Taxes When You Receive Stock Options or RSUs

Equity compensation — in the form of stock options or restricted stock units (RSUs) — is increasingly common, particularly in the technology sector and among startups. But the tax rules governing different types of equity compensation vary significantly, and choosing the wrong approach can result in a much larger tax bill than necessary.

Restricted stock units (RSUs) are the simplest form of equity compensation from a tax standpoint. When your RSUs vest — meaning you've met the time or performance conditions required — you recognize ordinary income equal to the fair market value of the shares on the vesting date. Your employer will typically withhold income taxes and payroll taxes and include the vesting income on your W-2. From a tax perspective, RSUs are essentially the same as cash compensation — you owe income tax at your marginal rate on the value of the shares when they vest. After vesting, your cost basis in the shares equals the value on which you paid tax, and any subsequent appreciation is taxed as a capital gain when you sell.

Non-qualified stock options (NQSOs) are also relatively straightforward: you owe no tax when they're granted. When you exercise the options (buy the stock at the exercise price), you recognize ordinary income equal to the difference between the fair market value and the exercise price. That income is subject to income tax and payroll taxes, and your employer includes it on your W-2. After exercise, your basis in the shares is the fair market value on the exercise date, and subsequent appreciation is taxed as capital gain when sold.

Incentive stock options (ISOs) have more complex and potentially more favorable tax rules. You owe no regular income tax when ISOs are granted or when you exercise them. The spread at exercise (fair market value minus exercise price) is not taxable for regular income tax purposes but is an "adjustment item" for the Alternative Minimum Tax (AMT) — which means exercising ISOs can trigger significant AMT liability in high-value situations. If you hold the shares for at least one year after exercise and two years after grant, the entire gain from exercise price to eventual sale price is taxed at long-term capital gains rates rather than ordinary income rates — a potentially enormous tax saving. If you sell too soon (a "disqualifying disposition"), the spread at exercise is taxed as ordinary income, similar to NQSOs.

For early-stage startup employees with restricted stock (not RSUs), an 83(b) election filed within 30 days of receiving the shares can lock in a low taxable value now and start the long-term capital gains clock running from the grant date, potentially converting all future appreciation to long-term capital gains. This strategy only makes sense when the current fair market value is low (as in a brand-new startup) and the future appreciation potential is high. Missing the 30-day window to file the 83(b) election is permanent and irrecoverable. If you receive significant equity compensation of any type, working through the tax implications with a professional who specializes in this area before you make decisions about exercising, holding, or selling is strongly recommended.