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What Are Stock Appreciation Rights SARs and How Do They Work

What Are Stock Appreciation Rights SARs and How Do They Work

Stock Appreciation Rights (SARs) are a type of employee compensation linked to the company’s stock price during a predetermined period. SARs are profitable when the company’s stock price rises, similar to employee stock options (ESOs). However, employees do not have to pay the exercise price with SARs. Instead, they receive the increase in stock or cash.

The primary benefit of SARs is that employees can receive proceeds from stock price increases without buying stock.

Key Takeaways:

– SARs are employee compensation linked to the company’s stock price during a preset period.

– Unlike stock options, SARs are often paid in cash and do not require the employee to own any asset or contract.

– SARs are beneficial to employers as they do not have to dilute share price by issuing additional shares.

Understanding SARs:

SARs offer the right to the cash equivalent of a stock’s price gains over a predetermined time interval. Employers almost always pay this bonus in cash, but they may pay it in shares. Employees can exercise SARs after they vest. Employers issue SARs along with stock options, known as tandem SARs, to fund the purchase of options and pay taxes when the SARs are exercised.

SARs are transferable and subject to clawback provisions. Clawback provisions allow the company to take back some or all of the income received under the plan, such as if an employee goes to work for a competitor before a specified date. SARs are often awarded based on a vesting schedule tied to company performance goals.

SARs are taxed the same way as non-qualified stock options (NSOs). There are no tax consequences on the grant date or when they are vested. However, participants must recognize ordinary income on the spread at the time of exercise. Employers also withhold supplemental federal income tax and funds for state and local taxes.

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Employers may withhold taxes on SARs in the form of shares. The recognized income upon exercise becomes the cost basis for taxes when holders sell the shares.

Special Considerations:

SARs are similar to phantom stock. The major difference is that phantom stocks reflect stock splits and dividends, while SARs reflect stock price increases over a specified period. Phantom stock is taxed as ordinary income upon receipt and does not have to follow the rules of tax-qualified plans like employee stock ownership plans (ESOPs) and 401(k)s.

Advantages and Disadvantages:

The greatest advantage of SARs is flexibility. Companies can structure SARs in different ways for different individuals. However, this flexibility requires making choices regarding which employees receive SARs, the value of the bonuses, the liquidity of the SARs, and vesting rules.

Employers like SARs for their favorable accounting treatment and the issuance of fewer shares compared to traditional stock plans. SARs can motivate and retain employees like other forms of equity compensation. However, SARs are a high-risk form of compensation as they expire worthless if the stock does not appreciate.

Example of SARs:

An employee earns 200 SARs as a performance bonus that matures after two years. If the stock price increases by $35 a share over those two years, the employee receives $7,000 (200 SARs x $35 = $7,000) in additional compensation. SARs may have a clawback provision where employees lose them if they leave the company before the two-year period ends.

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