What Is Equity-Based Compensation? Types, Taxes, and 83(b) Election

Equity-based compensation is pay delivered in the form of an ownership stake in your employer instead of, or alongside, cash. It shows up in four main shapes: stock options (both incentive and non-qualified), restricted stock units, restricted stock awards, and employee stock purchase plans. Each has its own rules for when the shares are truly yours, when tax is due, and how much time you have to act before you lose them. Getting the mechanics wrong can cost thousands in avoidable tax or forfeited shares, so it pays to understand the shape of the award before the first vesting date arrives.

How an Equity Award Moves From Paper to Shares

Every award runs through the same sequence, whatever the type. The grant date is when the company formally awards you the equity. The grant document lays out how many shares you received or have the right to buy, at what price if any, and what you have to do to keep them.

Vesting is how you earn the right to keep the shares. Most schedules are time-based. The common tech and startup structure is four years with a one-year cliff: nothing vests during your first year, then 25% vests on your one-year anniversary, and the rest vests in smaller monthly or quarterly increments until you reach full vesting at year four.¹ Some awards use performance-based vesting instead, tying shares to revenue targets, product milestones, or other business goals.

For stock options, vesting by itself doesn’t hand you any shares. You still have to exercise the option, paying the predetermined strike price to buy the stock. For RSUs there’s no purchase step. Once they vest, the company delivers shares directly to your brokerage account in a process called settlement.

The fair market value of the stock drives almost every tax calculation that follows. At a public company, FMV is the trading price on the relevant date. At a private company, FMV comes from an independent 409A valuation, which must be updated at least every twelve months or sooner if a major event such as a funding round changes the company’s value.

Restricted Stock Units

Restricted stock units, or RSUs, are the simplest and most widely used form of equity compensation at public companies. An RSU is a promise: the company will give you shares once you meet the vesting requirements. You own nothing until vesting happens, and you pay nothing to receive the shares. Once vested, the stock appears in your brokerage account automatically.

Because there’s no purchase decision, no strike price, and no expiration to track, an RSU is essentially a deferred stock bonus. Its value moves with the stock price. If the stock is worth $50 on your vesting date, each unit delivers $50 of value before tax.

Non-Qualified Stock Options

Non-qualified stock options (NSOs, sometimes NQSOs) give you the right to buy shares at a fixed strike price, usually set at the stock’s FMV on the grant date. NSOs can be granted to employees, contractors, directors, and advisors.

The value lives in the gap between the strike price and the current market price. If your strike is $20 and the stock trades at $50, each option is worth $30 in the money. You have to actually exercise, paying $20 for a share worth $50, to capture that value. If the stock never climbs above your strike price, the options are underwater and worthless to exercise. Most option grants expire ten years after grant. Miss that deadline and the options are gone.

Incentive Stock Options

Incentive stock options (ISOs) work the same way mechanically as NSOs, but they qualify for potentially favorable tax treatment if you meet the strict requirements of the Internal Revenue Code.² Only employees can receive ISOs. Contractors, board members, and consultants are not eligible.

ISOs come with a built-in cap. If the total fair market value of ISOs that become exercisable for the first time in any single calendar year exceeds $100,000, the excess is automatically treated as NSOs.² The $100,000 is measured using the stock’s FMV on the grant date, and options count in the order they were granted.

Restricted Stock Awards

Restricted stock awards (RSAs) look like RSUs at first glance but differ in one critical way: you become the legal owner of the shares on the grant date, not on the vesting date. You can vote the shares and receive dividends right away. The shares are still subject to forfeiture if you leave before vesting, and the company can typically buy back any unvested shares, often at whatever you originally paid.

RSAs are most common at early-stage startups, where the stock price is very low. That low starting value is what makes the 83(b) election, covered below, so powerful for this type of award.

Employee Stock Purchase Plans

Employee stock purchase plans (ESPPs) let you buy company stock at a discount through payroll deductions. Under a qualified plan governed by Section 423, the maximum discount is 15% off fair market value.³ Most plans land somewhere between 5% and 15%.⁴

Many ESPPs also include a look-back provision that calculates the purchase price using the lower of the stock price at the start or the end of the purchase period. If the stock rises during that window, your discount applies to the earlier, lower price, which can push the effective return well above the stated discount rate.

Qualified ESPPs cap purchases at $25,000 worth of stock per calendar year, measured by FMV on the first day of the offering period.³

How Each Type Is Taxed

Tax treatment is where equity compensation gets genuinely complicated. The common thread across every type is your tax basis: the amount already recognized as ordinary income plus any cash you paid to acquire the shares. When you eventually sell, capital gains tax only applies to appreciation above that basis.

RSU Tax Treatment

RSUs trigger a single, straightforward tax event. On the vesting date, the full FMV of the delivered shares is ordinary income, reported on your W-2 alongside your salary.⁵ Your employer withholds federal income tax, Social Security, Medicare, and any state tax at that time. Your basis equals the FMV on the vesting date.

If you hold the shares and later sell at a higher price, the gain above your basis is a capital gain. Sell within a year of vesting and it’s short-term, taxed at ordinary rates. Hold longer than a year and you qualify for the lower long-term capital gains rate.⁵

NSO Tax Treatment

NSOs create two separate tax events. At exercise, the difference between the stock’s FMV on the exercise date and your strike price is the bargain element, taxed as ordinary income. Your employer withholds income tax, Social Security, and Medicare on that amount.

The second event happens at sale. Your basis is the strike price you paid plus the bargain element already taxed as ordinary income. Any gain above that is a capital gain. Hold more than a year after exercise and it’s long-term; sell sooner and it’s short-term at ordinary rates.

ISO Tax Treatment

ISOs offer the possibility of paying only long-term capital gains rates on your entire profit, but only if you clear two holding requirements. You must hold the shares at least two years after the grant date and at least one year after the exercise date. A sale that meets both is a qualifying disposition.⁶

Sell before you meet either holding period and you’ve made a disqualifying disposition. The bargain element at exercise (up to the amount of your actual gain) gets reclassified as ordinary income, and any remaining profit is taxed as a capital gain.⁷

The catch that trips up many ISO holders: even without selling a share, exercising ISOs can trigger the Alternative Minimum Tax. For AMT purposes, the bargain element at exercise is added back to income as a preference item.⁸ If you exercise a large block when the stock sits well above your strike price, you could owe a significant AMT bill without receiving any cash. The AMT you pay may come back as a credit in later years, but the immediate outlay can hurt.⁹

Your employer must file Form 3921 with the IRS and send you a copy whenever you exercise ISOs. The form reports the grant date, exercise date, exercise price, and FMV at exercise. You need it to report the AMT adjustment and calculate your basis when you eventually sell.¹⁰

RSA Tax Treatment

By default, RSAs follow the RSU pattern: no tax on the grant date, and ordinary income recognized at vesting based on the shares’ FMV at that point. The 83(b) election, below, offers an alternative that’s unique to this award type.

ESPP Tax Treatment

ESPP tax treatment depends on whether you make a qualifying or disqualifying disposition. A qualifying disposition requires holding the shares at least two years from the offering date and one year from the purchase date.¹¹

In a qualifying disposition, the ordinary income portion is limited to the lesser of your actual gain on the sale or the discount you received at purchase. Anything above that is long-term capital gain. In a disqualifying disposition, the ordinary income equals the discount based on the FMV on the purchase date, regardless of what you actually sold the shares for.¹¹

The 83(b) Election for Restricted Stock

The Section 83(b) election is available only for restricted stock awards, and it’s one of the few genuinely powerful planning tools in equity compensation. By filing the election, you choose to recognize the stock’s value as ordinary income on the grant date instead of waiting until vesting. File when the shares are worth almost nothing, say a penny each at an early-stage startup, and you pay a trivial amount of tax upfront. All future appreciation is then taxed as capital gain when you sell.

The deadline is non-negotiable. You must file with the IRS within 30 days of the grant date. The IRS now provides a dedicated Form 15620 for the election.¹² Miss the 30-day window and the option is gone. No extensions.

The risk is real. If the stock price drops or you leave before vesting and forfeit the shares, you’ve already paid tax on income you never actually kept, and you can’t recover that payment. The 83(b) is a calculated bet: it works spectacularly when the stock appreciates and costs you money when it doesn’t.

Withholding, Sell-to-Cover, and Cashless Exercise

Equity compensation generates ordinary income, and your employer must withhold tax on it, the same way they withhold from your paycheck. The awkward part is that vesting RSUs or exercising options creates income without creating cash. You owe tax on shares, not dollars.

For RSUs, the standard fix is a sell-to-cover transaction. Your employer automatically sells enough of your newly vested shares to cover federal income tax withholding, Social Security, Medicare, and state tax. You keep the rest. If you were expecting 100 RSUs and your combined withholding rate is roughly 40%, about 60 shares actually land in your account.

For stock options, a cashless exercise is the common approach. Your broker simultaneously exercises the options and sells enough shares to cover the strike price and the withholding on the bargain element. No cash leaves your bank account. The trade-off: you’ve sold shares immediately, and for ISOs that creates a disqualifying disposition, which eliminates the favorable capital gains treatment you were hoping for.

One often overlooked issue. Employers typically withhold at the federal supplemental wage rate, which may be lower than your actual marginal rate. A large vesting event or option exercise can push you into a higher bracket, leaving a significant balance due at tax time. If your adjusted gross income was above $150,000 in the prior year, you need to pay at least 110% of last year’s total tax liability through withholding and estimated payments to avoid an underpayment penalty. For incomes at or below $150,000, the threshold is 100% of the prior year’s tax. Paying at least 90% of your current-year tax liability also satisfies the safe harbor.

What Happens to Your Equity When You Leave

Leaving a job, whether by resignation or layoff, has very different consequences depending on the type of equity you hold. This is where people lose the most money, usually because they didn’t understand the deadlines until it was too late.

Unvested RSUs. Forfeited immediately. They go back to the company’s equity pool the moment your employment ends. Nothing to exercise, no grace period.
Vested RSUs. Already delivered as shares in your brokerage account. Yours to keep and sell whenever you want.
Vested stock options. Most option agreements give you a post-termination exercise window, commonly 90 days from your last day, to exercise vested options. For ISOs specifically, the tax code imposes a hard 90-day deadline. Miss it and the options expire. Some companies offer extended exercise windows, but any ISO exercised after day 90 automatically converts to an NSO and loses its favorable tax treatment.²
Unvested options. Forfeited on termination, the same way unvested RSUs are.
Unvested RSAs. The company repurchases them, typically at your original purchase price.

If you’re thinking about leaving and hold significant vested but unexercised options, run the numbers before you resign. Calculate the strike price you’d need to pay, the tax hit on the bargain element, and whether you have the cash on hand to cover both. Many people have discovered after handing in notice that they couldn’t afford to exercise inside the 90-day window.

1
Investopedia. Understanding Cliff Vesting: Process, Types, and Benefits
2
Office of the Law Revision Counsel. 26 US Code 422 – Incentive Stock Options
3
Office of the Law Revision Counsel. 26 US Code 423 – Employee Stock Purchase Plans
4
Morgan Stanley. Confused About Your ESPP? Here’s What You Need to Know
5
Fidelity. Filing Taxes for Your Restricted Stock, Restricted Stock Units, or Performance Awards
6
KPMG. Incentive Stock Options – Navigating the Requirements for Compliance
7
NASPP. Disqualifying vs Qualifying: ISOs
8
National Center for Employee Ownership. Stock Options and the Alternative Minimum Tax
9
J.P. Morgan Wealth Management. Incentive Stock Options and the AMT
10
Morgan Stanley at Work. Form 3921: Who Needs to File, How and When
11
Internal Revenue Service. Stocks, Options, and Splits FAQ
12
Internal Revenue Service. Form 15620 – Section 83(b) Election