How Are Stock Appreciation Rights Taxed?
Understand how exercising Stock Appreciation Rights creates taxable income. Learn how this gain is treated as wages, impacting your withholding and W-2 reporting.
Stock Appreciation Rights, or SARs, are a form of employee compensation tied to the performance of a company’s stock. They provide an employee with the right to receive a payment equal to the increase in the company’s stock price over a predetermined period. Unlike stock options, an employee with SARs does not need to purchase anything to receive the value they have accrued.
The Mechanics of Stock Appreciation Rights
The lifecycle of a Stock Appreciation Right begins with a grant, where the SARs are formally issued to an employee. The grant agreement specifies the number of SARs, the grant date, and the grant price. The grant price, or exercise price, is the fair market value of the company’s stock on the grant date and serves as the baseline for measuring future appreciation. For instance, an employee might be granted 1,000 SARs when the company’s stock is valued at $20 per share.
Following the grant, SARs are subject to a vesting schedule that dictates when the employee earns the right to exercise them. Vesting can occur all at once (cliff vesting) or in increments over time (graded vesting). This schedule is tied to continued employment or achieving performance goals. Until the vesting requirements are met, the employee cannot access the value of their SARs.
When an employee exercises their vested SARs, they claim the accrued value. The gain is the difference between the stock’s market price on the exercise date and the grant price, multiplied by the number of SARs exercised. Continuing the earlier example, if the stock price has risen to $50 per share at exercise, the employee’s gain is $30,000. This amount can be paid out in cash or an equivalent value of company stock.
Taxation at Key Events
There is no tax event for an employee at the time of grant or vesting. The Internal Revenue Service does not consider the grant or vesting of a SAR as the receipt of income, so no tax liability is incurred. This deferral allows the value of the SARs to grow without immediate tax consequences, shifting the taxable event to a later stage.
The tax event occurs when the SARs are exercised. The entire gain realized by the employee is treated as ordinary compensation income in the year of exercise. This income is subject to federal and applicable state and local income taxes at the employee’s regular marginal tax rate. The amount is also subject to Social Security and Medicare taxes, collectively known as FICA taxes.
If the payout is in company stock instead of cash, the income recognized upon exercise establishes the cost basis for the shares. For tax purposes, the cost basis is the stock’s fair market value on the exercise date. When the employee later sells these shares, any appreciation above this basis is taxed as a capital gain.
The holding period for determining the type of capital gain begins the day after the exercise date. A sale within one year results in a short-term capital gain taxed at ordinary income rates. A sale after one year qualifies for the potentially lower long-term capital gains rates.
Employer Reporting and Withholding Requirements
When an employee exercises SARs, the employer is obligated to handle tax withholding, similar to how it is managed for regular salary. The payout is considered supplemental wages, and the employer must withhold federal income taxes. This withholding reduces the net proceeds an employee receives, whether the payout is in cash or shares. If the payout is in shares, the company withholds a portion of the shares equal in value to the required tax amount.
The employer must also withhold FICA taxes from the SARs payout, which includes a 6.2% Social Security tax up to the annual wage base limit and a 1.45% Medicare tax. The employer is also required to pay its own matching share of these taxes. For higher-income employees, an Additional Medicare Tax of 0.9% also applies to compensation over certain thresholds. Employers must withhold this additional tax once an employee’s compensation for the year exceeds $200,000.
Income from exercising SARs is reported on the employee’s annual Form W-2. The taxable amount is included in Box 1 (Wages, tips, other compensation). This amount is also included in Box 3 (Social Security wages) and Box 5 (Medicare wages and tips).
Compliance and Structural Variations
To maintain their tax-deferred status, SARs must comply with Internal Revenue Code Section 409A. A rule under this section is that the exercise price cannot be less than the stock’s fair market value on the grant date. Failure to meet this and other criteria can result in immediate taxation of the SARs’ value upon vesting, plus an additional 20% penalty tax.
SARs can be issued with stock options, creating a Tandem SAR. In this arrangement, an employee receives both a SAR and a stock option, and exercising one cancels the other. This gives the employee flexibility to either exercise the option to buy stock or exercise the SAR to receive the appreciation in cash or stock. The tax treatment for exercising the SAR portion of a tandem award is identical to that of a standalone SAR.
SARs differ from phantom stock, another form of compensation tied to stock performance. Phantom stock plans award hypothetical shares paid out in cash at a future date or upon a specific event. Unlike SARs, which are exercised at the employee’s discretion, phantom stock payouts are often automatically triggered. The income from phantom stock is also taxed as ordinary income when received.