Equity compensation is a powerful tool for building wealth, especially if you’re an early employee of a successful company. When managed effectively, your equity comp has the power to fast-track your financial goals and help you acquire significant growth.
And whether you love surprises or can’t stand them, there’s one thing everyone can agree on—surprises at tax time are almost never a good thing. Yet, if your company offers equity compensation in the form of stock options or restricted stock units (RSUs), there may be some extra tax consequences to consider throughout the year.
Let’s walk through a few common tax mistakes together.
Pitfall #1: Failing to understand how different equity compensation types are taxed.
Not all equity comp is created equal—particularly when it comes to when and how they’re taxed. Here’s a quick, general breakdown of when you can expect your equity comp to experience a taxable event:
RSUs: When RSUs vest, they will be subject to ordinary income tax. When you sell the vested units, you will need to pay taxes once again—but this time only on the capital gains. If you held the vested shares for more than a year, you’ll pay the long-term capital gains rate, which tops out at 20%. For shares sold within less than a year of vesting, you’ll need to pay the short-term capital gains tax rate, which is the same as your ordinary income tax rate.
Incentive stock options (ISOs): ISOs only trigger taxes when shares are sold, not when they’re granted or exercised. Again, you’ll pay either short-term or long-term capital gains tax on the profit earned from selling shares, just depending on how long you held the exercised options beforehand.
Non-qualified stock options (NSOs): Unlike ISOs, you may owe some tax when exercising NSOs. The amount subject to ordinary income tax will be based on the difference between the exercise price and fair market value (FMV) of the option. If you exercise company A stock for $10/share and the FMV is $15/share, you may owe tax on the $5/share spread.
Pitfall #2: Underestimating the importance of estimated tax payments.
When your company shares are exercised or RSUs vest, it can increase your taxable income significantly—even pushing you into a higher tax bracket, depending on your other sources of income.
In the case of RSUs, employers are required to withhold some shares to cover the taxes at the time of vesting. With ISOs, this happens when the shares are sold (since no tax is due when exercised). While this can help ease the tax burden put on your shoulders, there’s one problem—companies are only required to withhold based on the 22% tax rate. If your total taxable income pushes you into a higher tax bracket, you’ll be responsible for covering the rest of the tax bill.
To manage your potential tax liability, you may need to make quarterly tax payments, also called estimated tax payments. These are required by the IRS when you expect to owe at least $1,000 come tax time (after deductions and credits). If you neglect to pay estimated taxes when required, you could be hit with hefty fines and penalties (plus, of course, a large tax bill that may be easier to address in small chunks throughout the year).
Pitfall #3: Not considering the possibility of AMT.
If you’re awarded ISOs, you may be more likely to pay the alternative minimum tax (AMT), as opposed to the traditional tax system you’re used to. While we don’t want to go too far down the AMT rabbit hole here (you should discuss this possibility with a tax professional), here’s the gist of what could happen:
Your ISO grant price is what you’ll pay per share of company stock, and it’s typically “discounted” from the fair market value. The difference between the FMV and grant price is called the bargain element. With NSOs, you need to claim the bargain element on your tax return. With ISOs, you are required to report it as part of the AMT calculation for the year the options are exercised. Because of this, you may be required to pay AMT the year you exercise your ISOs.
But don’t fret—the AMT you owe in the year you exercise your ISOs may be “returned” to you in the form of AMT credit, which can be applied to future tax years.
Again, this is a quick introduction to ISOs and AMT, and you will likely want to consult with a financial professional to understand the full scope of your specific tax circumstances.
And finally, not seeking help from tax and financial professionals.
Equity compensation is complicated. Taxes are complicated. Combine them, and it’s enough to intimidate most employees out of managing their equity proactively. To make the most of this opportunity (and avoid making costly missteps), consider working with a professional who understands the nuances of your equity comp and cares deeply about your greater financial well-being.Our team at Mission Street is here to bring simplicity, clarity, and understanding to your financial life—no matter how complex things may feel right now. If you’re preparing for options to vest or considering selling employer stock, we highly recommend reaching out to our team first. We’ll be more than happy to provide guidance and insights based on your current needs, other taxable income sources, and long-term goals.
