SAR Taxation
SAR taxation can be complex. Here is what you need to know!
Tax Implications of SARs
SAR taxation is modestly straightforward. There are a handful of nuances to understand, but the when/how is it taxed, and strategies related to that are comfortably understandable for most.
When taxation occurs: SARs are taxed when they are exercised (no taxation occurs when it is granted).
Taxation type (ordinary income): When a SAR is exercised, the bargain element (if any) is considered ordinary income. So if you exercise 5,000 SARs with a $2 per share bargain element, you'll generate $10,00 of income. As ordinary income, it is also subject to FICA taxes (Medicare; Social Security) and state taxes (if applicable).
Note: If the bargain element is $0 (or negative), you haven't generated any income (or tax obligation).
Withholding (and cash value receipt): SARs generate ordinary income when they are exercised, and are subject to withholding at that time. Because of how SARs work (you receive a cash payment from the company for the value when you opt to exercise), the company will calculate the required withholding taxes, hold them back, and pay you the cash net of withholding taxes. Withholding for FICA and state taxes (if applicable) will also apply.
Unique Items and Special Situations
SARs Paid in Shares
While uncommon, it is possible for some or all of a SAR exercise to be settled and paid in stock (versus cash). When that occurs, income taxes are still owed on the value received for the exercise (though withholding is usually "payable" in shares if the SAR is settled in shares). Thereafter, any change in the stock price will be taxed as capital gains or losses when the shares are eventually sold. The holding period for this purpose begins the day after the SARs are exercised and shares are received.
Understanding 409a Valuation Rules/Frequency May Help You Optimize
The value you receive from exercising SARs at a pre-IPO company is a function of the 409a valuation. As noted here (409a Valuation), certain events and situations can trigger a 409a valuation to be updated, and understanding your company’s business dynamics can help you strategize on timing. For example, if a new VC round seems likely in the next 3-6 months, and is anticipated to be at a higher valuation, the 409a will likely increase soon. If you are planning on exercising in the near-term, understanding this likely change can help you optimize the cash payment you receive upon exercise.
Taxation Example
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