Equity compensation is one of the most complex areas of individual tax planning. The same economic value - $500,000 worth of company stock - can generate wildly different tax outcomes depending on whether it is delivered as incentive stock options, nonqualified options, restricted stock, RSUs, or founder shares qualifying as §1202 QSBS. Understanding the tax treatment of each type before accepting or exercising equity is essential. The decision of when to exercise, whether to file a §83(b) election, and when to sell can easily be worth hundreds of thousands of dollars in tax savings or costs.
ISO (Incentive Stock Option): No ordinary income at exercise. Spread at exercise is an AMT preference item. Qualifying disposition (held 2 years from grant, 1 year from exercise) = long-term capital gain on full appreciation. Disqualifying disposition = ordinary income on spread at exercise. Only available to employees.
NSO (Nonqualified Stock Option): Ordinary income at exercise equal to spread (FMV minus exercise price). Employer withholds; income on W-2. Basis equals FMV at exercise. Subsequent appreciation = capital gain from exercise date.
Restricted Stock: §83(b) election within 30 days of grant converts all future appreciation to capital gain from grant date. Without §83(b), ordinary income at each vesting date at FMV. Best for early-stage founders when FMV is near zero.
RSU: Ordinary income at vesting at FMV. No §83(b) election available. Employer withholds at 22% supplemental rate. Basis equals income recognized. Subsequent gain/loss is capital from vesting date.
QSBS (§1202): Up to 100% exclusion of capital gain for stock held 5+ years in qualifying C-corp. Must be original issuance; company gross assets under $50M. Most valuable for founders and early investors.
For ISO holders: the exercise timing decision determines AMT exposure. Exercising ISOs at a time when the spread is small (early in the year, when stock price is near the strike price) minimizes the AMT preference item. Running AMT projections before exercising a large ISO grant is essential.
For restricted stock holders: the §83(b) election must be filed within 30 days of grant - this is a hard deadline with no exceptions. At early-stage companies where FMV is low, the §83(b) election typically costs little in current tax and converts all subsequent appreciation to capital gain. The §83(b) election also starts the §1202 QSBS five-year clock from the grant date rather than from each vesting date.
For NSO holders: the decision of when to exercise depends on the current spread, expected appreciation, and the taxpayer's current vs. expected future marginal rate. Exercising early (when spread is small) minimizes ordinary income; waiting until liquidity maximizes ease but may maximize ordinary income if the company has grown.