How are RSUs, ISOs and ESPPs taxed? A plain-English guide

This guide explains equity pay in general terms. It is not tax advice for your family. Your award agreement and your plan documents control the details. Ask your own CPA before you vest, exercise or sell.

What kinds of equity pay are there?

There are four common kinds: restricted stock units (RSUs), incentive stock options (ISOs), nonstatutory stock options (NSOs) and employee stock purchase plans (ESPPs). Each is taxed at different moments. Knowing which one you hold is the first step in any plan.

The IRS splits options into two groups. Per its stock options topic page, “Options granted under an employee stock purchase plan or an incentive stock option (ISO) plan are statutory stock options.” Options that are neither are nonstatutory. RSUs are a promise of shares in the future, not an option.

This table gives the big picture. The sections below fill in each row.

How are RSUs taxed?

RSUs are generally taxed as pay when they vest and the shares are yours. The amount is the value of the shares at that point. Your employer usually reports it on your W-2.

The IRS rule behind this is the one for restricted property. Publication 525 says, “When the property becomes substantially vested, you must include its FMV, minus any amount you paid for it, in your income for that year.” Your plan terms decide the exact moment, so read your award agreement.

After the vest, the shares are in your account and the tax cost is set. Any later gain or loss on a sale is a separate matter. The IRS says that “if you hold the asset for more than one year before you dispose of it, your capital gain or loss is long-term.” The holding period for shares you received at vest generally starts on the vest date.

Three questions to ask:

1. Does the withholding at vest match what I will owe?
2. Should I keep the shares or sell some at vest?
3. Is my plan one of the rare ones that allows a deferral election for private-company stock?

The last question relates to a narrow rule. Publication 525 describes an election for “qualified employees” of private corporations to defer income tax on certain stock for up to 5 years. Most employees do not qualify, and the plan must offer it. Our RSU year-end tax checklist walks through the year-end steps.

How are ISOs taxed, and what is the AMT risk?

For regular tax, you generally owe nothing when you receive or exercise an ISO. You owe tax when you sell. But the alternative minimum tax is a second, parallel tax system, and it treats an ISO exercise differently.

Here is the IRS wording. Topic 427 says that “you may be subject to alternative minimum tax in the year you exercise an ISO.” The Form 6251 instructions explain why: “For the regular tax, no income is recognized when an incentive stock option (ISO), as defined in section 422(b), is exercised. However, this rule doesn’t apply for the AMT.”

In plain terms, the AMT can count the gap between the stock’s value at exercise and your exercise price as income. That is true even if you keep every share. You can owe a tax bill on paper gain.

Here is a round example, for illustration only. Say you pay $20,000 to exercise options on shares worth $200,000 on the day you exercise. The gap is $180,000. The regular tax shows no income. The AMT form generally counts the $180,000 as an adjustment. Whether you actually owe AMT depends on all your other income and deductions, so only a full calculation can say.

One simple case is covered by the IRS. If you exercise and sell in the same year, the regular tax and the AMT treatment match and no adjustment is required. But selling right away also turns the gain into pay-like income, which is the point of the next section.

Ask your CPA to run an AMT estimate before you exercise, and again before year end. Our post on ISO exercise and AMT questions lists what to bring.

What decides whether a sale of ISO shares is capital gain?

A holding period decides it. If you sell ISO shares after meeting the holding period, the gain is capital gain. If you sell too early, part of the gain becomes ordinary income.

Publication 525 states the test: “You satisfy the holding period requirement if you don’t sell the stock until the end of the later of the 1-year period after the stock was transferred to you or the 2-year period after the option was granted.” Meet it, and your “gain or loss from the sale is capital gain or loss.”

Miss it, and you have what the IRS calls a disqualifying disposition. Then the gain is ordinary income up to a set amount, and any extra is capital gain. Your employer sends Form 3921 after an ISO exercise. It “will report important dates and values,” per Topic 427. Keep it with your tax records.

How are nonstatutory options taxed?

Nonstatutory options are taxed when you exercise them, and the amount is treated as pay. For most of them, the IRS says there is no taxable event at grant. At exercise you include “the fair market value of the stock received on exercise, less the amount paid.”

That means an NSO exercise creates income in the year you exercise, whether or not you sell. Employers usually withhold some tax. Ask whether it is enough. After the exercise, your basis in the shares is the value you included, so a later sale taxes only the change since then.

The planning question for NSOs is timing: how many options to exercise in one year, given what the extra income does to your tax bracket.

How is an ESPP taxed?

An ESPP is a statutory plan, so you generally owe no tax when you buy shares. You owe tax when you sell. How long you held the shares decides how the gain is split between ordinary income and capital gain.

Publication 525 says: “If you sold stock acquired by exercising an option granted under an employee stock purchase plan, you need to determine if you satisfied the holding period requirement.” The purchase may be at a discount. That discount is where the ordinary income piece comes from in many cases.

After your first sale or transfer, your employer sends Form 3922. Topic 427 says this form “will report important dates and values needed to determine the correct amount of capital and ordinary income.” Without it, the sale is hard to report correctly.

How does California treat equity pay?

California follows a similar structure but publishes its own rules. The Franchise Tax Board’s Publication 1004 says, “For federal and California alternative minimum tax (AMT), you must treat stock acquired through the exercise of an incentive stock option as if the option were a nonstatutory stock option.” The FTB adds that “An AMT adjustment must be made in the year you exercise the incentive stock option.” So the AMT question applies on both returns.

California also has sourcing rules for people who move. The FTB says that “California taxes the wage income received by a nonresident from employee stock options on a source basis.” If you were a California resident when you exercised nonstatutory options, California taxes the gain between the stock’s value and your option price.

These rules matter if you moved into or out of California between grant and exercise, or if you plan to retire out of state. Tell your CPA the dates of every move. California also has a separate rule for something called a “California qualified stock option.” The FTB says it applies only to an option “issued after January 1, 1997, and before January 1, 2002,” so most readers will not have one.

What should I think about before I sell or exercise?

Think about taxes, concentration and your goals together. A tax-only view can lead you to hold too much of one company. A sell-everything view can create a bigger bill than needed.

Concentration means a large share of your wealth sits in one stock. You may already depend on that company for your paycheck. Putting your savings in the same place ties two things to one outcome. That is a risk question, not a promise about any stock’s price.

Questions for your CPA and planner:

1. What is my total tax if I act this year versus next year?
2. How much of my wealth is in one company stock today?
3. Does an exercise create AMT?
4. Where will the cash for the tax come from?
5. Could I give shares to charity instead of selling them?

Giving shares that you held for more than one year is one tool families use. The guide on giving appreciated stock explains it, and the post gift appreciated stock or sell first compares the two paths. The glossary entry on donating appreciated stock gives the short version.

What mistakes cost people the most?

The costly mistakes are usually timing mistakes, not math mistakes. Most can be spotted months ahead if you look.

Write the dates on a calendar. A vest date, a holding-period date and a year-end date can sit weeks apart, and the order you act in changes the result.

What records should I keep?

Keep the paper trail from the start, because the tax depends on dates and values:

1. Your grant and award agreements.
2. Vest and exercise confirmations.
3. Form 3921 for each ISO exercise and Form 3922 for ESPP transfers.
4. Pay stubs or W-2s showing what was withheld.
5. Your tax return, including any AMT form.
6. Records of every move between states.

Next step

Seek First offers Tax Strategy & Filing, with an in-house CPA team or by working with your CPA. See the tax planning page for more on how the firm approaches tax planning. To talk through your equity pay, schedule a free call for 20 minutes or phone (866) 398-4044.