Equity Compensation Explained: Tax and Planning Strategies for Stock Options, RSUs, ESPPs, and ESOPs

For many employees, compensation goes beyond a paycheck. Navigating the equity maze of stock options, restricted stock, employer stock purchase plans (ESPPs), and employer stock ownership plans (ESOPs) can feel overwhelming, but with the right strategies, you can make informed decisions that build your wealth and minimize your tax burden, while directly participating in the company’s success. These opportunities can be lucrative, but they also come with a complex set of rules, tax implications, and risks that employees must understand.

Stock Options

Non-Qualified Stock Options (NQSOs)

Non-qualified Stock Options (NQSOs) are a common form of equity compensation that grant employees the right to purchase company stock at a predetermined price, known as the strike price. These grants typically include a specific number of shares and follow a vesting schedule, meaning the options become exercisable over a specified period of time.

For example, if XYZ company granted you 300 shares on September 1, 2025, vesting over three years with a strike price of $15, the shares are not available to exercise at the time of grant. After one year, you can exercise 100 shares on September 1, 2026, then 100 more on September 1, 2027, and the last 100 on September 1, 2028. However, even when the shares vest, you are not obligated to exercise your right to buy immediately. In fact, sometimes it makes sense to wait.  

When to Exercise Stock Options

Exercising stock options can be advantageous when the market price is higher than the strike price (known as being “in the money”). For example, if the XYZ stock price increased to $30 per share, your exercise price would still be $15. Exercising at that point could be beneficial, provided your shares are vested.

On the other hand, if the stock price falls below $15, your options are “out of the money.” In this case, it would not make sense to exercise since you could purchase shares cheaper on the open market. Ultimately, whether to exercise depends on your overall financial plan and tax strategy. Working with a tax planning advisor or retirement planning specialist can help you determine the right timing.

Ways to Cover the Exercise Cost

When you exercise stock options, you must pay the strike price for the shares. Here are common ways to cover that cost:

• Exercise and hold: Use your own cash to buy and keep all the shares.
• Sell-to-cover: Use your cash initially, then sell enough shares to cover the stock option cost and taxes.
• Cashless Exercise: A portion of shares is simultaneously sold to cover the exercise price, taxes, and any associated fees. No upfront cash is required.

Tax Implications of Exercising NQSOs

Of course, we cannot overlook the tax implications of exercising an NQSO. The tax treatment of NQSOs depends on the timing of exercise and sale:

• Ordinary income: The spread between the strike price and the market price at exercise is taxed as ordinary income, plus Social Security and Medicare taxes.
• Capital gains: Any profit when selling the stock is taxed as capital gains. The rate depends on the holding period:
  • Short-term capital gains if sold within one year.
  • Long-term capital gains if sold after one year.

Understanding these stock option tax rules can help you avoid surprises and align decisions with your overall financial plan.

What are Incentive Stock Options (ISOs)?

Incentive Stock Options (ISOs) are a less commonly offered form of equity compensation than NQSOs, but they can provide favorable tax advantages if specific holding requirements are met. Unlike NQSOs, the spread between the strike price and the market price is not taxed as ordinary income at the time of exercise.

Instead, if the shares are held for at least one year after exercise and two years after the grant date, any gains may qualify for long-term capital gains tax rates.

ISO Holding Requirements and Tax Advantages

The value of ISOs comes from meeting the IRS’s required holding periods. To qualify for favorable tax treatment:

1. Hold the shares at least one year after exercising.
2. Hold the shares at least two years after the grant date.
3. Sell the shares only after both conditions are met to qualify for long-term capital gains.

This makes ISOs appealing for employees who can hold stock longer-term and integrate them into a retirement planning strategy.

The Alternative Minimum Tax (AMT) and ISOs

Even with potential tax advantages, ISOs can trigger the Alternative Minimum Tax (AMT), a parallel tax system that affects many high-income earners. When you exercise ISOs, the spread (the difference between the strike price and market price) may be counted as income for AMT purposes, even if you don’t sell the stock.

This makes AMT planning with stock options critical. Without careful tax analysis, you may face a large AMT bill in the year you exercise.  Consulting with a tax planning advisor before exercising ISOs can help avoid unexpected tax burdens.

What Happens to Stock Options When Employment Ends?

Each company has its own policy on what happens to stock options after termination. In many cases, there is a 30-180 day grace period to exercise vested stock options. Additionally, vested ISOs must be exercised within 90 days, or they convert to NQSOs.  Any unvested stock options are generally forfeited upon termination.

Failing to understand your company’s rules could result in losing the value of your stock options. Reviewing your equity plan documents or consulting with a financial advisor before you leave a job is essential to avoid costly mistakes.

Restricted Stock (RSUs and RSAs)

What are Restricted Stock Units (RSUs)?

Restricted Stock Units (RSUs) are a common form of equity compensation in which an employee is granted shares of a stock, typically tied to a vesting schedule or performance goal. While you don’t own the shares immediately, they become yours once the vesting conditions are met.

When RSUs vest, the fair market value of the shares is taxed as ordinary income and is typically reported on your paycheck. Many employers will automatically sell a portion of the vested shares to cover tax withholding. You may then hold or sell the remaining shares just as you would any other stock.

How RSUs are Taxed

Taxing on RSUs is straightforward:

• At vesting: The fair market value is taxed as ordinary income.
• When sold: Any additional gain or loss is subject to capital gains tax.
  • Short-term capital gains apply if shares are sold within one year of vesting.
  • Long-term capital gains apply if sold after one year.

These RSU tax rules make timing decisions critical. Holding shares longer can reduce your tax rate, but it also increases exposure to company-specific risk.

What are Restricted Stock Awards (RSAs)?

RSAs are similar to RSUs in that they are subject to vesting requirements, but with RSAs, you technically own the shares upon grant. They are subject to forfeiture if conditions are not met.

The 83(b) Election for RSAs

With RSAs, employees can choose to file an “83(b) election,” with the IRS within 30 days of the grant date. This allows the employee to:

1. Recognize the fair market value of the shares as ordinary income in the year the RSA is granted rather than the year it vests.
2. Pay taxes upfront, potentially at a lower rate.
3. Benefit from long-term capital gains treatment on any appreciation after the grant date.

The 83(b) strategy may be appropriate if you expect your income or the stock value to increase significantly by the time of vesting. However, it carries risks; if the stock price falls or you leave before vesting, you may have paid unnecessary taxes.

Employer Stock Purchase Plans (ESPP)

What is an ESPP?

An Employer Stock Purchase Plan (ESPP) allows employees to purchase company stock at a discount, often up to 15% below market price, through payroll deductions. Unlike stock options, ESPPs rarely have vesting schedules, meaning employees typically own the shares outright at purchase.

Qualified vs Non-Qualified ESPPs

There are two types of ESPPs: qualified and non-qualified. Their tax treatment differs:

1. Qualified ESPPs – Must meet IRS criteria, include most employees, and allow up to a 15% discount. Taxes are deferred until shares are sold.
2. Non-Qualified ESPPs – Do not meet IRS standards but allow more flexible designs, including discounts above 15% or custom eligibility rules.

ESPP Tax Treatment: Qualifying vs Disqualifying Dispositions

The tax rules for ESPPs depend on how long you hold the shares after purchase:

• Qualifying Disposition (Meets IRS holding periods: 2 years from offering dates, 1 year from purchase date):
  • The discount is taxed as ordinary income. The ordinary income portion is the lesser of:
    • (a) the actual discount received at purchase, or
    • (b) the difference between the sale price and the purchase price.
  • Any gain beyond the purchase price is taxed as a long-term capital gains.
• Disqualifying Disposition (sold before the holding period is met):
  • The full discount received at the time of purchase is treated as ordinary income, regardless of the sale price.
  • Any profit realized beyond the initial discount is subject to capital gains tax.

These ESPP tax rules make holding periods an important factor in deciding when to sell.

Employee Stock Ownership Plans (ESOPs)

What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that gives employees ownership in their company. Instead of contributing money, the employer contributes shares of company stock or cash to purchase company stock, which is then placed into a trust for the benefit of the employee.

Generally, employees with one year of service are eligible to receive company shares. Those shares will vest over time based on the company’s plan.  

How ESOP Distributions Work

Like other retirement plans, employees typically receive their ESOP distributions after they leave the company or reach the retirement age specified in the plan. If all or part of the ESOP account is vested at separation from service and before the employee is 59 1/2, any distribution would be subject to a 10% early distribution penalty.

Employees can:

• Take a cash distribution (taxed as ordinary income)
• Receive company stock instead of cash. In this case, the stock’s current market value is taxed as ordinary income, and later gains are taxed as capital gains.
• Roll over their ESOP account into an IRA or another qualified retirement plan to continue tax deferral.

The Net Unrealized Appreciation (NUA) Strategy

A powerful tax planning technique with ESOPs (and other qualified plans like a 401(k)s) is the Net Unrealized Appreciation strategy. The NUA strategy involves transferring company stock into a taxable brokerage account instead of keeping it in the retirement plan.

• At the time of transfer, the original cost basis is taxed as ordinary income.
• Any appreciation above that basis is taxed later at long-term capital gains, potentially resulting in lower overall tax liability.

For instance, if you own employer stock with a cost basis of $50,000 and a market value of $250,000:

• You pay ordinary income tax on $50,000.
• The $200,000 of appreciation is taxed at long-term capital gains rates when you sell the stock.

Navigating the Equity Maze: Final Thoughts on Equity Compensation

While navigating the maze of employer stock plans and equity compensation strategies, it is crucial not to lose sight of diversification. Over time, your investment portfolio may become heavily concentrated in a single company’s stock. This can be tempting, especially if you’re confident in the business and its prospects. However, overexposure to a single company introduces significant risk.  

History offers many reminders: once-prominent companies like Enron (2001), Lehman Brothers (2008), and Blockbuster all collapsed, leaving employees with concentrated holdings especially vulnerable.

Diversification remains one of the most effective tools for managing portfolio risk. To protect and grow your wealth, be sure to sit down with a CERTIFIED FINANCIAL PLANNER® practitioner who can help you design a tax-efficient strategy to balance your employer stock with broader, more resilient investment plans.

Sources

• ISO vs NSO: Navigating Tax Implications for Stock Options - Dimov Tax & CPA Services -
• Cashless Exercise of Stock Options: Comprehensive Guide and Insights - Accounting Insights
• 83b Election on RSUs — EquityFTW
• ESPP Qualified vs Non-Qualified: Key Differences and Tax Implications - Accounting Insights
• NUA: The Key to Reducing Tax Liability on Your Employee Stock Shares | Cerity Partners

The information included herein was obtained from sources which we believe reliable. This article is for informational purposes only, does not represent any specific investment, and should not be construed as investment or tax advice.

Author: Wyatt Sten, CFP® | Allegheny Financial Group | September 2025

Allegheny Financial Group is an SEC Registered Investment Advisor.