Does Equity Compensation Count as Taxable Income?

Equity compensation is a common employee benefit, particularly in startups and growing companies. It offers employees a stake in the company’s future, aligning their interests with shareholders. The tax treatment of equity compensation is intricate, varying significantly based on the type of equity and the timing of events like grant, vesting, exercise, and sale. This article clarifies the different types of equity compensation and their tax implications.

Understanding Common Equity Compensation Types

Companies offer various forms of equity compensation to attract and retain talent.

Non-Qualified Stock Options (NSOs) grant an employee the right to purchase company stock at a predetermined price, known as the exercise price, after a vesting period.

Incentive Stock Options (ISOs) are employee-only stock options offering favorable tax treatment if conditions are met. Like NSOs, ISOs allow buying stock at a set price after vesting. Their key difference is deferred tax implications until shares are sold, provided holding period requirements are met.

Restricted Stock Units (RSUs) promise company shares on a future date, contingent on conditions like continued employment and vesting. Unlike stock options, RSUs are received once vested without purchase. Restricted Stock Awards (RSAs) directly transfer company shares at grant, but shares are subject to forfeiture until vesting.

Employee Stock Purchase Plans (ESPPs) allow employees to purchase company stock, often at a discounted price, through payroll deductions. These plans are typically offered to a broad base of employees and usually provide up to 15% off the market price.

Timing of Equity Income Recognition

The point at which equity compensation income becomes taxable varies by award type.

For Non-Qualified Stock Options (NSOs), income is recognized at exercise. The taxable amount is the difference between the stock’s fair market value (FMV) on the exercise date and the exercise price paid.

Incentive Stock Options (ISOs) do not trigger regular income tax at grant or exercise. The tax event for ISOs occurs when the shares are sold. Exercising ISOs can have Alternative Minimum Tax (AMT) implications, especially if the spread between the exercise price and FMV at exercise is substantial.

For Restricted Stock Units (RSUs), income is recognized when units vest, and the shares’ FMV on the vesting date is taxable ordinary income. Restricted Stock Awards (RSAs) are similarly taxed at vesting, based on the shares’ FMV, unless a Section 83(b) election is made.

If a Section 83(b) election is filed for RSAs within 30 days of grant, income is recognized at grant, based on the shares’ FMV at that date. This accelerates the tax event, even if shares are restricted. For Employee Stock Purchase Plans (ESPPs), the tax event occurs when shares are sold, with a portion potentially treated as ordinary income and another as capital gain depending on holding periods.

Tax Treatment of Equity Income

Equity compensation income is taxed based on the award type and recognition timing.

NSO income recognized at exercise (the “bargain element” or difference between FMV at exercise and exercise price) is ordinary income, subject to federal income, Social Security, and Medicare taxes. Cost basis is the exercise price plus recognized ordinary income. Subsequent gain or loss upon sale is capital, with the holding period beginning on exercise.

For Incentive Stock Options (ISOs), if shares are held for specific periods (at least two years from grant and one year from exercise), any gain upon sale is generally taxed as a long-term capital gain (“qualifying disposition”). If holding period requirements are not met (“disqualifying disposition”), the spread between exercise price and FMV at exercise (or sale price, if lower) is ordinary income, with additional gain as capital gain. Basis is the exercise price paid.

RSU shares’ fair market value at vesting is taxed as ordinary income, subject to federal income, Social Security, and Medicare taxes. Basis is their FMV on vesting. Any appreciation or depreciation after vesting is a capital gain or loss when sold, with the holding period beginning on vesting.

RSAs without a Section 83(b) election are taxed like RSUs; the shares’ FMV at vesting is ordinary income and establishes the basis. If a Section 83(b) election is made, the shares’ FMV at grant (less any amount paid) is immediately taxed as ordinary income, becoming the basis. Future appreciation is capital gains tax upon sale, with the holding period commencing on grant.

Employee Stock Purchase Plans (ESPPs) have specific tax rules upon sale. If shares are held for a “qualified disposition” (at least two years from offering and one year from purchase), the discount received at purchase is ordinary income, and any additional gain is a long-term capital gain. If holding period requirements are not met (“disqualifying disposition”), the difference between FMV at purchase and the discounted purchase price is ordinary income, with any further gain as capital gain. The basis is the purchase price plus any ordinary income recognized.

Reporting Equity Income

Reporting equity income involves specific forms.

For Non-Qualified Stock Options (NSOs), the ordinary income recognized at exercise is reported by the employer on Form W-2, typically in Box 1 for wages and sometimes Box 12 with Code V.

Ordinary income from Restricted Stock Units (RSUs) and Restricted Stock Awards (RSAs), recognized at vesting or grant (if an 83(b) election is made), is also reported on Form W-2. This income is usually in Box 1, Box 3 (Social Security wages), and Box 5 (Medicare wages and tips). Withheld taxes are in Boxes 2, 4, and 6.

When shares acquired through any equity plan are sold, the transaction is reported on Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions,” issued by the brokerage firm. This form details sale proceeds, sale date, and often the cost basis. Form 1099-B information is crucial for calculating capital gains or losses, reported on Schedule D of an individual’s tax return.

Accurate cost basis reporting on Form 1099-B prevents overpaying capital gains taxes. If the basis is not reported or is incorrect, individuals must adjust it when filing their tax return to reflect ordinary income already recognized and taxed. For Employee Stock Purchase Plans (ESPPs), employers may also issue Form 3922, “Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423,” to report stock purchase details, aiding in determining correct ordinary income and basis upon sale.