At this time, the employee has two options: they can exercise the stock appreciation rights, pay the taxes on it, and receive the proceeds of the sale; or they can leave the SARs unexercised. Unexercised stock appreciation rights will be subject to market fluctuations. Should the stock price continue to go up, additional value can be created. However, should the stock price decrease in value, wealth can be lost.

If we change the assumption to assume the date is December 31, 2023, it would make sense for the employee to exercise the right. If they do not, the right will expire, and any value will then be forfeited.

How Are Stock Appreciation Rights Taxed?

Upon receipt, no taxes are due on stock appreciation rights. Like their non-qualified stock option cousins, tax is due at exercise rather than receipt. Specifically, gain in excess of the grant price is taxed as ordinary income and is subject to payroll tax that must be paid by the employee. The tax will likely be paid from cash (or shares) that is withheld upon exercise of the employee’s stock appreciation right.

Following our example above, the amount of taxable income (which will appear on a W-2) for the employee is $15,000. If we assume a federal tax of 25% and a payroll tax of 7.65%, we can calculate a tax liability of $4,898 for net proceeds to the employee of $10,102 (this resembles a cashless exercise).

If the employee decides to take receipt of the stock appreciation rights in shares, the cost basis of the shares will be equal to the exercise share price. Any further appreciation or loss will be taxed as a capital asset that is subject to both short-term and long-term capital gains rules.

Planning for Stock Appreciation Rights

Stock appreciation rights look similar and operate very similarly to their stock option cousins. For this reason, many of the planning considerations remain the same. However, some key questions should be asked:

How much company stock do I own?
When is the best time to exercise my shares?
Do I want to take receipt of my earnings in cash or in stock?
How does this fit into my overall financial and retirement plan?
While many of the answers to these questions will be the same as they are for stock options, a key distinction exists that should be touched on. The result of exercise stock appreciation rights is often the receipt of cash, while the result of exercising stock options is often the receipt of stock.

One risk of an employee stock option is that the accumulation of so many shares over time can lead to concentration risk. As concentration risk increases, it’s important that the employee has a strategy in place to manage this risk.

Because stock appreciation rights are often paid in cash, it takes a concerted effort on the part of the employee to buy additional shares of company stock. From a behavioral standpoint, one could suggest that using cash on hand to buy more shares of an increasingly concentrated position is more difficult. Following this assumption, stock appreciation rights may lead to a portfolio that is more diversified (assuming the cash isn’t received and spent, which is also quite possible).

On one side, there is the risk of owning too much stock in one company. On the other, the risk of spending the proceeds instead of saving them is very likely. A good financial plan can help balance these risks while developing a strategy to manage these risks equally.

This article was republished with permission from Daniel Zajac.