Employees who have stock appreciation rights (SARs), which are given out when the market value of the company’s shares rises over the option exercise price, earn deferred incentive pay. Given that it grants the bearer the right to collect a sum of money equal to the surplus of the given shares’ market value over a certain period, it functions similarly to a stock option. However, SAR doesn’t require employees to pay the price for exercising the option. SAR allows businesses to design the compensation plan that best serves the employees and is an amazing way to attract and retain employees. However, before issuing SARs, businesses should compare it with other stock-based remuneration methods and understand stock appreciation rights taxation.
This article discusses everything you need to know about stock appreciation rights. The article will deepen your understanding of SARs with a stock appreciation rights example. We will also compare stock appreciation rights vs ESOP and stock appreciation rights vs phantom stocks to allow businesses to choose the best way of granting employee stock-based awards.
Stock appreciation rights
Stock appreciation rights (SARs) are a fantastic tool for firms to compensate their staff. Although the provided pay is based on the company’s equity, the employer is not required to issue a significant number of new shares under this plan. Due to these benefits, many businesses use these plans to provide remuneration to their workers, which aids in business expansion. Let’s understand it in detail.
What are stock appreciation rights?
Employee remuneration based on the business’s stock value over a defined period is known as stock appreciation rights (SARs). It gives the owner a chance to benefit from the increase in value of a certain number of shares of business stock over a predetermined amount of time.
SARs are comparable to employee stock options because they are advantageous for workers whenever the company’s stock value increases (ESOs). However, with SARs, workers are exempt from paying the exercise price. Instead, they are given the whole stock or cash price rise. Employees with stock appreciation rights may benefit from stock price gains without purchasing more shares.
How do stock appreciation rights work?
The entitlement to the monetary equivalent of a stock’s price increases over a certain period is provided by stock appreciation rights. Regarding stock options, stock appreciation rights are given at a predetermined price and often have a vesting timeframe and expiry date.
The employee may exercise a vested SAR at any time before it expires. Based on the terms of an employee’s plan, the profits may be distributed in cash, shares, or a mix of cash and shares. Proceeds may be considered like any shares of stock in a brokerage account if compensated in the form of shares.
SARs are often given out by employers together with stock options. They aid in financing the acquisition of options and the payment of taxes owed when the SARs are exercised. SARs may be transferred and often come with clawback clauses. Clawback clauses outline the circumstances in which the business may reclaim all or a portion of compensation under the plan. For instance, they could let the company cancel SARs if an employee joins a rival company before the deadline.
Types of stock appreciation rights
There are two types of stock appreciation rights:
- Stand-alone SARs – These are issued independently of any stock options and are provided as separate instruments.
- Tandem SARs – These are awarded along with Non-Qualified Stock Options or Incentive Stock Options, entitling the holder to execute the option as a stock option or a SAR. When one sort of exercise is chosen, another cannot be done.
Pros and cons of stock appreciation rights
SAR provides several benefits over other stock compensation options. The fact that no payment is needed to exercise them for money is the biggest benefit to the workers. Without covering the purchase of the shares, an employee will immediately get the earnings from an exercise. Here are a few benefits for the employer:
- SARs are adaptable in many ways that are most effective for certain people. Companies using SAR plans may choose which individuals get benefits, how liquid the SARs are, how much bonuses are worth, and the optimal vesting schedule.
- SARs have less complicated accounting regulations than other types of stock compensation.
- SAR boosts employee motivation by offering extra benefits above and beyond normal pay that are linked to a company’s success, inspiring them and reducing turnover.
- SARs do away with qualified stock options’ preferential tax treatment.
SARs are a risky type of employee pay despite their numerous advantages. SARs frequently expire meaningless if the company’s stock doesn’t rise. Like straight stock options, tandem SARs may also hurt a company’s share price since they will increase the number of outstanding shares, lowering profits per share.
Special considerations for stock appreciation rights
SARs and phantom stock are related in various respects. The main distinction is that phantom stocks often represent dividends and stock splits. Phantom stock is a type of stock-based remuneration that grants an employee the right to a one-time cash payout equal to the rise in stock price.
The phantom stock reward that an employee gets is taxable at the time of receipt as ordinary income. Since phantom stock isn’t tax-qualified, it is exempt from the regulations that apply to 401(k)s and employee stock ownership plans (ESOPs).
Example of stock appreciation rights
Take into account an employee who receives a productivity incentive of 500 SARs. Additionally, imagine that the SARs reach their maturity after five years. Over the next five years, the company’s stock rises by $10 per share. Consequently, the employee gets paid an extra $5,000 (500 SARs x $10 = $5,000). Additionally, these SARs could have a clawback clause that makes workers forfeit them if they leave the firm before the five-year window closes.
Tax treatment of stock appreciation rights
The tax status of SARs is often similar to that of non-qualified stock options (NSOs). Both on the day of the grant and when they become vested, there are no tax repercussions of any sort. At the time of exercise, participants must recognize ordinary revenue on the spread. The operational responsibility of withholding tax collection and submission to the Internal Revenue Service (IRS) falls on employers. The majority of employers will additionally deduct additional federal income tax. Additionally, they will set aside money to cover local and state taxes as needed.
Employers often withhold taxes on SARs in the form of shares. An employer may, for instance, only distribute a fixed number of shares and withhold the rest to pay the tax. Similar to NSOs, when holders sell their shares, the revenue received upon exercise becomes the cost basis for taxation.
However, awardees who only receive stock options have some drawbacks, such as having to put together the funds to exercise the option, needing to pay stock broker compensations on any trades, having to pay taxes on the fringe benefits and gain, and the possibility of a downturn in the underlying stock’s market value. If the corporation grants SAR in addition to the stock options, it may reduce the possible cash shortage. These rights will provide the money required to pay for the outflows.
Stock appreciation rights vs ESOP
Employee stock options are another type of stock-based compensation. Employee stock options, or ESOPs, are granted to workers as part of an ESOP Plan, giving them the “option or right” to buy the company’s shares. Employees participating in ESOPs must fund the exercise price and acquire the shares. Additionally, they pay different taxes than SARS. Let’s look at the difference between SARs and ESOP in detail with the table below –
|The employee is under no obligation to make an advance payment to exercise SAR.||To get the shares, employees must pay the exercise price.|
|Participants are not subject to taxes upon granting or vesting.||Employees are subject to exercise price taxes without any cash receipt.|
|Taxed as ordinary income.||Taxed as both capital gains and ordinary income.|
|May be paid in cash, stock, or a mix of both.||Compensated with shares that must be issued, shareholders' rights must be included.|
Stock Appreciation Rights vs Phantom Stock
Although they are relatively similar, SARs and phantom stock differ. The primary distinction is that phantom stocks often represent dividends and share splits. A promise to earn compensation equivalent to either the rise in stock prices or the worth of the company’s shares over a certain period is made to an individual when they receive a phantom stock.
SARs, on the other hand, provide the buyer with the right to the cash equivalent of increases in the specified number of shares throughout a certain length of time. Most of the time, this bonus is provided in cash. However, the business can also give the employee bonus in stock. SARs may often be exercised when they become exercisable or after vesting.
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