Stock appreciation rights (SARs) are a type of compensation that can be offered to employees or independent contractors. If you are an employee or contractor, a SAR allows you to receive the increase in value of a company's stock over a set period of time. You can do so by cashing out or exercising your SAR for shares of stock.
If you have stock appreciation rights as an employee benefit or you're offered them as an independent contractor, it's important to understand how they work. Here’s a closer look at stock appreciation rights, examples, and how they compare to employee stock options.
Definition and Examples of Stock Appreciation Rights
The IRS states on its website that “a Stock Appreciation Right (SAR) is an arrangement, during a specified period, which the employee has the right to receive the increased value of the employer's stock by cashing out or exercising the SAR."
In other words, employees do not directly own shares of their company’s stock. Instead, they can receive the difference in the value of an employer’s stock share when it increases. For example, let’s say you were granted stock appreciation rights on 10 shares of your company ABC’s stock, valued at $10 per share. Over time, the share price increases from $10 to $12. This means you’d receive $2 per share since that was the increased value. At $2 per share, you’d receive $20 total ($2 x 10 = $20). This is a simple example; other factors come into play before you can be compensated.
- Alternate definition: Stock appreciation rights are a type of equity-based compensation. This means any compensation that's paid to an employee, director, or independent contractor is based on the value of the specified stock.
- Acronym: SAR or SARs
Stock appreciation rights can be offered as part of an employee compensation package alongside stock options and are referred to as tandem SARs.
How Do Stock Appreciation Rights Work?
Employees and independent contractors with stock appreciation rights can benefit from increases in the value of company stock over a predetermined time period. Exercising a SAR allows participants to receive the proceeds of a stock increase in cash or in an equivalent number of shares, without having to purchase the stock.
Companies may offer these benefits for various reasons. They may choose to offer SARs if:
- They intend for employees and independent contractors to share in the equity value of the company, but not in the equity itself
- Offering more conventional compensation structures, such as an employee stock ownership plan (ESOP) or profit-sharing plan, is cost prohibitive or limited by corporate restrictions
- Their goal is to supplement existing stock ownership plans without providing additional shares of stock directly
- Offering equity shares is not an option because the company is a nonprofit or government entity
Stock appreciation rights are governed by the Internal Revenue Code and U.S. Treasury regulations. These rules specify that, for tax purposes, amounts received after exercising a SAR arrangement are included in the employee's income. SARs also constitute wages and create a deduction to the employer.
Typically, employees can exercise SARs once they’re vested or become available to exercise. This vesting period, similar to a vesting schedule associated with 401(k) plans, can vary from company to company.
Stock appreciation rights can expire. The expiration date may be accelerated if you leave your employer or retire.
For example, say that your company offers you a SAR arrangement in which you're granted 100 shares of stock worth $10 each. The SAR vests in five years.
Five years later, you decide to exercise the arrangement. By this time, the stock's value has climbed to $50 per share. This entitles you to the $40 per-share increase. This is a value of $4,000 because it’s based on the 100 shares in the arrangement ($40 x 100 = $4,000).
Depending on the options offered by the company, you may be able to receive this amount in cash or an equivalent number of stock shares. The latter option would afford you 80 shares at the current share price of $50 ($4,000 / $50 = 80). Again, you got this $4,000 benefit without having to purchase shares of stock directly.
Stock Appreciation Rights vs. Employee Stock Options
Stock appreciation rights and employee stock options offer two paths to equity. With stock options, employees have the right to buy shares of company stock at a preset price for a set time period.
Here's how stock appreciation rights compare to employee stock options:
|Stock Appreciation Rights||Employee Stock Options|
|Employees and independent contractors do not have to directly purchase shares of a company’s stock to benefit from a SAR||Employees have the option to purchase shares of company stock directly|
|SARs can pay cash or stock shares when they're exercised||Employees must sell their shares to exercise their stock options and receive cash payments|
|Stock appreciation rights are treated as taxable compensation when they're exercised; capital gains tax may apply if you receive shares instead of cash and then sell those shares||Taxation depends on whether you receive non-qualified or incentive stock options|
With stock appreciation rights, you don't need to buy shares of stock to benefit from an increase in the stock's value. Employee stock options, on the other hand, require you to exercise your right to purchase company stock in order to benefit from any increase in value.
When you exercise a stock appreciation right, the company may offer cash or shares of the company stock valued at the same amount. When you exercise a stock option, on the other hand, you're buying shares of stock in the company. If you want to convert those shares to cash, you'd have to sell them after exercising the option.
Stock appreciation rights are treated as taxable income when you exercise them. If you receive shares of stock instead of cash, and then decide to sell those shares, you may owe capital gains tax on the appreciated value. Stock options are taxed differently, depending on whether they're non-qualified or incentive stock options.
With NSOs, you'll pay ordinary income tax when you exercise the options. This tax applies to the difference between the fair market value of the shares when you exercised them and what you actually paid for them. You'd also owe capital gains tax if you sell the shares at a profit. With incentive stock options, you'd owe capital gains tax only when you sell the shares.
- Stock appreciation rights (SARs) can enhance your compensation package by allowing you to leverage share price increases without having to purchase any stock.
- You may be able to receive the value of share price appreciation in cash or stocks, depending on how the plan is structured.
- Companies may offer stock appreciation rights arrangements alongside other stock ownership plans to employees and independent contractors.
- SARs are treated as taxable compensation when you exercise them. You may also owe capital gains tax if you’re compensated in the form of stock shares and sell them for a profit later.
Frequently Asked Questions (FAQs)
How do I report stock appreciation rights on my tax return?
Stock appreciation rights are reported on tax Form 1040 along with other taxable income for the year. Your employer should provide you with Form W-2 by the end of January. That W-2 will include any income you may have received through exercising SARs during the prior tax year.
How are stock appreciation rights different from phantom stock?
Phantom stock refers to a promise to pay a bonus to an employee in one of two ways. Employees can receive the equivalent of the value of company shares or the increase in that value over a certain time period. Phantom stock plans are not tax-qualified and payments are typically made at a predetermined date. They may also reflect stock splits and dividends.
What happens to stock appreciation rights when a company is bought?
This can depend on the company and how the arrangement is structured. For instance, following a merger or acquisition, a company may restructure the SAR plan or provide a different path to stock ownership.