Equity Compensation: Award Types, Vesting, and Capital Gains

Equity compensation ties part of your pay to your employer’s stock rather than delivering it as cash, and the tax treatment and vesting rules for equity compensation depend entirely on which type of award you hold. Restricted stock units, restricted stock awards, incentive stock options, non-qualified stock options, and employee stock purchase plans each have their own taxable moment, their own holding-period rules, and their own deadlines that decide how much of the grant you actually keep. Get the type right, hit the deadlines, and the rest is arithmetic.

The Award Types and How Each Is Taxed

The award type controls when the IRS considers you paid, whether the income is ordinary or capital, and what elections you can make to change that. Read your grant agreement first; everything below flows from what it says you were granted.

Restricted Stock Units

RSUs are a promise to deliver shares once you meet the vesting conditions. Until then, you don’t own anything, can’t vote, and receive no dividends. When the units vest, the fair market value of the delivered shares is treated as ordinary income, and your employer withholds federal and state tax at that moment.¹ Any change in value after vesting is a capital gain or loss when you sell.

Restricted Stock Awards and the Section 83(b) Election

RSAs give you actual shares on the grant date, subject to transfer restrictions. You can vote them and collect dividends while you wait for the restrictions to lift. Without any election, you owe ordinary income tax on the fair market value of the shares when they vest, minus anything you paid for them, under Section 83 of the tax code.²

RSA holders have an option RSU holders don’t: the Section 83(b) election. Filing within 30 days of the grant date lets you pay tax on the shares’ value at grant rather than at vesting.³ At an early-stage startup where the stock is worth pennies, that can mean paying almost nothing upfront and converting all future appreciation into capital gains. The risk is real. If the stock drops or you leave before vesting, the tax you paid is gone, and the statute explicitly bars a deduction for forfeited property when an 83(b) election was made.² The 30-day deadline cannot be extended.

Incentive Stock Options

ISOs are available only to employees and must satisfy Internal Revenue Code Section 422.⁴ When you exercise, no regular income tax is due on the spread between the strike price and the market value.⁵ That is the appeal, and it is also the trap. The spread is a preference item for the Alternative Minimum Tax and gets reported on Line 2i of Form 6251. A large enough spread can push you into AMT and generate a tax bill on shares you haven’t sold.

Exercising ISOs and selling the shares in the same calendar year removes the AMT adjustment, because the regular tax and AMT treatment become identical.⁶ The cost of that shortcut is losing the favorable long-term treatment that makes ISOs valuable. To qualify for long-term capital gains rates on the full gain, you have to hold the shares at least one year after exercise and at least two years after the grant date. Selling earlier is a disqualifying disposition, and the spread becomes ordinary income.⁴

Non-Qualified Stock Options

NSOs carry none of the statutory restrictions ISOs do, which is why companies use them for contractors, advisors, and board members. When you exercise, the spread between strike price and market value is ordinary income, and your employer withholds tax on it as wages. Any gain after exercise is a capital gain.⁵

Employee Stock Purchase Plans

ESPPs let you use after-tax payroll deductions to buy company stock at a discount. Under Section 423, the purchase price cannot be less than 85% of fair market value, so the maximum discount is 15%.⁷ Many plans include a look-back that applies the discount to the lower of the price at the start or end of the offering period, which can make the effective discount much larger if the stock rose.

Phantom Stock and Stock Appreciation Rights

Phantom stock pays a cash bonus equal to the value of a set number of shares at a future date. SARs pay only the appreciation between grant and exercise. Neither delivers actual stock. Both payouts are ordinary income when received, taxed like a cash bonus. Companies that don’t want to dilute their share count, or private companies that can’t easily issue stock, often use these instruments.

How Vesting Works

Vesting converts a promise into ownership. Most schedules run three to five years and start with a cliff, a minimum service period before anything vests at all. A one-year cliff means an employee who leaves at eleven months walks away with nothing. Once you clear the cliff, shares typically vest monthly or quarterly. A common structure is a one-year cliff followed by monthly vesting over the remaining three years of a four-year grant.⁸

Some grants tie vesting to company milestones instead of time served. Revenue targets, product launches, or stock price thresholds can all serve as triggers. Miss the target, and those shares never vest.

Acceleration in an Acquisition

When your employer is acquired, unvested equity doesn’t automatically vest. What happens depends on the change-of-control language in your grant agreement. Single-trigger acceleration vests everything on the deal closing. Acquirers dislike this because it eliminates the incentive for you to stay. Double-trigger acceleration requires two events: the deal closes and you are terminated without cause or your role is substantially diminished within a set window, often 12 months. Only then do the unvested shares accelerate. Double-trigger is far more common because acquirers insist on it.

Annual Dollar Caps on ISOs and ESPPs

Federal law caps how much equity can receive preferential treatment in a single year. Exceeding the cap doesn’t cost you the equity; it costs you the tax break on the excess.

For ISOs, no more than $100,000 worth of options, measured by fair market value on the grant date, can become exercisable for the first time in any calendar year. The excess is automatically treated as a non-qualified stock option.⁴ Options count in the order they were granted, so earlier grants absorb the limit first.⁹

For ESPPs, you cannot purchase more than $25,000 worth of stock in any calendar year across all of your employer’s plans, again measured at grant-date fair market value.⁷

Capital Gains When You Sell

Once you own shares outright, whether from vested RSUs, exercised options, or ESPP purchases, future gains are capital gains. Shares held longer than one year qualify for long-term capital gains rates of 0%, 15%, or 20%, depending on total taxable income.¹⁰ For 2026, the 15% rate kicks in at $49,450 for single filers and $98,900 for married couples filing jointly. The 20% rate applies above $545,500 for single filers and $613,700 for joint filers.¹¹ Shares held one year or less are taxed at your ordinary income rate.

High earners face a second layer. If your modified adjusted gross income exceeds $200,000 for single filers or $250,000 for joint filers, the 3.8% Net Investment Income Tax applies to capital gains.¹² That pushes the effective top federal rate on long-term gains to 23.8%. Equity recipients often cross those thresholds in years when a large grant vests or a concentrated position sells, even if their salary alone wouldn’t trigger the surtax.

State taxes add another bite. Nine states impose no capital gains tax; others tax gains at rates reaching 13% or higher. Your state of residence at the time of sale determines which applies.

Reporting and the Cost-Basis Trap

Equity compensation creates reporting obligations that go beyond your W-2. Your employer files Form 3921 whenever you exercise an ISO, and Form 3922 for ESPP purchases, capturing grant date, exercise or purchase date, price, and fair market value.¹³ Keep them. You’ll need them when you sell.

When you sell, your broker reports the transaction on Form 1099-B, and the cost basis it shows is often wrong. For RSUs and NSOs, the income already taxed at vesting or exercise should be baked into your basis. The 1099-B usually shows only what you paid out of pocket, which can be zero. If you don’t correct it on Form 8949, you’ll be taxed twice on the same income. Enter code “B” in column (f) and adjust the basis in column (g) to reflect the income already reported on your W-2.¹⁴

If you exercised ISOs and held the shares past year-end, you’ll also need Form 6251 to calculate any AMT liability, with the spread reported on Line 2i.⁶

Exercising, Blackouts, and Wash Sales

Stock options can be exercised for cash, cashless (exercise and immediately sell everything, with proceeds covering the strike price, taxes, and fees), or sell-to-cover (exercise all, sell only enough to cover strike and withholding, keep the rest). RSUs have nothing to exercise since shares deliver automatically at vesting, but the employer still needs withholding, usually handled by an automatic sell-to-cover of a portion of the vesting shares.

At a public company, you cannot sell whenever you want. Most employers impose trading blackouts around quarterly earnings, with a window that opens a day or two after results are released and closes as the next earnings approach. Unscheduled blackouts can also arise around mergers or other significant events. Selling during a blackout can expose you to insider trading liability. A Rule 10b5-1 plan, adopted while you don’t hold material nonpublic information, lets you schedule trades in advance so they execute even during blackouts, after a cooling-off period set by the SEC.¹⁵

The wash sale rule is another quiet trap. If you sell company shares at a loss and acquire substantially identical shares within 30 days before or after the sale, the IRS disallows the loss.¹⁶ The disallowed loss shifts to the basis of the replacement shares, so it isn’t permanently gone, but you can’t claim it this year. Exercising options, buying through an ESPP, RSU vesting, and even dividend reinvestment all count as acquisitions for wash sale purposes. Selling company stock at a loss shortly before an ESPP purchase settles or an RSU tranche vests can trigger a wash sale without any intent.

What Happens When You Leave

Departure is where equity mistakes get expensive. Unvested shares are typically forfeited, whether you quit, were laid off, or were fired for cause.

For vested stock options, your grant agreement sets a post-termination exercise window. It’s often 90 days, though it can run from 30 days to as long as 10 years. Miss the window and you permanently lose the right to buy those shares. ISOs carry an additional statutory rule: to preserve ISO tax treatment, you must exercise within three months of leaving. Even if your company gives you a longer window, any exercise after the three-month mark converts the ISO into an NSO for tax purposes.⁴

Vested RSU shares already delivered to your brokerage are yours. You own the stock and can hold or sell on your own timeline, subject to any remaining blackout restrictions or insider trading policies that extend past your departure.

At a pre-IPO company, exercising options on the way out means paying the strike price plus taxes on stock you cannot yet sell. For ISOs with a large spread, the AMT bill can be substantial. Run the numbers before your termination date so you aren’t making a five- or six-figure decision under a 90-day clock. Once the company does go public, employees and insiders are typically locked out of selling for 180 days under a lockup agreement with the underwriters.¹⁷

1
Internal Revenue Service. US Taxation of Stock-Based Compensation Received by Nonresident Aliens
2
Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
3
Internal Revenue Service. Form 15620 – Section 83(b) Election
4
Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options
5
Internal Revenue Service. Topic No. 427, Stock Options
6
Internal Revenue Service. 2025 Instructions for Form 6251
7
Office of the Law Revision Counsel. 26 USC 423 – Employee Stock Purchase Plans
8
Internal Revenue Service. Retirement Topics – Vesting
9
eCFR. 26 CFR 1.422-4 – $100,000 Limitation for Incentive Stock Options
10
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
11
Tax Foundation. 2026 Tax Brackets and Federal Income Tax Rates
12
Internal Revenue Service. Net Investment Income Tax
13
Internal Revenue Service. Instructions for Forms 3921 and 3922
14
Internal Revenue Service. Instructions for Form 8949
15
U.S. Securities and Exchange Commission. Rule 10b5-1 – Insider Trading Arrangements and Related Disclosure
16
Office of the Law Revision Counsel. 26 USC 1091 – Loss From Wash Sales of Stock or Securities
17
U.S. Securities and Exchange Commission. Initial Public Offerings, Lockup Agreements