Understanding Stock Appreciation Rights
What Are Stock Appreciation Rights (SAR’s)?
Stock Appreciation Rights provides a way for Employers to give key employees incentives to stay with them by providing them an opportunity to participate in and be rewarded for their contribution to the long-term growth of the company.
To illustrate, in acknowledgement of your value and to encourage you to stay with them for the long term, your company gives you 1,000 shares of SAR’s (stock grant) at $10 per share on January 2nd, 2019. Your SAR units will vest on January 2, 2022. Starting on this date, and up until a designated expiration date, you will have the option of exercising your right to the appreciation of your 1,000 shares. Any SAR shares not exercised after the expiration date will be voided.
For example, if the market price is $25 and the grant price is $10, the difference is $15. The potential appreciated value is $15,000 (1,000 shares x $15).
Depending on our company policy, you could receive the $15,000 as a cash bonus (called a cashless exercise) or you could receive $15,000 worth of company stock.
If you receive stock, it is important to note that the price of the stock on the date you exercise your SAR’s is the “exercise” price (your cost basis). The number of shares you actually receive will be the appreciation value divided by your exercise price. In this case it will be 600 shares ($15,000 / $25)
Now what happens if the price of the stock on the date your stock vests is lower than the grant price? In this case, your SAR is considered to be “underwater” and you won’t be able to exercise your right. You would have to wait until the market price goes above the grant price.
How are SAR’s taxed?
The appreciation value whether it is received in cash or in stock is treated as compensation and is taxed at your ordinary income tax rates. In our example above, the $15,000 will be added to your total gross income for the year.
Your company will typically withhold a standard amount for Federal and State taxes on your behalf. Sometimes this is sufficient but depending on your income level, the amount of tax withheld might not be enough especially if you are in a high tax bracket. In this situation it is not uncommon to owe more taxes at the end of the year.
Risks of owning SAR shares
An inherent risk of SARs is not properly managing your SAR shares once they are fully vested. One mistake that can happen is not maximizing compensation potential by waiting to long to exercise (not selling when price of your company stock is high). Second, you wait too long and your SAR’s value becomes negative. Third, you miss out on your compensation benefit altogether because you lost track of the expiration date of your SARs and they expire before you could take action.
If you do manage to exercise your SARs and you are given stock compensation, you now have the risk of stock ownership. An inherent risk of owning shares of stock is the risk of investment losses.
Holding on to company stock exposes you to the risk of having a “concentrated stock position”. This happens when you hold on to a large amount of your company stock to such a level that it can potentially impact the value of your entire investment portfolio.
If your portfolio becomes concentrated, a dramatic change in your company stock can have an impact on the entire portfolio. While this might not seem like a big deal if your company stock is rising but if it were to drop in price, your entire portfolio would lose value. This impact can be significant especially if you are nearing retirement.
A major tax risk of SARs is not considering the tax impact of your additional compensation. This can happen if your SAR’s value has grown significantly from the time they are granted to you and when they fully vest. If you have a large amount of SARs shares that are fully vested, you may want to consider exercising your rights over a period of years in order to minimize the tax impact so as to not push your income into a higher marginal tax bracket and / or limit your ability to take advantage of tax credits and deductions.
This content is developed from sources believed to be providing accurate information, and provided by Attune Financial Planning. Please consult your financial, legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information only.