Tax Treatment of Employee Stock Options and RSUs

Quick overview

Employee stock options (ISOs and NSOs) and restricted stock units (RSUs) are common forms of equity compensation. They create taxable events at different times: at grant, vesting, exercise, or sale. Understanding when income is recognized, how your tax basis is set, and whether payroll taxes or the Alternative Minimum Tax (AMT) apply will help you plan sales, estimated tax payments, and diversification.

Note: This article explains general U.S. federal tax rules as of 2025. It is educational and not individualized tax advice. Consult a tax professional for decisions that rely on your personal tax situation.

Key types and when taxes normally hit

• Non‑Qualified Stock Options (NSOs): When you exercise NSOs, the difference between the market price on the exercise date and the strike (exercise) price—called the bargain element—is taxable as ordinary income and typically reported on your Form W‑2. After exercise, any subsequent gain or loss when you sell the shares is treated as capital gain or loss based on the holding period and your adjusted basis (which includes the amount included as ordinary income at exercise). See our deep dive on Non‑Qualified Stock Options (NSOs).

• Incentive Stock Options (ISOs): ISOs can receive preferential tax treatment (long‑term capital gains) if you meet the holding-period rules: hold shares for at least two years after the grant date and at least one year after exercise. If you dispose of ISO shares before meeting those windows (a disqualifying disposition), the bargain element is ordinary income. Additionally, exercising ISOs generates an AMT adjustment in the year of exercise that can trigger AMT liability even if you don’t sell shares (see the AMT section below). For form reporting, employers provide Form 3921 for ISO exercises (IRS Form 3921). Related glossary: Incentive Stock Option (ISO).

• Restricted Stock Units (RSUs): RSUs are treated as ordinary income when they vest (i.e., when shares are delivered or the right to shares becomes nonforfeitable). The fair market value (FMV) of the shares at vesting is included in your wages and subject to income tax withholding and payroll taxes (Social Security and Medicare). Your basis in the shares equals the FMV reported as income, and any gain or loss when you later sell the shares is capital gain or loss measured from that basis.

Important: An 83(b) election (accelerated recognition of income) applies to restricted stock, not typical RSUs. Most RSU plans are unfunded until delivery, so 83(b) is not available for standard RSUs.

What gets reported and where

• W‑2 wages: Income from vested RSUs and the ordinary‑income portion of NSO exercises generally appears on your Form W‑2 for the year of vest or exercise. Employers usually withhold income tax and payroll taxes at that time.
• Form 3921: Issued for ISO exercises (gives dates, exercise price, FMV on exercise)—used by taxpayers and the IRS to compute gain on later sale and to determine whether ISO rules were met (IRS, Form 3921: https://www.irs.gov/forms-pubs/about-form-3921).
• Form 1099‑B: Your broker reports sales of shares. You’ll use broker records plus the wage income recognized at vest or exercise to calculate capital gains on Schedule D/ Form 8949.
• AMT and Form 6251: If you exercise ISOs, the bargain element may be an AMT preference item that must be reported on Form 6251 (IRS AMT guidance: https://www.irs.gov/individuals/alternative-minimum-tax).

How basis and capital gains are calculated

• For NSOs: Adjusted basis = exercise price + ordinary income included at exercise. When you sell, gain = sale price − adjusted basis. If you hold more than one year after the sale, gain may be long‑term capital gain.
• For RSUs: Basis = FMV at vest (the amount taxed as ordinary income). A later sale produces capital gain/loss based on difference between sale price and that basis, with holding period starting at vest.
• For ISOs: If you meet the qualifying disposition rules, the entire difference between sale price and exercise price is treated as capital gain (long‑term if holding rules satisfied). If not, portions may be ordinary income.

Simple numeric example

• NSO example: Strike $10, exercise price becomes market $30 for 100 shares. At exercise, ordinary income = ($30 − $10) × 100 = $2,000. Basis = $30 × 100 = $3,000. If you later sell at $50, capital gain = ($50 − $30) × 100 = $2,000 (likely long‑term if held >1 year after exercise).
• RSU example: 100 RSUs vest when FMV is $50. Wages = $5,000 included on W‑2; basis = $5,000. If you sell later at $60, gain = ($60 − $50) × 100 = $1,000 (capital gain; holding period measured from vest date).

AMT—why ISOs can be tricky

Exercising ISOs creates an AMT adjustment equal to the bargain element (FMV at exercise minus exercise price). You may owe AMT in the exercise year even if you don’t sell shares. The AMT you actually pay may become a credit (minimum tax credit) in later years if you pay AMT in a year when your regular tax is lower (IRS Pub. 525 and Form 6251). Planning techniques include exercising in years with lower income, staggering exercises across years, or exercising only a portion of your grant.

Payroll taxes and withholding

• RSUs: Employers generally withhold federal income tax and payroll taxes at vest. Common methods include sell‑to‑cover (broker sells shares to cover taxes), net‑settlement, or withholding cash.
• NSOs: The ordinary income recognized at exercise is subject to income tax and payroll taxes; employers typically handle withholding through payroll at exercise.
• ISOs: No regular withholding at exercise for federal income taxes; however, the AMT issue still exists and no automatic AMT withholding occurs, which can surprise taxpayers.

Practical tax planning strategies (professional tips)

1. Plan for withholding and estimated taxes: If your employer’s withholding (or sell‑to‑cover) doesn’t cover the full tax, make estimated tax payments to avoid penalties.
2. Diversify after vest/exercise: Company stock concentration is a common client risk—sell some shares once vested or post‑exercise to rebalance. Use a staged selling plan tied to your financial goals.
3. Use hold‑period rules to your advantage: For ISOs, holding for 2 years from grant and 1 year from exercise can convert ordinary income into capital gains on the full appreciation. That strategy requires careful AMT monitoring.
4. Time exercises: Consider exercising when the stock price is relatively low, or in a year with lower taxable income to reduce AMT or ordinary income consequences.
5. Coordinate with life events: If you expect a big income change (home sale, job change), evaluate whether to accelerate or delay exercising or selling.
6. Keep accurate records: Save Form 3921, broker statements, W‑2s, and grant documentation. You’ll need them to substantiate basis and holding periods when you sell.

Common mistakes to avoid

• Assuming all gains are capital gains: Many people forget that RSUs and NSO exercise gains are ordinary income at vest/exercise.
• Ignoring AMT risk for ISOs: Exercise can trigger unexpected AMT—estimate AMT liability before large ISO exercises.
• Not adjusting withholding or making estimated payments: Tax withholding from RSUs may be insufficient for higher earners; plan ahead.
• Missing IPO / lockup windows and blackout periods: You may be prevented from selling immediately, which raises concentration risk.

Reporting checklist for tax returns

• Confirm ordinary income from RSU vesting appears on your W‑2 and matches your records.
• Use Form 3921 data to track ISO exercises and to determine qualifying vs. disqualifying dispositions.
• Report stock sales on Form 8949 and Schedule D using the broker’s 1099‑B and your basis adjustments (include the amount reported as wage income at vest or exercise).
• If you paid AMT, retain calculations and Form 6251; look for potential credit carryforwards.

Example year‑end strategy (simple plan)

1. Estimate ordinary income from upcoming vesting and likely withholding shortfall.
2. Decide whether to sell a portion to cover tax and rebalance the portfolio.
3. For ISOs, run an AMT projection before exercising large blocks in one year.
4. Document your decisions and coordinate with your planner or CPA.

Frequently asked short answers

• Can I do an 83(b) election for RSUs? Usually no—83(b) applies to restricted stock, not standard RSUs. Always check your specific plan docs.
• Will my employer withhold enough tax when RSUs vest? Often not—large vesting events can push you into higher brackets, so plan for estimated tax or a larger sell‑to‑cover.
• Do I pay FICA on RSUs? Yes—RSU income at vest is subject to Social Security and Medicare taxes (payroll taxes).

Final takeaways

• RSUs: taxed as ordinary income at vest; basis = FMV at vest; later sales generate capital gain/loss.
• NSOs: ordinary income at exercise on the bargain element; basis includes that income; later sales produce capital gain/loss from that basis.
• ISOs: potential capital‑gain treatment if holding rules are met, but exercises may create AMT exposure and require careful planning.

For related topics and deeper planning resources on this site, see our guide to Restricted Stock Units (RSUs) and our piece on Stock Option Planning.

Author credentials: As a Certified Financial Planner (CFP®) with 15+ years advising clients on compensation and tax planning, I regularly run AMT projections and design staged‑selling plans to manage concentration risk and tax surprises.

Professional disclaimer: This content is educational and does not replace personalized tax advice. Tax laws change and individual circumstances vary—consult a licensed tax professional or CPA before taking action.

Authoritative sources

• IRS Publication 525, Taxable and Nontaxable Income (stock options & compensation): https://www.irs.gov/publications/p525
• IRS About Form 3921 (exercise of an incentive stock option): https://www.irs.gov/forms-pubs/about-form-3921
• IRS Alternative Minimum Tax (AMT) guidance: https://www.irs.gov/individuals/alternative-minimum-tax
• Consumer Financial Protection Bureau, guidance on managing company stock (general investor protection): https://www.consumerfinance.gov/