Equity compensation isn’t just for Silicon Valley startups—it’s a powerful tool that businesses of all sizes use to recruit, retain, and motivate key employees. When you accept an equity grant, you’re taking partial ownership in your company. That ownership can grow over time, but understanding how it works—when it vests, how it’s taxed, and how to incorporate it into your broader financial plan—is essential.
Below, we answer common questions about restricted stock units (RSUs), stock options, employee stock purchase plans (ESPPs), and other forms of equity compensation—and how to make the most of these benefits.
What Is Equity Compensation?
Equity compensation means receiving a portion of your pay in company shares or rights to buy shares. Common forms include RSUs, non-qualified stock options (NSOs), incentive stock options (ISOs), ESPPs, and performance stock units (PSUs).
Companies use these plans to conserve cash while aligning employee interests with long-term company success. Before taking any action, read your grant agreement carefully to understand the award type, vesting schedule, and restrictions.
How Do Restricted Stock Units (RSUs) Work—and When Should I Sell Them?
RSUs are promises to deliver company shares once specific conditions are met—typically continued employment through a vesting period. RSUs have no value until they vest, but once they do, the shares are yours, and the fair market value is taxed as ordinary income.
A typical vesting schedule might include a one-year “cliff” (25% of shares vest) with the remainder vesting quarterly or monthly over the next three years.
When to sell depends on your goals and risk tolerance. Some sell immediately to cover taxes and diversify; others hold if they believe in the company’s long-term prospects. Keep in mind potential blackout periods that restrict trading, and consult your advisor about the tax implications of selling.
(Tip: If vesting occurs during a blackout, your company may use share withholding or a 10b5-1 plan to satisfy tax obligations.)
RSUs vs. Stock Options – Which Is Better?
Stock options give you the right—but not the obligation—to buy shares at a fixed strike price. If the stock price rises above that price, you can exercise and either hold or sell
There are two main types:
- Non-Qualified Stock Options (NSOs): Available to most employees. When exercised, the bargain element (market value minus strike price) is taxed as ordinary income. Later appreciation is taxed as a capital gain upon sale.
- Incentive Stock Options (ISOs): Offered to key employees and eligible for favorable long-term capital gains treatment if held at least two years from grant and one year from exercise. Exercising ISOs can trigger the alternative minimum tax (AMT)—so tax projections are crucial.
RSUs always have value once vested, making them less risky than options, which can expire worthless if the stock price stays below the strike. Options, however, can offer greater upside if the company’s value soars. The best choice depends on your risk tolerance, time horizon, and confidence in your company’s growth.
What Taxes Do I Pay on RSUs and Stock Options?
Taxes are among the most confusing aspects of equity compensation:
- RSUs: The full fair market value at vesting is taxed as ordinary income. Employers typically withhold shares or cash for taxes. Any later appreciation is taxed as a capital gain.
- NSOs: The “bargain element” at exercise (market value minus strike price) is taxed as ordinary income. Subsequent gains are capital gains when sold.
- ISOs: Exercising is not taxable under regular income tax, but the bargain element counts toward AMT income. Meeting the two-year/one-year rule allows long-term capital gains treatment. Selling earlier (a disqualifying disposition) causes some or all gains to be taxed as ordinary income.
Work with a tax professional to estimate your AMT exposure and avoid surprises—especially when exercising large ISO positions.
What Is an Employee Stock Purchase Plan (ESPP)?
An ESPP allows employees to buy company shares at a discount (up to 15%) through payroll deductions over a set period. At the purchase date, contributions buy shares at the lower of the stock price at the start or end of the offering period.
There are two types:
- Qualified (Section 423) ESPPs: Eligible for favorable tax treatment if held two years from the offering date and one year from purchase. Ordinary income is generally limited to the lesser of the plan discount or the gain at purchase, with the rest as capital gain.
- Non-Qualified ESPPs: Taxed more like a cash bonus on the discount portion.
Qualified ESPPs also have a $25,000 annual purchase limit (based on grant-date value).
How Are ISOs Taxed Under the Alternative Minimum Tax (AMT)?
The AMT ensures high-income taxpayers pay a minimum tax. When you exercise ISOs, the bargain element (fair market value minus strike price) is added to your income for AMT purposes—even though you haven’t sold the shares.
This can push you into AMT territory. If you later sell in a qualifying disposition, you may receive a credit for AMT paid. Use IRS Form 6251 projections before exercising large blocks of ISOs, and consult your tax advisor to plan effectively.
What Is a Section 83(b) Election—and Should You File One?
A Section 83(b) election lets you pay income tax on the value of restricted stock or early-exercised options at the time of grant, rather than at vesting.
If the shares appreciate, future growth is taxed at capital gains rates, but if you leave early or the stock declines, you may have prepaid tax on income you never realize.
Key points:
- Must be filed within 30 days of grant or exercise.
- Once made, the election cannot be revoked.
- Not available for RSUs.
Because the risks can outweigh the benefits, consult with your advisor before filing.
How to Manage Equity Compensation After an IPO
An IPO can be a life-changing event—but it introduces new restrictions and risks.
- Understand Lockup Restrictions: Most companies require insiders to hold shares for 90–180 days post-IPO. Plan liquidity needs ahead.
- Diversify Gradually: Reduce concentration risk by selling portions of vested RSUs or exercised shares. Work with an advisor on a selling plan that balances risk, tax, and long-term goals.
- Review Tax Withholding: IPO-related income can push you into higher brackets. Ensure withholdings and estimated payments are adequate.
- Create a Long-Term Plan: Decide how much of your net worth you want tied to employer stock. A disciplined diversification strategy protects future goals.
How to Diversify Away from Concentrated Employer Stock
Concentration risk occurs when too much of your wealth depends on one company’s performance. Ways to diversify include:
- Sell Gradually: Establish a structured selling plan (such as a 10b5-1 plan).
- Exchange Funds: Swap concentrated stock for a diversified portfolio without immediate tax impact.
- Hedging Strategies: Use options or structured notes for downside protection.
- Charitable Giving: Donate appreciated shares to charities or donor-advised funds to reduce exposure and potentially earn tax deductions.
Putting It All Together
Equity compensation can be one of the most rewarding—and complex—parts of your compensation package. By understanding RSUs, options, ESPPs, and related tax rules, and by developing a diversification plan, you can turn equity into a powerful engine for long-term wealth.
Everyone’s financial picture is unique, and what’s right for one person may not be right for another. We always recommend sitting down with a qualified financial professional to discuss your individual goals.
At North Texas Wealth Management, we specialize in helping clients integrate equity awards into comprehensive financial plans. Whether you’re managing vesting schedules, mitigating taxes, or balancing concentrated stock with your overall portfolio, our advisors can help you design a strategy aligned with your values.
Reach out today to start building the life you want.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. 810128
