Receiving SARs is not the same as receiving equity in the company. We need to be strategic about when we choose to exercise. If we exercise too early, we can lose potential gains. If we wait too long, we may face an expected tax bill depending on the type of SAR we have.
The tax treatment for Cash-Settled SARs is very simple. The amount paid during exercise is taxed and withheld at the US supplemental income tax rate of 22% plus any state and local taxes, Medicare, and Social Security and the income appears on our W-2 for the year. In some cases, our employer may elect to use a different aggregate withholding method in which case more of the SAR payout will be withheld.
Let's step through a quick example.
Stock-Settled SARs have the same tax treatments as NSOs. There is no tax owed during grants and vesting. Upon exercise, the appreciation difference is taxed as supplemental income just like a Cash-Settled SAR. However, we are receiving shares in the company and unless there is a liquidity event, we cannot sell our shares to cover the taxes. We must come up with extra cash to exercise Stock-Settled SARs. In the case we don't have the cash to cover taxes, the company may withhold shares and pay on our behalf.
Let's walk through the same example as above with SARs that are Stock-Settled.
If possible, we should wait as long as we can to exercise our Cash-Settled SARs. The longer we wait, the more time the shares of the company has to appreciate. It's important to note that waiting does expose us to unpredictable Black Swan events which materially affect a business such as Covid-19.
Exercising Stock-Settled SARs as soon as we can reduce our tax liability. Since we own shares in the company after exercise, we do not lose out if the value of the shares continues to appreciate. The obvious risk is if the company shuts down after we exercised and we lose what we owed in taxes. Both of these decisions should be made with the help of a tax accountant. Reach out to an Archimedes expert today.