The Complete Guide to Equity Compensation Taxes

Four Kinds of Equity, Four Different Tax Rules

Startup and tech employees are often granted some mix of restricted stock units (RSUs), incentive stock options (ISOs), non-qualified stock options (NSOs), and employee stock purchase plan (ESPP) shares — and it's easy to assume they're all taxed roughly the same way. They aren't, and the differences are large enough to cost (or save) tens of thousands of dollars depending on which one you're holding and when you act.

RSUs are taxed as ordinary wages the moment they vest — there's no choice involved and no way to defer it (IRS Publication 525, Tax Topic 427). NSOs are taxed as ordinary wages the moment you exercise them, on the "bargain element" between the strike price and current value. ISOs have no regular income tax at exercise at all, but the same bargain element can trigger the Alternative Minimum Tax (AMT) instead (IRC §421-422, §56(b)(3)). ESPP shares split your gain between ordinary income and capital gains depending on how long you hold them, and are the only one of the four exempt from FICA on the ordinary-income portion (IRC §3121(a)(22)).

This guide walks through each one, then covers the AMT mechanics that connect ISOs to a potential future tax credit most people never claim. Every figure here is sourced from IRS Rev. Proc. 2025-32 (2026 tax brackets and AMT thresholds) and the IRC sections cited throughout — you can run your own numbers with the calculators linked at the end of each section.

RSUs: Taxed at Vest, Not at Grant or Sale

Restricted stock units are taxed based on their fair market value on the date they vest — not when they were granted, and not when you eventually sell them. Because RSU income is legally a "supplemental wage" under the same IRS regime that governs bonuses, employers generally withhold federal tax at the flat supplemental rate: 22% up to $1,000,000 of cumulative supplemental wages for the year, and 37% above that (IRS Publication 15, Circular E, Section 7).

That flat withholding rate is frequently NOT your actual marginal tax rate. If your total income puts you in the 32% or 35% bracket, 22% federal withholding on a large RSU vest will under-withhold, leaving you a tax bill (and possibly an underpayment penalty) the following April. This is the single most common RSU surprise, and it's worth checking with our quarterly estimated tax calculator if your vests are large relative to your salary.

Most employers handle the tax bill via "sell-to-cover" — automatically selling a portion of your newly vested shares to cover the withholding — so you never see the cash, only the net shares deposited. State supplemental withholding rates vary widely; California's Employment Development Department, for example, publishes a 10.23% supplemental rate that explicitly covers "bonuses and stock options." Run your specific state and share count through our RSU Vesting Tax Calculators for an exact breakdown of federal withholding, state withholding, and shares retained after sell-to-cover.

ISOs vs. NSOs: The Exercise-Time Fork in the Road

Stock options come in two flavors, and the fork happens at exercise. An NSO (Non-Qualified Stock Option) is taxed immediately: the spread between the stock's current fair market value and your strike price is added to your W-2 wages, subject to federal and state income tax withholding plus full FICA (Social Security up to the annual wage base, Medicare, and the Additional Medicare Tax above $200,000).

An ISO (Incentive Stock Option) has no regular income tax or FICA due at exercise at all. Instead, the same bargain element becomes an AMT "preference item" under IRC §56(b)(3) — it doesn't affect your regular tax return, but it can push your Tentative Minimum Tax above your regular tax, in which case you owe the difference as AMT. This can mean a real, payable cash tax bill on paper gains you haven't sold to realize — sometimes called "phantom income," and one of the most painful surprises for employees who exercise a large ISO grant early, before selling any shares.

ISOs aren't automatically cheaper: NSOs guarantee ordinary-rate tax plus FICA immediately, while ISOs trade that for AMT's lower 26%/28% rates but a potentially much larger taxable base (since AMT disallows many deductions). Compare your specific numbers with our ISO vs. NSO Calculator, which estimates both outcomes side by side including an AMT estimate for the ISO path.

The AMT Exemption Just Got Tighter for 2026

For 2026, the AMT exemption is $90,100 for single filers and $140,200 for married filing jointly — but the bigger change is the phase-out. Under the One Big Beautiful Bill Act, the income level where the exemption starts disappearing dropped to $500,000 (single) and $1,000,000 (joint), down from roughly $626,350/$1,252,700 in 2025, and the phase-out rate doubled from 25 to 50 cents per dollar over that threshold. Many taxpayers in the $500K-$1.3M range who haven't owed AMT in years may owe it again in 2026 — a group that heavily overlaps with employees exercising meaningful ISO grants.

Once AMT Taxable Income is calculated, it's taxed at just two rates: 26% up to $244,500 (2026, most filing statuses) and 28% above that — often lower than the top 37% regular marginal rate, but applied to a base that can be much larger than your regular taxable income once preference items are added back. Long-term capital gains and qualified dividends keep their regular preferential rate (0%/15%/20%) even under AMT, so capital gains alone rarely trigger it. Use our standalone AMT Calculator to check your exposure before a large ISO exercise, not after.

ESPP: Qualifying vs. Disqualifying Dispositions

Shares purchased through a Section 423 qualified Employee Stock Purchase Plan split your eventual gain between ordinary income and capital gains, and which split applies depends entirely on how long you hold the shares.

A qualifying disposition requires holding the shares at least 2 years from the start of the offering period AND at least 1 year from the purchase date. In that case, ordinary income is capped at the lesser of the discount at grant or your actual gain at sale — the rest is long-term capital gain. A disqualifying disposition (sold before meeting either holding period) instead taxes the FULL bargain element at purchase (purchase-date fair market value minus your discounted price) as ordinary income, regardless of what the stock does afterward — even a later price drop doesn't erase this ordinary income, though it can create a separate capital loss.

One quirk worth knowing: unlike NSO exercise income, ESPP ordinary income is exempt from FICA under IRC §3121(a)(22) and IRS Notice 2002-47 — only federal and state income tax apply. And Section 423(b)(8) caps how much stock you can purchase at $25,000 of fair market value (measured at the offering-period start, before your discount) per calendar year across all your employer's qualified ESPPs. Work through both disposition types with our ESPP Tax Calculator.

Getting Your AMT Money Back: The Minimum Tax Credit

AMT triggered by an ISO exercise usually isn't gone forever. Because the ISO bargain element is a "deferral item" — your AMT cost basis and regular-tax cost basis eventually converge once you sell the shares — the AMT it generates typically becomes a Minimum Tax Credit (Form 8801) you can use to offset regular tax in a future year, under IRC §53.

The catch: you can only use the credit in a year you are NOT paying AMT, and only up to that year's "cushion" — regular tax minus tentative minimum tax. AMT caused by permanent "exclusion items" instead (the standard deduction, a disallowed SALT deduction, and similar items per the Form 8801 instructions) is not creditable and is simply lost, so it's worth knowing which kind of AMT you actually paid. Any unused credit carries forward indefinitely (IRC §53(b)) — but many people who pay AMT from an ISO exercise never file Form 8801 in later years to claim it back. Our AMT Credit Calculator separates the creditable and non-creditable portions of your AMT and projects how many years it may take to use up the credit.