https://carta.com/blog/taxes-on-stocks-what-you-need-to-know/
Keeping track of tax obligations isn’t most people’s idea of fun, but if you’re earning equity, you need to know what types of tax you’ll owe—and when you’ll need to pay them. 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.
This article will run through the basics of equity taxation and help you determine whether your shares qualify for any preferential treatment—usually in the form of lower tax rates. We’ll also walk you through some steps to avoid the common mistake of paying the same tax twice on exercised options. That’s important if you’ve recently sold shares on the public market or as part of a secondary liquidity transaction (like a tender offer or a Carta Cross auction).
Important note: While we’re here to help you understand how taxes on stocks work, we aren’t giving tax advice in this article. You should definitely check in with your own tax advisor.
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. We’ll talk more about that later on.)
Three major milestones can trigger a tax liability: equity vesting, exercising your options, and selling your shares.
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 (RSUs) or restricted stock awards (RSAs), 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. Be aware that this approach may trigger a tax payment before your stock has vested, and have other complications you should discuss with your tax advisor.
Unlike RSUs, stock options, including incentive stock options (ISOs) and non-qualifying stock options (NSOs), must be exercised for you to acquire the stock. Exercising an option means buying the shares at the strike price. This must be completed before the option grant expiration date, or if you’ve left the company, before the end of the post-termination exercise window, discussed below. While the options to purchase may vest over time, you only acquire the stock when you exercise your options.
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. While your employer will withhold taxes upon NSO exercise, your ultimate tax liability may exceed the withheld amount.
For ISOs, the spread between the strike price and FMV at time of exercise could subject you to the alternative minimum tax (AMT) for that tax year. (More on that below.)
If you’re planning on leaving a company, tax considerations might affect your decision about whether and when to exercise your shares. Many companies require former employees to exercise their shares during a post-termination exercise window, a limited (and usually short) period of time following an employee’s departure. Many employees end up forfeiting their options because they haven’t planned ahead for how they’ll pay the exercise price or the income taxes due on the stock award.
Post-termination exercise windows are typically 90 days, but your equity plan should have more details. At Carta, we’ve seen trends of extended post-termination exercise windows as a more employee-friendly benefit. But even in cases where the window is longer than 90 days, there is another consideration: 90 days following an employee’s departure from the company, ISOs are disqualified from special tax treatment under current IRS rules, and are converted to NSOs. If you have ISOs, this means that even if your company permits a longer post-termination exercise window, waiting longer to exercise will change your tax circumstances.
By helping private companies organize regular liquidity events for current shareholders to sell their equity, CartaX makes it easier for employees of participating companies to overcome difficulties imposed by the post-termination exercise window. Through these liquidity mechanisms, employees can meet double-trigger vesting schedules, if applicable, and sell their shares. The proceeds from these sales can help employees meet the costs and tax obligations of exercising more stock later on, such as when they leave their company.