How Are Equity Grants Taxed on RSUs, NSOs, and ISOs?

Equity grants are a form of compensation companies use to give employees an ownership stake in the business. This non-cash pay aligns employee interests with company performance, as the grant’s value increases if the company’s stock price rises. Understanding the tax implications is necessary for financial planning, as different types of grants are taxed at different times and rates.

Understanding Common Types of Equity Grants

The most prevalent forms of equity grants are Restricted Stock Units (RSUs), Non-qualified Stock Options (NSOs), and Incentive Stock Options (ISOs). An RSU is a promise from an employer to grant an employee a specific number of company shares at a future date, provided certain conditions like continued employment are met. A vesting schedule outlines when the employee gains full ownership, at which point the shares are delivered as compensation without purchase.

Stock options provide the right, but not the obligation, to purchase a set number of company shares at a predetermined price, known as the strike or exercise price. This price is usually the stock’s fair market value (FMV) on the grant date. NSOs are a flexible compensation tool that can be granted to employees, directors, and consultants.

Incentive Stock Options are reserved exclusively for employees and offer specific tax advantages. A limitation for ISOs is that an employee can only receive up to $100,000 worth of stock, valued at the grant date, that becomes exercisable for the first time in any calendar year. Any amount exceeding this limit is treated as an NSO for tax purposes. For both NSOs and ISOs, the value is realized only if the stock’s market price rises above the strike price, creating a profitable spread.

Taxation at Grant, Vesting, and Exercise

For Restricted Stock Units, no tax is due at the grant date. The taxable event occurs when RSUs vest, at which point the full fair market value of the shares is considered ordinary income. This income is subject to federal, state, and employment taxes, including Social Security and Medicare, and is reported on the employee’s Form W-2.

With Non-qualified Stock Options, there is no tax at grant or vesting. The taxable event for NSOs occurs at exercise, and the taxable income is the difference between the stock’s fair market value on the exercise date and the strike price paid. This difference, called the bargain element, is taxed as ordinary income and is also subject to employment taxes.

For regular tax purposes, Incentive Stock Options have no tax consequences at grant or exercise, allowing an employee to acquire shares without immediately owing regular income tax. However, the bargain element from an ISO exercise is a preference item for the Alternative Minimum Tax (AMT). The AMT is a separate tax calculation that ensures individuals with high incomes and significant deductions pay at least a minimum amount of tax, and a large enough bargain element can trigger an AMT liability in the year of exercise.

The Section 83(b) Election

The Section 83(b) election allows an individual to alter the timing of taxation for property received for services, such as restricted stock awards, but it does not apply to standard RSUs or stock options. This election permits the recipient to pay ordinary income tax on the property’s fair market value at the grant date instead of when it vests. If the stock is acquired for its fair market value at grant, the immediate tax liability would be zero.

An employee must file a written statement with the IRS within 30 days of the grant date, a deadline that cannot be extended. The election letter must include:

• The taxpayer’s personal information
• A description of the property received
• The date of the grant
• The property’s fair market value at the time of grant
• The amount, if any, paid for the property

A copy of the election letter must also be provided to the employer. The reason to make this election is the expectation that the stock’s value will increase. By paying tax on the lower value at grant, any future appreciation is deferred until the stock is sold and is taxed as a capital gain.

A risk exists with this election, as an employee who leaves the company before the stock vests forfeits the shares and cannot recover any taxes paid. The decision to file an 83(b) election requires careful consideration of the potential for stock appreciation against the risk of forfeiture and the upfront tax cost.

Taxation Upon Sale of Shares

The tax treatment upon selling shares depends on the cost basis and the holding period. The cost basis is the amount used to determine capital gain or loss. For RSU shares, the basis is the fair market value on the vesting date. For NSO shares, the basis is the strike price paid plus the bargain element that was taxed as ordinary income.

The holding period begins the day after the shares are acquired, which is the vesting date for RSUs and the exercise date for options. If shares are held for one year or less, any gain is short-term and taxed at ordinary income rates. If held for more than one year, the gain is long-term and taxed at lower capital gains rates.

Incentive Stock Options require a “qualifying disposition” for favorable tax treatment. The shares must be sold at least two years after the grant date and one year after the exercise date. If met, the entire gain between the sale price and the strike price is a long-term capital gain, and the cost basis is the strike price paid.

If these holding periods are not met, the sale is a “disqualifying disposition.” The bargain element at exercise is taxed as ordinary income. Any additional gain between the exercise date FMV and the final sale price is a capital gain, characterized as short-term or long-term based on the holding period after exercise.

Reporting and Withholding

When RSUs vest or NSOs are exercised, the ordinary income is considered supplemental wages. Employers report this income on Form W-2, and it is subject to federal and state income tax withholding, plus Social Security and Medicare taxes. Employers often handle withholding through a “sell-to-cover” transaction, where a portion of the shares are sold to pay the taxes.

The federal withholding rate on supplemental wages is a flat 22% for amounts up to $1 million annually and 37% for amounts over $1 million. These rates may not cover the total tax liability for those in higher tax brackets, potentially requiring additional estimated tax payments to avoid a penalty.

When shares are sold, the brokerage firm reports the sale proceeds to the IRS on Form 1099-B. The employee must report the sale on Form 8949 and summarize the totals on Schedule D. Taxpayers should verify the cost basis on Form 1099-B, as this information can be incorrect for equity compensation.

Employees who exercise ISOs will receive Form 3921, which provides the grant date, exercise date, strike price, and FMV at exercise. This information is needed to calculate the AMT preference item and any capital gain.