Taxes on equity

Author:

Spencer Kimbro, Esq.

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Read time:

9 minutes

Published date:

April 1, 2025

Having a solid understanding of how equity is taxed will help you make smart decisions as you earn equity, exercise your options, and sell your shares.

What triggers taxes on equity?

Two taxes generally apply to employee equity earnings: ordinary income tax and capital gains tax. Typically, you’ll owe income tax on your equity in the tax years during which you acquire shares. Capital gains tax comes into play when you sell your shares. (A third tax, the alternative minimum tax (AMT), may also apply to certain equity earners.)

Three major milestones can trigger a tax liability: equity vesting, exercising your options, and selling your shares.

1. Vesting restricted stock

Vesting refers to the process of earning an asset as you meet certain conditions. Usually, these conditions are milestone-based or time-based—like completing a specific project or remaining an employee at your company for a defined amount of time.

With stock options, you vest the right, or option, to purchase your shares at a defined price (the “ strike price”), which is set by the company in your award letter. When you vest restricted stock, such as restricted stock units (RSU) or restricted stock awards (RSA), you take ownership of your shares as they vest.

Stock award vesting can either be single-triggered or double-triggered. Single-trigger awards require that you meet just one condition for vesting; typically, it’s an amount of time that must elapse from the date of the award. Double-trigger vesting requires that a second condition be met; usually, this is a liquidity event—such as a company IPO, acquisition, or secondary offering—that enables you to sell vested shares.

When you vest restricted stock, it triggers ordinary income tax on the fair market value (FMV) of the shares on the vesting date. This income tax is due by the filing of your tax return for the related calendar year. If you hold RSAs, you have the option to file an 83(b) election, which lets you pay income tax on your shares in the year you are granted the award.

2. Exercising your options

Unlike RSUs, stock options, including incentive stock options (ISO) and non-qualifying stock options (NSO), must be exercised for you to acquire the stock. Exercising an option means buying the shares at the strike price.

If you’re exercising NSOs, you will have to pay income tax on the difference, or spread, between the exercise price and the fair market value (FMV) of the shares at the time of exercise. This spread counts as ordinary income. For ISOs, the spread between the strike price and FMV at time of exercise could subject you to AMT.

3. Selling your shares

You may owe ordinary income tax or capital gains tax when you sell your stock. The amount you’ll pay in capital gains depends on the type of equity you hold.

Ways you may be able to pay less in taxes on your equity upon sale

The qualified small business stock (QSBS) exemption

If you hold qualified small business stock (QSBS), you may be entitled to a reduced capital gains rate for federal taxes on the sale of your stock—possibly as low as 0%. To take advantage of QSBS benefits, you need to meet two basic criteria:

1. The company that issued you stock must have been a qualifying small business at the time you acquired your shares.
2. You’ve held your stock for at least five years since the acquisition date.

83(b) elections

If your equity plan allows early exercise, you can pay taxes on your shares at the time of the early exercise, as opposed to at time of vesting, by making an 83(b) election.

Qualifying dispositions on ISOs

If you hold ISOs, you might save significantly on your tax liability at the point of sale by ensuring that you meet the criteria for a qualifying disposition. Meeting these requirements will entitle you to the lower, long-term capital gains rate.

Planning for the alternative minimum tax (AMT)

Another thing to consider when exercising your ISOs is the alternative minimum tax (AMT). To calculate your AMT, you make adjustments to your taxable income based on IRS instructions.

Stepping up your tax basis

One of the most common mistakes that taxpayers make is the failure to step up their tax basis when selling their equity. This means taking credit for the tax you’ve already paid on the equity you sell.

Maximize your gains by planning ahead

It’s exciting to work for a company that offers equity compensation. However, many tax-related rules can be tricky to navigate. You should always consult with a tax advisor before selling your shares.

Give your employees support in their tax decisions

Carta Equity Advisory helps the employees of our customer companies make informed decisions about equity ownership and taxes.