Equity-based compensation is pay delivered as an ownership stake in your employer instead of, or alongside, cash. The four forms you’re most likely to encounter are restricted stock units (RSUs), stock options (both non-qualified and incentive), restricted stock awards (RSAs), and employee stock purchase plans (ESPPs). Each one has its own rules for when the shares become yours, when you owe tax, and what happens if you leave the company. Getting those details wrong can cost thousands of dollars in avoidable tax or forfeited equity.
From Grant to Shares You Can Sell
Every equity award moves through the same sequence, regardless of type. The grant date is when the company formally awards you the equity. The grant document spells out how many shares you received or have the right to buy, at what price, and what you have to do before the shares are truly yours.
Vesting is how you earn the right to keep those shares. Most vesting is time-based. The most common structure in tech and startup companies is a four-year schedule with a one-year cliff: nothing vests during the first year, 25% vests on your one-year anniversary, and the remainder vests in smaller increments (often monthly or quarterly) until you’re fully vested at four years.1Investopedia. Understanding Cliff Vesting: Process, Types, and Benefits Some awards use performance-based vesting instead, tying shares to revenue targets, product milestones, or other business goals.
For stock options, vesting alone doesn’t deliver shares. You still have to exercise, meaning pay the predetermined strike price to buy the stock. For RSUs there’s no purchase step; once they vest, the company delivers shares directly into your brokerage account in a process called settlement.
The fair market value (FMV) of the stock drives nearly every tax calculation in equity compensation. For publicly traded companies, FMV is the trading price on the relevant date. For private companies, an independent appraiser sets FMV through a 409A valuation, which must be updated at least every 12 months or sooner if a major event like a funding round changes the company’s value.
The Main Types
Restricted Stock Units
RSUs are the simplest and most widely used form of equity compensation at public companies. An RSU is a promise: the company agrees to give you shares once you meet the vesting requirements. You don’t own anything until vesting, and you don’t pay anything to receive the shares. Once vested, they appear in your brokerage account automatically.
With no purchase decision, no strike price, and no expiration date, RSUs function as a deferred stock bonus. Their value tracks the stock price directly. If the stock is worth $50 on your vesting date, each RSU delivers $50 of value, minus taxes.
Non-Qualified Stock Options
Non-qualified stock options (NSOs) give you the right to buy company shares at a fixed strike price, typically set at the stock’s FMV on the grant date. NSOs can be granted to employees, contractors, directors, and advisors.
Their value comes from 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 $30 in the money. You have to actually exercise to capture that value, paying $20 for a share worth $50. If the stock never climbs above your strike, the options are underwater and worthless to exercise. Most option grants expire 10 years after the grant date; miss that deadline and you lose them.
Incentive Stock Options
Incentive stock options (ISOs) work mechanically the same as NSOs, but they qualify for potentially favorable tax treatment if you meet strict requirements set by the Internal Revenue Code.2Office of the Law Revision Counsel. 26 US Code 422 – Incentive Stock Options Only employees can receive ISOs. Contractors, board members, and consultants are not eligible.
ISOs come with a built-in cap. If the total FMV of ISOs that become exercisable for the first time in any single calendar year exceeds $100,000, the excess is automatically treated as NSOs.2Office of the Law Revision Counsel. 26 US Code 422 – Incentive Stock Options The $100,000 figure uses the stock’s FMV on the grant date, and options are counted in the order they were granted.
Restricted Stock Awards
Restricted stock awards (RSAs) differ from RSUs in one critical way: you become the legal owner of the shares on the grant date, not when they vest. You can vote the shares and receive dividends immediately. The shares are still subject to forfeiture if you leave before vesting, and the company can usually buy them back 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 worth considering.
Employee Stock Purchase Plans
Employee stock purchase plans let you buy company stock at a discount through payroll deductions. Under a qualified plan governed by Section 423 of the tax code, the maximum discount is 15% off FMV.3Office of the Law Revision Counsel. 26 US Code 423 – Employee Stock Purchase Plans Most plans offer discounts between 5% and 15%.4Morgan Stanley. Confused About Your ESPP? Here’s What You Need to Know
Many ESPPs also include a look-back provision that calculates the purchase price using the lower of the stock price at the start or end of the purchase period. If the stock rises during the period, you get the discount applied to the earlier, lower price, which can produce returns well above the stated discount. Qualified ESPPs limit purchases to $25,000 worth of stock per calendar year, measured by FMV on the first day of the offering period.3Office of the Law Revision Counsel. 26 US Code 423 – Employee Stock Purchase Plans
How Each Type Is Taxed
Taxes are where equity compensation gets genuinely complicated. The anchoring concept across every type is your tax basis: the amount already recognized as ordinary income plus any cash you paid for the shares. When you sell, you only pay capital gains tax on appreciation above that basis.
RSUs
RSUs trigger a single tax event. On the vesting date, the full FMV of the delivered shares counts as ordinary income and is reported on your W-2 alongside your salary. Your employer withholds federal income tax, Social Security, Medicare, and any state tax at that time. Your basis equals FMV on the vesting date. If you later sell at a higher price, the gain above basis is a capital gain: short-term if you sell within a year of vesting, long-term if you hold longer.5Fidelity. Filing Taxes for Your Restricted Stock, Restricted Stock Units, or Performance Awards
NSOs
NSOs create two tax events. The first happens when you exercise: the difference between FMV on the exercise date and your strike price, called the bargain element, is taxed as ordinary income with income tax, Social Security, and Medicare withheld. The second event happens when you sell. Your basis is the strike price plus the bargain element already taxed. Gain above basis is a capital gain, long-term if you sell more than one year after exercising.
ISOs
ISOs offer the possibility of paying only long-term capital gains rates on your entire profit, but only if you satisfy two holding requirements: at least two years after the grant date and at least one year after the exercise date. A sale meeting both conditions is a qualifying disposition.6KPMG. Incentive Stock Options – Navigating the Requirements for Compliance Sell before meeting either period and you’ve made a disqualifying disposition: the bargain element at exercise (up to the amount of your actual gain) is reclassified as ordinary income, and any remaining profit is a capital gain.7NASPP. Disqualifying vs Qualifying: ISOs
Here’s the catch that trips up many ISO holders. Even if you don’t sell a single share, exercising ISOs can trigger the Alternative Minimum Tax. For AMT purposes, the bargain element at exercise is added back to your income as a preference item.8National Center for Employee Ownership. Stock Options and the Alternative Minimum Tax Exercise a large block when the stock is well above your strike and you could owe a significant AMT bill without having received any cash. The AMT paid may come back as a tax credit in future years, but the immediate cash outlay can be painful.9J.P. Morgan Wealth Management. Incentive Stock Options and the AMT
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 correctly report the AMT adjustment and calculate your basis when you eventually sell.10Morgan Stanley at Work. Form 3921: Who Needs to File, How and When
RSAs
By default, RSAs look like RSUs for tax purposes: no tax on the grant date, ordinary income on vesting based on FMV at that point. The 83(b) election flips that pattern, and it’s covered below.
ESPPs
ESPP tax treatment turns 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. In a qualifying disposition, the ordinary income portion is limited to the lesser of your actual gain or the discount you received at purchase, and everything above that is long-term capital gain. In a disqualifying disposition, ordinary income equals the discount based on FMV on the purchase date, regardless of what you actually sold for.11Internal Revenue Service. Stocks, Options, and Splits FAQ
The 83(b) Election
The Section 83(b) election is available only for restricted stock awards, and it’s one of the few genuinely powerful tax planning tools in equity compensation. By filing it, you choose to recognize the stock’s value as ordinary income on the grant date rather than waiting until vesting. If you file when the shares are worth very little, say $0.01 per share at an early-stage startup, 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 the election with the IRS within 30 days of the grant date. The IRS now provides a dedicated Form 15620 for this purpose.12Internal Revenue Service. Form 15620 – Section 83(b) Election Miss the 30-day window and the option is gone forever. No extensions, no exceptions.
The risk is real. If the stock drops or you leave before vesting and forfeit the shares, you’ve paid tax on income you never actually kept, and you cannot recover it. The election works spectacularly when the stock appreciates, and it costs you money when it doesn’t.
Withholding: Sell-to-Cover and Cashless Exercise
Equity compensation creates ordinary income, and your employer is required to withhold tax on it. The problem is that vesting RSUs or exercising options generates income without generating cash. You owe tax on shares, not dollars.
For RSUs, the standard solution 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 taxes, and you receive the rest. If you were expecting 100 RSUs and your combined withholding rate is roughly 40%, you might see only about 60 shares land in your account.
For stock options, the most common approach is a cashless exercise. Your broker simultaneously exercises the options and sells enough shares to cover the strike price and withholding on the bargain element. No cash leaves your bank account. The trade-off: for ISOs, this immediate sale is a disqualifying disposition and eliminates the favorable long-term capital gains treatment.
One frequently overlooked problem: employers typically withhold at the federal supplemental wage rate, which may be lower than your actual marginal rate. A large vesting event or exercise can push you into a higher bracket, leaving a balance due at tax time. To avoid an underpayment penalty, estimated payments and withholding generally need to cover 100% of last year’s tax (110% if your prior-year AGI was over $150,000) or 90% of this year’s tax.
What Happens When You Leave
Leaving a job, voluntarily or through a layoff, has 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 too late.
- Unvested RSUs are forfeited immediately. They return to the company’s equity pool the moment your employment ends. No grace period.
- Vested RSUs are already shares in your brokerage account. Yours to keep and sell.
- Vested stock options typically carry a post-termination exercise window, commonly 90 days from your last day. For ISOs specifically, the tax code imposes a hard 90-day deadline. Some companies offer longer windows, but any ISO exercised after day 90 automatically converts to an NSO and loses its favorable tax treatment.2Office of the Law Revision Counsel. 26 US Code 422 – Incentive Stock Options
- Unvested options are forfeited on termination.
- Unvested RSAs are repurchased by the company, typically at your original purchase price.
If you’re thinking about leaving and hold significant vested but unexercised options, do the math 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 to cover both. Many people have discovered after submitting their resignation that they couldn’t afford to exercise within the 90-day window.
Trading Restrictions and Blackout Periods
Holding company stock through equity compensation comes with trading restrictions that don’t apply to outside investors. If you have access to material non-public information, such as upcoming earnings, a pending acquisition, or unreleased product data, selling your shares based on that knowledge is insider trading, a federal crime.
Most companies impose blackout periods during which employees, especially executives, directors, and anyone with access to inside information, cannot trade company stock. Blackouts typically begin about two weeks before the company files quarterly or annual earnings and end a couple of business days after results are released publicly.
To trade in a planned, compliant way, many executives use 10b5-1 trading plans, pre-arranged written plans specifying in advance when and how many shares will be sold. Under SEC rules that took effect in 2023, new or modified 10b5-1 plans require a mandatory cooling-off period before any trades can begin: 90 days for officers and directors (extending up to 120 days), and 30 days for other employees.13Morgan Stanley at Work. 10b5-1 Plan Changes: What You Should Know Even if you’re not a senior executive, your company’s insider trading policy likely applies to you. Read it before selling any shares.
Private Company Equity
Equity at a private company introduces a problem public-company employees never face: you may not be able to sell your shares at all. There’s no stock exchange, no daily price, and often no buyer. Shares might be worth a lot on paper, but converting them to cash requires the company going public, being acquired, or opening a secondary sale.
FMV at private companies is set by an independent 409A valuation, updated at least annually or after any material event that changes the company’s value, like a new funding round. The 409A valuation is often significantly lower than what investors pay in a funding round, because it accounts for illiquidity and other restrictions on common stock.
If you hold options at a private company, exercising them means spending real money for shares you can’t immediately sell. Weigh the exercise cost, the potential tax bill (including AMT for ISOs), and the realistic timeline for a liquidity event. Many early startup employees have exercised, paid taxes, and then watched the company stall or fail without recouping their investment.
Pay attention to double-trigger vesting if your company is acquired. Many RSU and option agreements at private companies require two events before equity fully vests: a change of control, and then either continued employment for a specified period after the deal closes or a qualifying termination like being laid off without cause. If your agreement has double-trigger vesting and you voluntarily resign right after an acquisition, you could forfeit a substantial portion of your unvested equity.
Diversifying Away From Concentrated Employer Stock
It’s easy to accumulate a dangerously large position in your employer’s stock, especially when RSUs vest in chunks and you never actively decide to sell. Financial advisors generally suggest keeping no more than 10% to 15% of your total portfolio in any single stock, including your employer’s.
A systematic approach works better than trying to time the market. Consider selling a fixed percentage of shares shortly after each vesting event, particularly once you’ve held long enough to qualify for long-term capital gains treatment. Over time, that converts concentrated single-stock risk into a diversified portfolio.
The emotional pull is strong, because selling can feel like betting against your own company. But your income, your career growth, and your future equity grants are already tied to this one employer. A concentrated stock position on top of that means a single company event, a bad earnings report, a regulatory problem, a product failure, could hit your salary, your future equity, and your savings at the same time. Selling is how you decouple your net worth from that single point of failure.