Equity compensation is a big part of pay at many tech companies and startups. The three most common types are restricted stock units (RSUs), incentive stock options (ISOs) and nonqualified stock options (NSOs). The tax rules differ for each one. So knowing which type you have helps you plan ahead and avoid surprises at tax time.
Below, we explain the basics of each type. We also include a chart for each one.
Restricted stock units (RSUs)
An RSU is a promise to give you company shares once you meet a vesting schedule. Usually, you owe no tax when you receive RSUs. Instead, you owe tax when they vest.
At vesting, the value of the shares counts as wages. So it shows up on your W-2, and your employer withholds tax, often by holding back some shares. However, the standard withholding rate may be lower than your actual tax rate. As a result, many RSU holders owe more when they file.
Your cost basis in the shares equals their value on the vesting date. Later, when you sell, you have a capital gain or loss. If you held the shares for more than a year after vesting, the gain is long-term.
Incentive stock options (ISOs)
An ISO gives you the right to buy company stock at a set price. ISOs can get special tax treatment. In general, you owe no regular income tax when you receive or exercise them.
However, the spread at exercise can trigger the alternative minimum tax (AMT). The spread is the difference between the stock’s value and your exercise price.
If you hold the shares more than two years from the grant date and more than one year from exercise, the sale is a qualifying disposition. In that case, your whole gain is a long-term capital gain. On the other hand, if you sell sooner, it is a disqualifying disposition. Then part of your gain counts as ordinary income.
Nonqualified stock options (NSOs)
An NSO also lets you buy company stock at a set price. Unlike ISOs, NSOs don’t get special tax treatment. Typically, you owe no tax when you receive them.
When you exercise, however, the spread counts as ordinary income. For employees, the W-2 reports it as wages. Your basis in the shares then equals their value on the exercise date. After that, any further gain or loss when you sell is a capital gain or loss.
Plan your equity compensation taxes
Timing matters with every type of equity compensation. For example, when you exercise, when you sell and which state you live in can all change your tax bill. For official guidance, see IRS Topic 427, Stock Options. For more detail, visit our tax preparation services page or book a free 15-minute call.