Ordinary Income Tax on Equity Compensation
Equity compensation—like stock options (ISOs and NSOs) and RSUs—is a powerful way to share in a company’s success, but it also comes with tax implications. One key concept to understand is ordinary income tax. This tax applies to a portion of your equity compensation and is taxed at the same rate as your regular salary or wages. Think of it like the government’s cut of your earnings.
1-sentence takeaway: Ordinary income tax is due on the difference between the fair market value (FMV) at the time of exercise/vesting and the price you paid for the equity.
Here’s a breakdown for different equity types:
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Non-Qualified Stock Options (NSOs): When you exercise NSOs, you’ll owe ordinary income tax on the “bargain element.” This is the difference between the fair market value (FMV) of the stock on the exercise date and the exercise price you paid. For example, if the FMV is $20 per share and your exercise price is $5, the bargain element is $15 per share, and you’ll pay ordinary income tax on that $15. Your company will also withhold taxes for you.
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Incentive Stock Options (ISOs): ISOs offer potential tax advantages. While there’s no ordinary income tax due upon exercise, the bargain element is considered as a preference item for the Alternative Minimum Tax (AMT). [[Alternative Minimum Tax AMT Learn more about AMT]]. When you eventually sell the shares acquired through ISO exercise, the difference between the sale price and the FMV on the exercise date is taxed as a capital gain, which could be at a lower rate than your ordinary income tax rate. - Restricted Stock Units (RSUs): RSUs are taxed as ordinary income when they vest. The value of the shares at the time of vesting is considered ordinary income. Taxes are typically withheld by your company at the time of vesting.
Key Differences in Tax Treatment Summary:
| Feature | NSO | ISO | RSU |
|---|---|---|---|
| Tax at Exercise/Vesting | Yes (Ordinary Income) | No (but AMT potential) | Yes (Ordinary Income) |
| Tax at Sale | Capital Gains | Capital Gains | Capital Gains |
Important Considerations:
- Tax rates: Your ordinary income tax rate depends on your income bracket and filing status.
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Holding period: How long you hold the shares after exercise/vesting affects whether any gains are taxed as short-term or long-term capital gains. [[Capital Gains Tax Learn more about Capital Gains Tax]]. - Tax advisors: This information is for educational purposes only and isn’t tax advice. Consult a qualified tax professional for personalized guidance.
So here’s what we covered:
- Definition of ordinary income tax in relation to equity compensation
- How ordinary income tax applies to NSOs, ISOs, and RSUs
- Key differences in tax treatment between these equity types
- The importance of consulting a tax advisor