What Are Stock Appreciation Rights?

A stock appreciation right (SAR) is a form of bonus compensation given to employees that is equal to the appreciation of company stock over an established time period. Similar to employee stock options (ESO), SARs are beneficial to the employee when company stock prices rise; the difference with SARs is that employees do not have to pay the exercise price, but receive the sum of the increase in stock or cash.

The primary benefit that comes with stock appreciation rights is the fact that the employee can receive proceeds from stock price increases without being required to buy anything outright.

Understanding Stock Appreciation Rights

Stock appreciation rights offer the right to the cash equivalent of value increases of a certain number of stocks over a predetermined time period. This type of bonus is almost always paid in cash; however, the company may pay the employee bonus in shares. In most cases, SARs can be exercised after they vest; when SARs vest, it simply means that they become available to exercise. SARs are generally issued in conjunction with stock options in order to assist in funding the purchase of options or to pay off taxes due at the time the SARs are exercised; these are referred to as "tandem SARs."

Like several other forms of stock compensation, SARs are transferable and are often subject to clawback provisions (conditions under which the company may take back some or all of the income received by employees under the plan, such as if the employee goes to work for a competitor within a certain time period or the company becomes insolvent). SARS are also frequently awarded according to a vesting schedule that is tied to performance goals set by the company.

SARs are taxed the same way as non-qualified stock options (NSOs). There are no tax consequences of any kind on either the grant date or when they are vested. Participants, however, must recognize ordinary income on the spread at time of exercise, and most employers will withhold supplemental federal income tax of 22% (or 37% for the very wealthy) along with state and local taxes, Social Security and Medicare. Many employers will also withhold these taxes in the form of shares. For example, an employer may only give a certain number of shares and withhold the remainder to cover the total payroll tax. As with NSOs, the amount of income that is recognized upon exercise then becomes the participant's cost basis for tax computation when the shares are sold.

Key Takeaways

  • Stock appreciation rights (SARs) are a form of compensation, often received as a bonus, that awards the cash value equivalent to the change in a company's stock over some vesting period.
  • Unlike stock options or stock bonuses, SARs are most often paid in the form of cash and do not require the employee to own any asset or contract.
  • SARs are beneficial to employers since they do not have to issue additional shares as compensation, which would dilute share price and earnings.

Advantages and Disadvantages

SARs have many advantages, the greatest of these being flexibility. SARs may be created in a variety of different designs that work for each individual. This, however, comes with numerous choices and decisions that must be made, including which employees receive bonuses and the value of those bonuses, liquidity issues, eligibility and vesting rules.

Employers like SARs because the accounting rules for them are now much more favorable than in the past; they receive fixed accounting treatment instead of variable and are treated in much the same manner as conventional stock option plans. But SARs require the issuance of fewer company shares and, therefore, dilute the share price less than conventional stock plans. And like all other forms of equity compensation, SARs can also serve to motivate and retain employees.

Stock Appreciation Rights vs. Phantom Stock

SARs are similar in some ways to so-called phantom stock. The major difference is that phantom stocks are typically reflective of stock splits and dividends. Phantom stock is a promise that an employee will receive a bonus equivalent to either the value of the company’s shares or the amount that the stock prices increase over a given period of time. The bonus an employee receives is taxed as ordinary income based on the time that it is received. Because phantom stock is not tax-qualified, it does not have to follow the same rules that employee stock ownership plans (ESOPs) and 401(k) plans must follow.

Example of Stock Appreciation Rights

As an example, consider an employee is given 200 SARs at their end-of year review as a performance bonus which mature after a period of two years.. The stock of the company then proceeds to increase by $35 a share over that two year period. This results in the employee receiving $7,000 (200 SARs x $35 = $7,000) in additional compensation.