Key Takeaways

  • Stock Appreciation Rights (SARs) give employees cash or stock bonuses equal to the increase in the company’s stock price over time, without requiring them to purchase shares.
  • SARs can be cash-settled or stock-settled, providing flexibility in compensation structures for both employers and employees.
  • They are often used to reward performance and align employee interests with shareholders without diluting equity.
  • Taxation occurs upon exercise, and the gain is treated as ordinary income; employers can generally deduct this expense.
  • Vesting schedules, exercise periods, and payout methods vary by plan, making careful documentation essential.
  • SARs differ from phantom stock because they reward appreciation, not total stock value.
  • Startups and private firms often favor SARs for their liquidity flexibility and non-dilutive nature.
  • Legal and tax planning is critical to ensure compliance with IRS rules, ERISA, and Section 409A for deferred compensation.

What are Stock Appreciation Rights?

Stock appreciation rights are a type of incentive plan based on your stock's value. Employees receive a bonus in cash or equivalent number of shares based on how much the stock value increases over a set period of time - usually from the date of granting the right up until the right is exercised. People familiar with phantom stock will recognize the basic similarities between the two. It is important to note that unlike stock options, employees also do not have to pay the exercise price to receive the bonus in stock or cash.

Holding stock appreciation rights is not the same as holding shares of stock. Employees do not receive a share of equity when you award appreciation rights.

You are free to set the bonus at any level you feel is appropriate. The bonus is usually paid in cash, but you can elect to award shares of stock instead.

For example, imagine an employee is granted a Stock-Settled SARs (SSAR) for 1,000 shares when the company’s stock price is $10 per share. When the employee exercises the vested SSAR, the stock price is $20 per share. The employee gains $10,000 (($20 current price - $10 grant price) x (number of SSARs exercised) which is then divided by the current stock price ($10,000 / $20) resulting in 500 shares. The employee would now owe income and employment taxes on the $10,000 which would cause the shares to be withheld or sold from the 500 shares to cover taxes and fees. The left over shares would be given to the employee to hold or sell.

However, imagine if an employee is granted Cash-Settled SARS (CSARs), the employee would just immediately owe income and employment taxes on the $10,000 gain and would receive the remaining amount in cash. As you can see, employees only receive benefits when the stock prices rise or appreciate.

How Stock Appreciation Rights Work

Stock appreciation rights are typically granted with a base price equal to the fair market value of the company’s stock on the grant date. When the stock’s value increases, employees “exercise” their rights and receive the difference between the current market price and the base price. This payment can be made in cash, stock, or a mix of both, depending on the company’s plan.

Employers often set vesting conditions—for example, performance goals or years of service—to encourage retention. Once vested, employees can exercise their SARs at any time before expiration, typically within a 7–10 year window. This flexibility allows workers to time exercises based on stock performance or personal financial goals.

SARs can be offered as standalone awards or paired with stock options (tandem SARs), enabling employees to use the SAR’s value to cover taxes or purchase costs when exercising options.

Phantom Stock vs. Stock Appreciation Rights

Phantom stocks are just a promise that an employee will receive a bonus equal to either the value of the company’s shares or the increase in stock price over time. They are typically reflective of stock splits and dividends. The bonus the employee receives is taxed as ordinary income based on the time it is received. However, since phantom stock is not tax-qualified, it does not follow the same rules as employee stock ownership plans (ESOPs) and 401(k) plans.

Stock appreciation rights offer the right to the cash equivalent of the increase in value of the stocks over time. This bonus is usually paid in cash or employee bonus in shares. Typically, SARs can be exercised after they vest. They are also issued with non-qualified stock options or incentive stock options to fund the purchase of options or pay off taxes due when the SARs are exercised, also known as tandem SARs.

Stock appreciation rights can be very flexible with differences in who gets how much, vesting, liquidity concerns, restrictions on selling shares, eligibility, rights to interim distribution of earnings, and rights to participate in corporate governance.

Why Are Stock Appreciation Rights Important?

Stock appreciation rights allow you to reward employees for helping your business grow without giving up equity. This is often an attractive option for young companies, such as start-ups. Employers have flexibility in payment options, depending on how their company is set up, and they can usually fund the rights (if paid in stock) through their own payroll system. The payments can be either cash, shares, or some combination thereof.

Employees also receive the benefit of not having to spend cash to buy a non-qualified stock option. Employees further benefit from the flexibility of stock appreciation rights in that they can choose when to exercise their rights at any point between the time it vests until the time it expires.

Benefits of Stock Appreciation Rights for Employers and Employees

SARs provide several advantages for both employers and employees:

For Employers:

  • No equity dilution: Unlike stock options, SARs don’t require issuing new shares, preserving ownership percentages.
  • Retention and performance alignment: Employees are motivated to help the company grow since their benefit depends on stock performance.
  • Cash flow flexibility: Employers can choose between cash or stock settlement based on liquidity.
  • Tax deductions: The company can usually deduct SAR payouts as compensation expenses.

For Employees:

  • No upfront cost: Employees aren’t required to purchase shares to participate.
  • Potential for significant upside: Gains are tied to the company’s stock appreciation.
  • Liquidity advantage: Cash-settled SARs provide immediate payouts, avoiding the need to sell shares.
  • Tax timing flexibility: Employees can choose when to exercise SARs within the allowed window, potentially optimizing their taxable income.

Reasons to Consider Using Stock Appreciation Rights

Growing companies commonly use stock appreciation rights for the following reasons.

It gives your employees incentives without giving up equity.

You are an S-Corp, LLC, partnership or other business entity that is limited in its ability to award stock.

It adds a different kind of incentive option to existing plans such as Employee Stock Option Plans (ESOP) or Employee Stock Purchase Plans (ESPP).

It saves employees from having to buy stock options.

Planning Considerations Before Implementing a SAR Plan

Before establishing a SAR plan, companies should evaluate key administrative and legal factors:

  • Valuation: The base price should reflect the fair market value on the grant date to avoid tax complications.
  • Compliance with Section 409A: Improperly structured SARs may be treated as deferred compensation, resulting in tax penalties.
  • Vesting and forfeiture terms: Clearly define what happens if an employee leaves before vesting.
  • Settlement method: Decide if the company will settle in stock, cash, or a combination.
  • Communication: Clearly explain how SARs work to employees to ensure transparency and engagement.

Engaging a qualified attorney or compensation consultant is strongly recommended to ensure the plan aligns with corporate goals and IRS regulations.

Reasons to Consider Not Using Stock Appreciation Rights

These are reasons to consider avoiding stock appreciation rights.

A plan that covers all employees and continues to provide benefits after termination may need to follow ERISA (retirement plan) rules.

You want the additional cash infusion that comes when employees buy options.

In certain situations, special shareholder approval may be required before issuing stock appreciation rights. This most commonly occurs when a publicly traded company pays the bonus in stock rather than cash.

Potential Drawbacks and Risks

Despite their flexibility, SARs have some downsides:

  • Cash obligations: Cash-settled SARs can create a significant expense for the employer when many employees exercise at once.
  • Tax complexity: Both employers and employees must carefully plan around taxation at exercise.
  • Administrative burden: Ongoing valuation and tracking of vested versus unvested rights can be resource-intensive.
  • Potential dilution: Although SARs are less dilutive than options, stock-settled plans still affect share count.
  • Unrealized value: If the company’s stock price does not appreciate, SARs may provide no benefit to employees.

Key Features

Stock appreciation rights contain several key features.

Base Price: The bonus is based on how much the stock has increased over the base price. The base price is usually the fair market value on the date the appreciation rights were granted.

Vesting: The rights may be conditional based on how long an employee works for the company, an employee's performance or the overall company's performance.

Exercise Period: The time during which the employee may exercise their appreciation rights. This often runs from when the rights vest to the expiration date.

Expiration Date: Stock appreciation rights often have an expiration date. If the conditions for the bonus aren't met by this date, the employee loses the rights. Most rights last from 7-10 years before expiring.

Tax Implications - Upon exercising rights, employees must report any income on the fair market value of the amount of the right received at vesting - even if it is a share and is not sold. The employer usually must withhold taxes (usually by withholding cash or shares).

Tax Treatment and Reporting Requirements

When employees exercise stock appreciation rights, the difference between the market price and the grant price is treated as ordinary income, reported on Form W-2. The employer must withhold income and payroll taxes. Employers can deduct this same amount as a compensation expense.

For cash-settled SARs, employees are taxed at exercise when they receive payment. For stock-settled SARs, the taxable value is based on the stock’s fair market value upon exercise, even if the shares are not sold. Future appreciation or losses after exercise are treated as capital gains or losses if the shares are held and later sold.

Frequently Asked Questions

  1. What is the difference between SARs and stock options?
    Stock options grant the right to buy shares at a fixed price, while SARs provide the value of appreciation without requiring stock purchases.
  2. How are stock appreciation rights taxed?
    Taxation occurs when SARs are exercised, and the gain is treated as ordinary income. The employer typically withholds applicable taxes.
  3. Can private companies offer SARs?
    Yes. Private companies often use SARs to reward employees without issuing actual stock, although valuation may be more complex.
  4. What happens if the stock price falls below the grant price?
    If the market price is below the grant price, SARs hold no intrinsic value and are typically not exercised.
  5. Are SARs subject to ERISA or deferred compensation rules?
    Depending on plan structure, SARs may fall under ERISA or Section 409A if considered deferred compensation. Proper legal drafting helps avoid penalties.

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