you know the ins and outs of how that accounts works, how to sell your stock and how to transfer the money out of the brokerage account to your personal funds.
- Think about your entire situation: SARs can play an important role in helping you achieve your financial goals, but you have to think about what role exercising your SARs will have on your overall plan and, especially, your taxes. Don’t feel like you need to figure all this out by yourself. This is a good time to seek the help an independent third-party, such as a tax planner, accountant or financial planner.
I hope you found this series informative and helpful. As always, I would love to hear about your specific issues or questions you have with equity compensation. Feel free to contact me at the links below.