Stock options and equity compensation sound amazing when you’re getting hired. Free money, right?
Your company is giving you a piece of the pie. What could go wrong?
Turns out, quite a bit from a tax perspective.
When Paper Gains Create Real Tax Bills
The biggest surprise hits when your equity vests or when you exercise options. You might not have any actual cash in your pocket. But the IRS treats it like you just got a bonus.
Say your company grants you stock options at $10 per share. Two years later when they vest, the stock is worth $50. You haven’t sold anything. Haven’t made a penny. But you owe taxes on that $40 difference like it was regular income.
This creates what’s known as phantom tax – owing money to the government on gains you can’t actually access yet.
ISOs vs NSOs Make Everything Confusing
Incentive Stock Options and Non-Qualified Stock Options get taxed completely differently. ISOs might trigger Alternative Minimum Tax even if you don’t owe regular income tax. NSOs get taxed immediately when you exercise them.
Most people don’t realize which type they have until tax season. By then it’s too late to plan around it.
Restricted Stock Units Hit Different
RSUs are simpler in some ways but create their own problems. When they vest, it’s just like getting a cash bonus. Except you get stock instead of money to pay the taxes with.
Companies often withhold some shares to cover taxes. But they usually don’t withhold enough. Especially if you’re in a high tax bracket or live in a state with income tax.
You end up owing more money come April.
Timing Can Make or Break You
When you exercise options or when stock vests matters huge for taxes. Exercise early in the year? You have time to plan. Exercise in December? Good luck scrambling to find tax money.
Some people try to time exercises around market conditions. But tax planning should probably come first.
State Taxes Add Another Layer
Different states treat equity compensation differently. California taxes it aggressively. Texas doesn’t have state income tax at all. If you move between states, things get even weirder.
Some states want their cut based on where you earned the equity. Others care where you live when it vests. A few want both.
Planning Actually Helps
The key is understanding what you have before you need to make decisions. Know whether your options are ISOs or NSOs. Understand when things vest. Figure out the tax implications before you exercise.
Consider spreading exercises across multiple years if possible. Sometimes it makes sense to exercise early and pay taxes on smaller amounts. Other times waiting is better.
Getting Help Makes Sense
Equity compensation taxes aren’t straightforward. The rules change based on your situation, your company’s structure, and timing.
Most regular tax preparers don’t deal with this stuff regularly. It’s worth finding someone who understands equity compensation if yours is significant.
Because owing surprise taxes on money you can’t access yet? That’s not fun for anyone.
William Gall is a seasoned attorney specializing in civil litigation and family law. With a legal career spanning over two decades, William has built a reputation for his meticulous attention to detail and his unwavering commitment to justice. In addition to practicing law, he is a prolific writer, contributing regularly to various legal blogs where he shares his insights on current legal trends, case law, and best practices. His articles are well-regarded in the legal community for their thorough research and practical advice, making complex legal concepts accessible to both legal professionals and the general public.