Stock Based Compensation Tax Treatment Explained

Stock-based compensation is a form of non-cash payment where companies grant employees an ownership stake. The value of this compensation is tied to the company’s stock price, aligning employee and company interests. The federal tax rules for this income vary significantly depending on the type of award and the timing of events like receiving, exercising, or selling the stock.

Types of Stock Based Compensation

Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) are a promise from an employer to grant an employee a specific number of company shares at a future date. This grant is contingent on satisfying conditions outlined in a vesting schedule, which can be based on time worked or performance goals. An employee does not own the stock when RSUs are granted. After vesting requirements are met, the company delivers the shares or cash equivalent, and the employee becomes a shareholder.

Non-Qualified Stock Options (NSOs)

Non-Qualified Stock Options (NSOs) give an employee the right to purchase a set number of company shares at a fixed price, called the strike price. The strike price is the stock’s fair market value on the grant date. An employee can exercise this option in the future, buying the stock at the strike price regardless of its current market value. The term “non-qualified” means these options do not meet Internal Revenue Code requirements for preferential tax treatment.

Incentive Stock Options (ISOs)

Incentive Stock Options (ISOs) allow employees to buy company stock at a set price and can receive more favorable tax treatment than NSOs if strict requirements are met. To qualify, an employee must hold the stock for at least two years from the grant date and one year from the exercise date. Meeting these holding periods allows the profit from the sale to be taxed at lower long-term capital gains rates. There is an annual limit of $100,000 on the value of ISOs (at the grant date) that can become exercisable for the first time in a calendar year.

Employee Stock Purchase Plans (ESPPs)

Employee Stock Purchase Plans (ESPPs) allow employees to buy company stock, often at a discount, through payroll deductions over an offering period. The discount can be up to 15% below the market value. Some plans include a “lookback” provision, applying the discount to the lower of the stock price at the start or end of the offering period. ESPPs can be “qualified” or “non-qualified,” with qualified plans offering tax advantages if holding period requirements are met.

Restricted Stock Awards (RSAs)

A Restricted Stock Award (RSA) is a grant of company stock that an employee receives on the grant date, but it is subject to restrictions. The shares are not fully owned until they have vested according to a time-based or performance-based schedule. If the employee leaves the company or fails to meet performance metrics before vesting is complete, they forfeit the unvested shares back to the company.

Taxation at Key Events

Taxation at Grant

The grant date is not a taxable event for most stock-based compensation, including RSUs, NSOs, and ISOs, as no income is recognized. The main exception is a Restricted Stock Award (RSA). With an RSA, an employee receives shares on the grant date that are subject to a risk of forfeiture. While tax is normally deferred until the shares vest, an employee can make a Section 83(b) election to be taxed at the time of grant.

Taxation at Vesting/Exercise

For RSUs, the fair market value of the shares is taxed as ordinary income upon vesting. This amount is subject to federal, Social Security, and Medicare taxes, which employers are required to withhold. This withholding is often handled by selling a portion of the vested shares.

When an employee exercises NSOs, the difference between the stock’s fair market value on the exercise date and the strike price is taxed. This “bargain element” is considered compensation and is taxed as ordinary income, subject to employment tax withholding.

ISOs receive unique treatment at exercise. For regular income tax purposes, no tax is due when ISOs are exercised, as the tax is deferred until the shares are sold. However, the bargain element from an ISO exercise is an income item for the Alternative Minimum Tax (AMT), which can create a tax liability in the year of exercise.

For ESPPs, the tax event occurs upon the sale of the shares, not at purchase. The tax treatment depends on whether it is a qualifying or disqualifying disposition.

Taxation at Sale

When shares from stock compensation are sold, the transaction is subject to capital gains tax on the difference between the sale price and the cost basis. For RSUs and NSOs, the cost basis is the fair market value on the vesting or exercise date, which was already taxed as ordinary income.

The holding period determines the tax rate. If shares are held for one year or less from the acquisition date (vesting for RSUs, exercise for options), the 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.

For ISOs to receive full long-term capital gains treatment on the entire gain, the sale must be a “qualifying disposition.” This requires holding the shares for at least two years from the grant date and one year from the exercise date. If not, it is a “disqualifying disposition,” and part of the gain becomes ordinary income.

Similarly, qualified ESPP shares must be held for at least two years from the offering date and one year from the purchase date to receive favorable tax treatment. A sale before these deadlines is a disqualifying disposition, which reclassifies a portion of the gain as ordinary income.

Tax Reporting and Required Forms

Form W-2

Your employer reports ordinary income from stock compensation on your Form W-2. Income from vesting RSUs or exercising NSOs is included in the wages in Box 1, and in Social Security and Medicare wages in Boxes 3 and 5. Some employers report this income informationally in Box 14, but you should confirm it is already included in Box 1 to avoid double-counting. Ordinary income from a disqualifying disposition of qualified ESPPs or ISOs may also be on the W-2.

Form 3921 (Exercise of an Incentive Stock Option)

If you exercise ISOs, your employer provides Form 3921. This form reports the grant date, exercise date, strike price, fair market value on the exercise date, and the number of shares acquired. This information is used to calculate the bargain element for the Alternative Minimum Tax (AMT). It is also used to determine your cost basis and holding periods for when you sell the shares.

Form 3922 (Transfer of Stock Acquired Through an ESPP)

If you purchase shares through a qualified ESPP, your employer provides Form 3922. This form details the offering date, purchase date, purchase price, fair market value on both dates, and the number of shares purchased. This information is used to determine if a sale meets holding period requirements and to calculate the ordinary income and capital gain to report.

Form 1099-B (Proceeds From Broker and Barter Exchange Transactions)

When you sell shares from a stock plan, your broker issues Form 1099-B, reporting the gross proceeds in Box 1d. The form also reports a cost basis in Box 1e, but this amount is often incorrect for equity compensation. Brokers may only report the original purchase price (like the strike price for options) and not the compensation income you already paid tax on. This understates your cost basis, and you must correct this on your tax return.

Form 8949 / Schedule D

Stock sales are reported on Form 8949, where you transfer the information from Form 1099-B. On this form, you must correct any inaccurate cost basis reported by your broker. You report the basis from the 1099-B and then enter an adjustment in column (g) to reflect the correct basis that includes your compensation income. The totals from Form 8949 are carried over to Schedule D, Capital Gains and Losses. Schedule D nets your gains and losses to determine the final net capital gain or loss reported on your Form 1040.

Special Tax Elections and Considerations

Section 83(b) Election

The Section 83(b) election allows an individual to pay tax on the value of restricted property when it is granted, rather than when it vests. This election is available for Restricted Stock Awards (RSAs) but not for RSUs. To make the election, you must file a written statement with the IRS within 30 days of the grant date, a deadline with no exceptions.

The benefit is recognizing ordinary income on the stock’s grant-date value, which may be very low for early-stage companies. All subsequent appreciation is treated as a capital gain taxed upon sale, and the long-term capital gains holding period begins at the grant date.

The risk is that if you forfeit the stock before it vests, you cannot get a refund for the taxes paid. You also risk paying tax on a higher value than the stock might have at vesting if its price declines.

Alternative Minimum Tax (AMT)

The Alternative Minimum Tax (AMT) is a parallel tax system that ensures high-income individuals pay a minimum amount of tax. It has its own rules for calculating income and includes items not taxed under the regular system. The exercise of Incentive Stock Options (ISOs) is a common trigger for the AMT.

While an ISO exercise is not taxed for regular tax purposes, the “bargain element” is considered income for the AMT calculation. This amount is added to your income on Form 6251. If your AMT liability is higher than your regular tax liability, you must pay the difference as AMT.

If you pay AMT from an ISO exercise, you may receive an AMT credit. This credit can be used in future years to reduce your regular tax liability in years when your regular tax is higher than your AMT.