Understanding Stock Appreciation Rights (SAR) Structure and Taxes

Understand SARs, their benefits, and taxation. Employees share in value growth without real shares, taxed upon payouts.

Stock Appreciation Rights (SAR), also referred to as phantom shares or virtual shares, are a widely-used financial instrument to engage and reward employees without granting actual ownership or voting rights in a company. This article explains how SAR works, its advantages, disadvantages, and the fiscal implications, using a practical example.

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What is a SAR?

A SAR gives an employee or a group of employees the right to receive financial benefits linked to the increase in the company's share value and dividend payouts. Importantly, SAR does not grant legal ownership or voting rights. Instead, it "pretends" as if the employees own shares of the company and allows them to benefit from its success.

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A Practical Example: How SAR Works

Let’s break this down using a simple company structure:

• The company starts with one founder who owns all shares (900 shares), representing 100% ownership.
• The founder wishes to:
  • Engage employees and management by making them co-owners virtually.
  • Ensure that 10% of the company’s value (upon sale) and dividends are shared with employees.

To achieve this, the founder issues 100 virtual shares (10% of the total) using the SAR structure. Here's what happens:

1. Before SAR Implementation:

   • The founder owns 900 shares, representing 100% legal ownership and value of the company.

2. After SAR Implementation:

   • The founder still legally owns 900 shares (100% of legal ownership).
   • However, virtually, the value of the company is now split:
     • Founder: 90% of the company's value.
     • Employees/Management: 10% of the company's value via SAR.

This setup is facilitated through contracts specifying each employee's SARs and their corresponding share in the company’s value.

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Advantages of SAR

The SAR structure offers several advantages:

1. No Upfront Costs or Taxes:

   • Employees receive SARs without purchasing them.
   • There are no fiscal consequences when the SARs are issued.

2. Simple and Cost-Effective Setup:

   • SARs can be implemented quickly without complex legal processes or high costs.

3. Engagement and Retention:

   • Employees feel like co-owners, motivating them to work towards increasing the company's value.

4. Value-Based Reward:

   • Employees benefit only when the company’s value increases, aligning their interests with the company’s success.

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How Taxes Work with SAR

While SARs are tax-efficient during setup, their payouts are subject to taxation. Here’s a step-by-step breakdown of fiscal implications:

Year 0 (SAR Issued)

• SAR is granted to an employee at a starting share value of €20.
• No taxes apply at this stage:
  • No corporate tax for the company.
  • No income tax or wealth tax for the employee.

Year 3 (Share Value Increases)

• The share value increases to €100 due to the company’s growth.
• Still no taxes:
  • Employees do not pay taxes on the appreciation because it remains fictional (no actual ownership).

Year 3 (Dividends Paid Out)

• When dividends are distributed, employees receive their share.
• Taxes are applied as follows:
  • The company withholds taxes (similar to withholding on bonuses).
  • The net amount after taxes is paid to the employee.

Year 5 (Exit: Company Sold)

• The company is sold, and the share value has increased to €150.
• Employees benefit from the increase:
  • Starting value: €20
  • Exit value: €150
  • Gain: €130
• This gain (€130) is paid to the employee as a bonus or salary.
• The company withholds taxes on the payout (in the Netherlands, the rate is approximately 50%).

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Disadvantages of SAR

Despite its benefits, SAR also has some downsides:

1. Heavy Taxation on Payouts:

   • Payouts during dividends or exit are taxed as income or bonuses, which can result in significant tax deductions (up to 50% in the Netherlands).

2. No Voting Rights:

   • Employees do not receive any legal ownership or control over the company.

3. Employee Payout Dependent on Growth:

   • SAR only becomes valuable if the company’s share value increases.

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Why Choose SAR?

The SAR structure is particularly beneficial when employees cannot invest in company shares directly. It enables founders to reward and retain employees by sharing the company’s success without complicating ownership structures. Although payouts are taxed heavily, the fact that SARs are issued at no cost and remain tax-free until dividends or exit events makes it an attractive incentive tool.

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Summary: How SAR Works

Stage	Event	Taxation
Year 0	SAR granted (e.g., at €20)	No taxes (company or employee).
Year 3	Share value increases (e.g., €100)	No taxes on unrealized gains.
Year 3 (Dividends)	Dividends paid out	Taxed as income; company withholds taxes.
Year 5 (Exit Event)	Company sold (e.g., at €150)	Gains taxed as income/bonus (up to 50%).

At the end of the process:

• The founder retains 100% legal ownership of the company.
• Employees receive their share (e.g., 10%) of the company’s value increase and dividends through SAR.

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Final Thoughts

The SAR structure is a powerful tool for founders seeking to align employee interests with company growth. By virtually sharing ownership and value without actual shares, it simplifies the process while fostering engagement and loyalty.

If you have further questions about SAR or need assistance setting up this structure, check out our knowledge base and blogs or contact us at Share Council.