Stock options are a major part of compensation in startups and tech, yet many employees still struggle to understand stock option taxation. The rules for how stock options are taxed—including Incentive Stock Options (ISOs), Non-Qualified Stock Options (NSOs), and Restricted Stock Units (RSUs); can affect everything from ordinary income to capital gains and the Alternative Minimum Tax (AMT).
This often leaves people unsure about the best time to exercise or sell. We see these challenges often when working with employees and founders who want clear guidance before making a financial move.
A common question we hear is:
Stock options are taxed based on the type you receive and when you exercise or sell. ISOs can trigger AMT at exercise. NSOs create ordinary income upon exercise. RSUs are taxed as regular income when they vest. Your final tax result depends on fair market value, holding periods, and whether your gains qualify for capital gains tax rates.
At CMP, we help employees and founders with income tax planning and business consulting. We offer other services to help them manage the financial effects of stock options. Our goal is to give clients clear steps to follow so they can avoid surprises and make informed decisions
This guide explains how ISOs, NSOs, and RSUs are taxed. It also shows what happens at each stage of the equity process. You will learn how to plan ahead to avoid surprises and make smart financial decisions.
Equity compensation gives you a stake in the company you work for. Instead of paying everything in cash, your employer may offer stock options, RSUs, or other shares that can grow in value over time. Companies use equity to attract talent, reward performance, and keep employees invested in the company’s success.
The most common equity types include Incentive Stock Options (ISOs), Non-Qualified Stock Options (NSOs), Restricted Stock Units (RSUs), and Employee Stock Purchase Plans (ESPPs). Each one works differently and follows its own tax rules. The next sections break down how each type is taxed so you can plan with more confidence.
Before we look at how stock options are taxed, it helps to understand a few basic terms. These dates and values shape when tax applies and how much you might owe.
Taxable events happen at exercise and sale, depending on the type of equity you hold. These terms will guide the rest of the discussion and help you see where taxes come into play.
Companies offer equity in several ways, and each type works differently.
Each award leads to different tax results. The next sections break down how these taxes work.
Stock options and other equity awards create tax obligations as you move through different stages of your equity timeline. Each point in the process plays a role in how much tax you owe and when you owe it. Most awards follow three main stages:
Across these stages, two types of tax rates matter most:
The timing of each step determines which tax rate applies. Your employer also reports these events to the IRS. NSO income usually appears on your Form W-2. Stock sales show up on Form 1099B. ISO exercises include Form 3921 so you can track your cost basis and potential AMT exposure.
The exercise step is often the first point where taxes show up for stock options. Here is how each equity type works at exercise.
|
Equity Type |
Tax on Exercise |
How it Works |
|
NSOs |
Taxed as ordinary income |
The IRS taxes the difference between the fair market value and the strike price on the day you exercise. |
|
ISOs |
No regular tax at exercise |
The spread between fair market value and strike price may count toward AMT. |
|
RSUs |
No exercise event |
RSUs turn into shares at vesting, so tax applies at vesting, not exercise. |
If your strike price is $5 and the fair market value at exercise is $15, the $10 spread is ordinary income for NSOs. For ISOs, this same $10 spread isn’t regular income but may be considered income for AMT purposes.
Taxes also come into play when you sell your shares. If the stock has increased in value since you exercised or received it, that gain is taxed as a capital gain.
The rate depends on how long you held the shares.
The holding period starts on the exercise date for stock options and on the vesting date for RSUs. Once you sell, the gain or loss is based on the difference between the sale price and your cost basis.
This timing is a key part of how much tax you pay.
Incentive Stock Options are a type of stock option that companies offer only to employees. They can provide tax benefits, but the rules are strict, and the timing of each step matters.
Your tax result depends on how long you hold the shares after exercise and how long it has been since the grant date.
The IRS limits the amount of ISOs that can become exercisable in a single year. The limit is $100,000 based on the grant date value. Any amount above that limit is treated as NSOs for tax purposes.
Say you receive 1000 ISOs with a strike price of $10. When you exercise, the fair market value is $25, which creates a $15 spread per share. You don’t pay regular income tax on exercise, but the $15000 spread counts toward AMT. If you hold the shares long enough to meet the qualifying periods, your gain on sale is taxed as long-term capital gain. If you sell earlier, part of that gain is treated as ordinary income.
NSOs are the most common type of stock option because companies can grant them to employees, consultants, and directors. The tax rules are straightforward, and most of the tax impact shows up at exercise.
You receive 1000 NSOs with a strike price of $5. You exercise when the fair market value is $15, creating a $10 spread per share. That spread becomes $10000 of ordinary income, and your employer withholds taxes on that amount. If you later sell the shares for $20, the additional $5 gain per share is a capital gain. This creates $5000 of capital gains tax exposure. Compared to ISOs, NSOs create a larger immediate tax bill because the spread is taxed as regular income at exercise.
RSUs are different from stock options because you don’t choose when to buy shares. The company gives you shares as they vest, and the value at vesting becomes taxable income.
Five hundred RSUs vest when the share price is $50. The $25000 value is taxed as ordinary income at vesting. If you keep the shares and sell them a year later when the price is $60, the extra $5000 becomes a long-term capital gain. RSUs are simple, but the tax hit at vesting often surprises employees who weren't expecting it.
Some companies offer other equity-style plans, but they are less common.
These plans work differently from stock options and Restricted Stock Units, but the same idea applies. Taxes depend on when you receive value and when you sell or receive cash.
The tax you pay depends on how you receive the income and how long you hold the shares. This matters because ordinary income tax rates are usually higher than capital gains rates.
Ordinary income tax applies when the IRS treats part of your equity as regular pay. This includes:
This income shows up on your Form W-2 if you’re an employee.
Capital gains tax applies when you sell stock you hold as an investment. Your gain is the difference between your sale price and your cost basis.
If you exercise an option at $10 and later sell at $18, the $8 gain is taxed in two different ways. Selling within one year creates a short-term gain taxed like regular income. Selling after one year creates a long-term gain taxed at a lower rate.
The Alternative Minimum Tax is a separate tax calculation that ensures certain taxpayers pay a minimum amount of tax. It matters for employees who exercise Incentive Stock Options.
When you exercise ISOs, the spread between the fair market value and the strike price counts as income for AMT. If the spread is large, exercising many ISOs at once can push this amount high enough to trigger AMT.
If your regular tax is lower than your AMT calculation, you pay the higher AMT amount for that year. This can surprise employees who weren’t expecting a tax bill at exercise, especially when they haven’t sold their shares.
Good tax planning exercises can lower your tax bill and help you avoid surprises. Focus on these steps:
Utah follows federal rules for recognizing income from stock options and other equity awards, but there are a few key points to know for state taxes.
Utah taxes all income at a flat 4.5 percent rate. This applies to the spread from NSOs at exercise, the value of RSUs at vesting, and any income reported on your Form W-2.
Utah does not offer a lower rate for long-term capital gains. All gains are taxed at the same flat state income rate.
Employers withhold Utah income tax on NSO exercises and RSU vesting the same way they withhold tax on regular wages. Stock sales flow through your Utah return using federal forms.
Holding shares longer can reduce federal taxes, but it does not reduce Utah taxes. Include Utah’s flat rate in your planning if you expect a large exercise or vesting event.
Here are answers to some of the questions employees ask most often.
It depends on the award. RSUs create tax at vesting. NSOs create tax at exercise. ISOs create tax only if AMT applies. All awards can create capital gains when you sell.
No. An award is classified at the time it’s granted. If it doesn’t meet the ISO rules, it will always be treated as an NSO.
It lets you pay tax when you receive restricted stock or early exercisable options instead of waiting until they vest. It can reduce taxes if the stock grows, but there is no refund if the value drops.
Most people sell some or all shares at vesting to cover taxes and limit risk. You get long-term capital gains only if you hold the shares for more than one year after vesting.
They expire with no value. To avoid losing potential income, track your vesting and expiration dates.
Stock options can be a valuable part of your compensation, but the tax rules are easy to misunderstand. When you know how ISOs, NSOs, and RSUs are taxed, you can plan better, avoid surprises, and make decisions that support your long-term goals.
At CMP, we help employees and founders work through these questions and choose the right timing for exercises and sales. Our team is here to guide you through the tax implications so you can move forward with clarity and confidence.
Before you exercise or sell your shares, talk with a qualified tax professional. A short conversation can help you time your decisions, reduce your tax burden, and protect your financial future.
Ready to optimize your stock option strategy? CMP specializes in tax planning for employees and founders with equity compensation. Click the button below for a consultation or call one of our three locations: Wasatch Front 801-467-4450, Cache Valley 435-750-5566, and Southern Utah 435-269-4540.