Equity grants are taxed in two stages: first as ordinary compensation income at a moment set by the grant type, and later as a capital gain or loss when you sell the shares. Which moment triggers the ordinary income, and how much room you have to convert future appreciation into lower-taxed capital gain, depends on whether you hold restricted stock units, restricted stock awards, non-qualified stock options, incentive stock options, or shares from an employee stock purchase plan. A single grant can produce ordinary income tax, capital gains tax, and the 3.8% net investment income tax across several years.
Restricted Stock Units
An RSU is a promise to deliver shares once you vest. The grant itself is not taxable because you own nothing yet. Tax kicks in on the delivery date, which for most companies is the same day the shares vest. The full fair market value of the delivered shares counts as ordinary income and appears on your W-2, subject to federal income tax, Social Security, and Medicare.1Internal Revenue Service. Topic No. 427, Stock Options
Your employer withholds before you see the shares. The federal supplemental withholding rate is 22%, rising to 37% on supplemental wages above $1 million for the year.2Internal Revenue Service. Publication 15 (2026), Employer’s Tax Guide Most companies handle this by selling enough shares at vesting to cover the tax, a process called sell to cover. The 22% flat rate often falls short of your actual marginal rate, so expect a possible balance due in April.
Dividend equivalents paid on unvested RSUs are taxed as ordinary compensation, not as qualified dividends, and follow regular wage withholding.
The fair market value taxed at vesting becomes your cost basis. When you later sell, capital gains tax only applies to appreciation above that basis, and holding the shares more than one year past vesting qualifies you for long-term rates.
Restricted Stock Awards and the 83(b) Election
A restricted stock award transfers real shares on the grant date, but you forfeit them if you leave before vesting. By default, you are taxed on the fair market value at vesting, when the forfeiture risk drops away—the same timeline as an RSU for most people.3Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
What sets RSAs apart is the Section 83(b) election. You can choose to pay ordinary income tax on the shares’ value at the grant date instead of at vesting. RSUs cannot use this election because no property has been transferred yet. The election must be filed with the IRS within 30 days of the grant date, and that deadline is absolute.
The logic: if the stock is worth pennies on the grant date, you pay tax on a tiny amount of ordinary income now, and all future appreciation is taxed as capital gain, long-term if you hold more than a year past the election. For early-stage startup shares, this can convert what would have been a heavy ordinary-income hit into lightly taxed long-term gain.
The gamble is unforgiving. If you forfeit the shares after making the election, the tax you paid is gone. There is no deduction. You paid income tax on compensation you never kept. That makes 83(b) a poor fit whenever there is real risk of leaving before vesting or of the company failing.
Non-Qualified Stock Options
NSOs give you the right to buy shares at a fixed exercise price for a set number of years. Nothing happens tax-wise at grant, and nothing happens at vesting. Tax enters only when you exercise the option and actually purchase the shares.1Internal Revenue Service. Topic No. 427, Stock Options
At exercise, the spread between the current fair market value and your exercise price is ordinary compensation income. If the stock trades at $50 and your exercise price is $10, the $40 spread is ordinary income on your W-2, with the same supplemental-wage withholding as RSU vests.2Internal Revenue Service. Publication 15 (2026), Employer’s Tax Guide A cashless exercise, where the broker sells enough shares to cover the exercise price and withholding, is common.
Your basis in the acquired shares equals the exercise price plus the ordinary income recognized. If you hold rather than sell same-day, the capital gains clock starts the day after exercise.
Incentive Stock Options
ISOs, defined in Internal Revenue Code Section 422, carry a real tax advantage but demand patience.4Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options Exercising an ISO does not trigger regular federal income tax. No ordinary income lands on your W-2 at exercise.
The AMT Catch
The exercise-day spread is not truly free. It is an adjustment item for the alternative minimum tax. You add it to your AMT income calculation, and if that pushes you above your AMT exemption, you can owe AMT despite owing no regular tax.5Internal Revenue Service. Instructions for Form 6251 People get blindsided exercising large batches in a single year: the spread produces a five- or six-figure April bill even though no shares were sold. Run Form 6251 numbers before exercising, not after.
AMT paid because of ISO exercises is a timing difference. You can recover it in later years through the minimum tax credit on Form 8801, which carries forward until used.6Internal Revenue Service. Instructions for Form 8801 The cash-flow hit in the exercise year is still real.
Qualifying and Disqualifying Dispositions
For full ISO treatment, hold the shares at least two years from grant and at least one year from exercise.4Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options Meet both, and your entire gain from exercise price to sale price is a long-term capital gain. No ordinary income.
Sell before either period is met and you have a disqualifying disposition. The lesser of the exercise-day spread or your actual gain is reclassified as ordinary income, with any remaining gain as capital gain. If the stock dropped after exercise and you sold at a loss, ordinary income is limited to whatever gain you actually realized.
The $100,000 Annual Limit
If the aggregate grant-date fair market value of ISOs that first become exercisable in a calendar year exceeds $100,000, the excess is automatically treated as NSOs.7eCFR. 26 CFR 1.422-4 – $100,000 Limitation for Incentive Stock Options The excess portion loses ISO treatment and produces ordinary income at exercise.
Employee Stock Purchase Plans
A qualified ESPP under Section 423 lets you buy company stock at a discount through payroll deductions.8Office of the Law Revision Counsel. 26 US Code 423 – Employee Stock Purchase Plans The maximum discount is 15%, and many plans include a look-back that prices the purchase at the lower of the offering-date or purchase-date price. Neither the deductions nor the purchase itself is taxable. You cannot acquire more than $25,000 of stock per year across all qualified ESPPs combined, measured at the grant-date value.9eCFR. 26 CFR 1.423-2 – Employee Stock Purchase Plan Defined
Qualifying Dispositions
Hold the shares at least two years after the offering date and one year after the purchase date, and the ordinary income you recognize on sale is the lesser of your actual gain or the offering-date discount.8Office of the Law Revision Counsel. 26 US Code 423 – Employee Stock Purchase Plans Everything above that is a long-term capital gain.
Disqualifying Dispositions
Sell too soon, and the entire purchase-date discount is ordinary income no matter what the stock did afterward. Any additional gain is short- or long-term capital gain based on how long you held the shares after purchase.
Selling the Shares
Whatever the grant type, the final sale produces a capital gain or loss. By that point, you have already recognized ordinary income at vesting (RSUs, RSAs), at exercise (NSOs), or at sale (ISOs, ESPPs). The essential step is making sure your basis reflects that prior income so the same dollars are not taxed twice.
Basis equals what you paid out of pocket plus what was already taxed as ordinary income. For RSUs, that is the fair market value at vesting. For NSOs, the exercise price plus the spread. For ISOs with a qualifying disposition, just the exercise price, because no ordinary income was recognized earlier.
The capital gains holding period starts the day after the taxable event: the day after vesting for RSUs and RSAs, the day after exercise for options. Shares held more than one year qualify for long-term rates of 0%, 15%, or 20% depending on taxable income. Shorter holdings are taxed at ordinary rates.10Internal Revenue Service. Topic No. 409, Capital Gains and Losses
The 1099-B Basis Trap
This is where most people overpay. Your broker issues a Form 1099-B reporting sale proceeds and cost basis to you and the IRS. Brokers frequently report the wrong basis, often just the exercise price or zero, because they don’t always account for the ordinary income already on your W-2.11Internal Revenue Service. Instructions for Form 8949
File using that number and the IRS treats nearly the entire sale price as gain. You pay capital gains tax on income you already paid ordinary tax on. To fix it, report the correct adjusted basis on Form 8949, which flows to Schedule D.12Internal Revenue Service. About Form 8949, Sales and Other Dispositions of Capital Assets Your employer or broker should provide a supplemental basis statement; compare it against your W-2 before filing.
The 3.8% Net Investment Income Tax
Capital gains from equity compensation shares are also subject to the net investment income tax. NIIT adds 3.8% on the lesser of your net investment income or the amount by which modified adjusted gross income exceeds $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately).13Office of the Law Revision Counsel. 26 US Code 1411 – Imposition of Tax These thresholds are not indexed for inflation. If you hold meaningful equity, you likely clear them in years when large tranches vest or you exercise. NIIT applies to the capital gain portion, not to ordinary income recognized at vesting or exercise. The effective top federal rate on long-term capital gains for high earners reaches 23.8%.
Wash Sales and Vesting Schedules
The wash sale rule disallows a capital loss if you buy substantially identical stock within 30 days before or after the sale.14Office of the Law Revision Counsel. 26 US Code 1091 – Loss From Wash Sales of Stock or Securities Automated RSU vesting counts as an acquisition. If you sell company stock at a loss and an RSU tranche vests within 30 days on either side, the loss is disallowed and shifted into the basis of the newly vested shares. Employees on monthly vesting schedules have almost no clean window. Sell-to-cover transactions at vesting can create the same problem if you sold at a loss shortly before.
The loss is not permanently lost, just deferred into the replacement shares’ basis. You recover it when you sell those shares. But if you were relying on the deduction this year, you won’t get it. Check your vesting calendar before selling company stock at a loss.
Qualified Small Business Stock
Equity in a qualifying small C corporation can produce gain that is partially or entirely excluded from federal income tax under Section 1202. The One Big Beautiful Bill Act changed the rules for stock issued on or after July 5, 2025.
For stock issued after that date, the corporation’s aggregate gross assets cannot exceed $75 million at and immediately before issuance (up from $50 million). The stock must be acquired at original issuance for money, property, or services. The company must be a domestic C corporation, and at least 80% of its assets by value must be used in an active qualified trade or business for substantially all of your holding period.
The exclusion is now tiered by holding period:
- Three to four years: 50% of the gain excluded.
- Four to five years: 75% excluded.
- Five years or more: 100% excluded.
The per-issuer cap is the greater of $15 million (up from $10 million, now inflation-indexed) or ten times your adjusted basis. Only non-corporate taxpayers can claim the exclusion. Health services, law, engineering, accounting, financial services, consulting, and any business whose principal asset is the reputation or skill of its employees are excluded from qualifying at all.
Private Company Equity and the 83(i) Deferral
Employees at private companies face a specific problem: equity vests and triggers tax, but there is no market to sell shares into. Section 83(i) lets qualifying employees defer income tax on stock from option exercises or RSU settlements for up to five years.3Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
The requirements are narrow. The corporation must have no publicly traded stock in any prior year and must have granted options or RSUs to at least 80% of its U.S. employees in the calendar year of grant, with the same rights and privileges. The stock cannot include a put right or a right to be cashed out at vesting. Excluded from making the election: any 1% owner, the CEO, the CFO, a family member of either, or one of the four highest-compensated officers at any time in the current or prior ten years.
The deferral ends at the earliest of five years, the date the stock becomes transferable, the date the company goes public, or the date you become an excluded employee. When income is finally recognized, withholding applies at the top individual rate of 37%. Few companies actually meet the 80% broad-based grant rule, but where the election is available, it can bridge the gap between a taxable event and the liquidity to pay for it. The election must be made within 30 days of the date the stock would otherwise be taxable.