How Are Different Types of Stock Awards Taxed?

Employee stock awards deliver value through company shares instead of direct cash payments, and this compensation comes with a distinct set of tax rules. The tax implications are not uniform across all award types, so it is important to understand the specific characteristics of the equity you have received.

Understanding Different Types of Stock Awards

A Restricted Stock Unit (RSU) is a promise from an employer to grant an employee a specific number of company shares at a future date. This grant is contingent upon completing a vesting schedule, which is the process of earning the right to the shares over time or by meeting performance goals. Once vested, the employee receives the shares outright.

A Non-Qualified Stock Option (NSO) gives an employee the right, but not the obligation, to purchase a set number of company shares at a predetermined price, known as the grant price or strike price. This price is fixed when the options are granted. The value comes from the potential for the stock’s market price to rise above the strike price. To acquire the shares, an employee must “exercise” the option by paying the strike price.

Incentive Stock Options (ISOs) function similarly to NSOs but can receive different tax treatment under specific circumstances. To qualify for this treatment, ISOs are subject to rules set by the Internal Revenue Service, including limitations on how long shares must be held after purchase. These options are designed to provide an incentive for employees to remain with the company.

Employee Stock Purchase Plans (ESPPs) allow employees to buy company stock, often at a discount from the fair market value. Purchases are made through payroll deductions accumulated over a specific offering period. The discount provides an immediate financial benefit, and any subsequent appreciation in the stock’s value can lead to further gains for the employee.

Key Taxation Events and Income Types

The taxation of stock awards involves ordinary income tax and capital gains tax. Ordinary income is taxed at the same progressive rates as your salary, while capital gains tax applies to the profit from selling an asset. The timing and type of tax depend on the specific award and key events like vesting, exercising, and selling the shares.

For Restricted Stock Units, the taxable event is vesting. When the shares become yours, their total fair market value is considered ordinary income. For example, if 100 RSUs vest when the stock is $50 per share, you have $5,000 of ordinary income. This amount is subject to federal, state, Social Security, and Medicare taxes.

For Non-Qualified Stock Options, the taxable event occurs at exercise. The difference between the market value of the stock at exercise and the strike price you pay is the “bargain element,” which is taxed as ordinary income. For instance, if your strike price is $10 and you exercise when the stock is $60, you have a $50 per share bargain element recognized as income.

Incentive Stock Options receive different treatment, as no regular income tax is due at exercise. This allows you to purchase shares without an immediate tax bill on the bargain element. However, this bargain element is a preference item for the Alternative Minimum Tax (AMT), a separate tax calculation that can affect certain taxpayers.

The final taxable event for all stock awards is the sale of the shares, which triggers capital gains tax. Your cost basis for determining gain or loss is established when ordinary income is recognized. For RSUs, the basis is the market value on the vest date; for NSOs, it is the market value on the exercise date, since you already paid tax on the bargain element.

The rate for capital gains depends on your holding period. If you sell shares one year or less from the acquisition date, the profit is a short-term capital gain taxed at your ordinary income rate. Holding the shares for more than one year makes the profit a long-term capital gain, taxed at lower rates.

Tax Reporting and Withholding

When you recognize ordinary income from RSUs or NSOs, your employer is required to withhold taxes. This process is similar to withholding on your regular paycheck. A common method is “sell-to-cover,” where the company automatically sells a portion of your new shares to cover the estimated income and payroll taxes.

The ordinary income you recognize from these awards is reported on your annual Form W-2. This income is included in the total wages found in Box 1 of the form. For NSOs, the bargain element recognized at exercise is identified in Box 12 of Form W-2 with the code “V”. This amount is already included in your total wages in Box 1.

You may receive supplemental tax forms from your employer or brokerage. If you exercise ISOs, your employer must provide you with Form 3921. If you purchase shares through an ESPP, you will receive Form 3922. These forms are informational and not filed with your tax return, but the information is necessary for accurately calculating your cost basis when you sell.

Reporting the sale of any shares acquired through a stock plan is a separate step on your personal tax return. The transaction is reported on Form 8949, and the totals are carried to Schedule D. You must ensure the cost basis reported by the broker on Form 1099-B is correct. Brokers may report an incorrect basis, so you must make any necessary adjustments on Form 8949 to avoid overpaying tax on income that was already taxed.

Special Tax Considerations and Elections

The Section 83(b) election applies to restricted stock awards, not RSUs. This election allows you to pay ordinary income tax on the stock’s value at the time it is granted, rather than when it vests. This irrevocable election must be filed with the IRS within 30 days of the grant date. This strategy is often considered by employees at early-stage companies where the stock value at grant is very low, potentially minimizing the ordinary income tax hit and starting the capital gains holding period sooner.

The Alternative Minimum Tax (AMT) is a parallel tax system that ensures certain individuals pay a minimum amount of tax. When you exercise and hold Incentive Stock Options, the bargain element is not counted for regular tax but is considered income for the AMT calculation. This can trigger a significant AMT liability in the year of exercise. The AMT is calculated on Form 6251, and you must pay the higher of your regular tax or the AMT. AMT paid on an ISO exercise can often be claimed as a credit against your regular tax in future years.

To receive the most favorable tax treatment on ISOs, the sale of the shares must be a “qualifying disposition.” This requires meeting two holding period rules: you must sell the shares more than two years after the grant date AND more than one year after the exercise date. If both conditions are met, the entire gain is taxed as a long-term capital gain. If you sell the shares without meeting both holding periods, it is a “disqualifying disposition,” and a portion of your gain will be reclassified and taxed as ordinary income.