Understanding the Tax Treatment of 2024 Equity Incentive Plan Awards
By Nolan J. De Jong and Gary M. Remer
Equity incentives in the form of several different types of stocks, rights, and options constitute a significant part of compensation packages for millions of Americans. But how, when, and to what extent such incentives become taxable is a far more complex exercise than making the same determination for salaries, wages, and other forms of compensation.
With the 2025 tax season in full swing, the following is an overview of the tax treatment under the Internal Revenue Code (IRC) of the following common incentives:
- Non-Qualified Stock Options
- Performance-Based Options
- Incentive Stock Options
- Stock Appreciation Rights
- Restricted Stock
As informative as a blog post may be, however, it is no substitute for personalized counsel from an experienced tax lawyer or other professional and should not be considered legal advice.
Non-Qualified Stock Options (NSOs)
What Is an NSO?
A Non-Qualified Stock Option (NSO) is a type of employee stock option that allows the recipient to purchase company stock at a predetermined price (known as the exercise price) within a specific time frame. NSOs are called “non-qualified” because they do not meet certain IRC requirements for special tax treatment that applies to incentive stock options (ISOs), as discussed below.
When Is the Taxable Event?
You are not taxed when NSOs are granted. However, upon exercise, the difference between the option price and the market value of the shares is treated as taxable ordinary income under IRC §83(a). Additionally, the company must report this income on your W-2 form for the year of exercise.
Example: You are granted NSOs to purchase 1,000 shares at $10 per share. When you exercise the options, the market price is $20 per share. The $10,000 difference ($20,000 market value – $10,000 purchase price) is taxed as ordinary income.
What Taxes Will Be Withheld?
Upon exercise of an NSO, the taxable ordinary income is subject to federal income tax, Social Security, and Medicare taxes. The company must withhold these taxes at the time of the NSO’s exercise.
What if I Sell the Shares?
Any increase or decrease in value after the exercise of an NSO is treated as a capital gain or loss when you sell the shares. The character of the gain or loss (long-term or short-term) depends on how long you hold the shares after exercise. If you retain the shares for more than one year from the exercise date, the IRS will typically treat the gain or loss as a long-term capital gain or loss, which is subject to lower tax rates. If the holding period is one year or less, the gain or loss will be treated as short-term and taxed at ordinary income rates under IRC §1(h).
Example: Using the scenario above, if you sell the shares for $25 each after holding them for two years, the additional $5,000 gain is taxed at long-term capital gains rates.
Performance-Based Options
What Are Performance-Based Options?
Performance-Based Options (PBOs) are a type of stock option granted to employees or executives, where the ability to exercise the options is contingent upon achieving specific performance goals. Employers typically tie these goals to the individual’s performance, team performance, or broader organizational metrics, such as revenue growth, earnings per share, market share, or achieving strategic milestones.
When Is the Taxable Event?
Similar to NSOs, no taxes are due at the grant of a PBO. Upon exercise, the difference between the market value and the exercise price is taxed as ordinary income.
Example: You are granted performance-based options to purchase 500 shares at $15 per share, exercisable upon reaching a sales target. When you meet the target and exercise your option, the market price is $25 per share. The $5,000 difference is taxed as ordinary income.
How Does the Option Interact With Performance Metrics?
PBOs are structured so they avoid classification as “applicable employee remuneration” under IRC §162(m) to ensure these options are not subject to the $1 million cap on deductible executive compensation for publicly held companies. Employees benefit from this alignment with clear performance goals, which tie compensation to measurable success.
What if I Sell the Shares?
Similar to NSOs, capital gains or losses apply to the sale of shares, depending on changes in value after exercise and how long after the exercise of the PBO they are sold.
Incentive Stock Options (ISO)
What Are ISOs?
An Incentive Stock Option (ISO) is a type of employee stock option that offers favorable tax treatment to employees, provided that the employee meets certain conditions. ISOs are governed by IRC §422 and are designed exclusively for employees of a company, not for contractors or consultants.
When Is the Taxable Event?
No taxes are due at the grant or exercise of an ISO if you meet specific holding requirements (i.e., holding the stock for at least two years after the grant date and one year after exercise). If these holding periods are not satisfied, the ISO may be subject to disqualifying disposition rules, causing the gain to be taxed as ordinary income rather than as a long-term capital gain. Additionally, the aggregate fair market value of the stock (measured at the grant date) that becomes exercisable in a single calendar year cannot exceed $100,000 for an ISO to retain its favorable tax treatment. If this limit is exceeded, the excess options may be treated as Non-Qualified Stock Options (NSOs).
Example: You are granted ISOs to purchase 1,000 shares at $12 per share. You exercise them when the market value is $20 per share but hold the shares for two years. When you sell at $30 per share, the $18,000 gain ($30 minus $12 times 1,000) is taxed as a long-term capital gain.
What Is Alternative Minimum Tax (AMT) and How Does It Impact the Tax I Pay?
If you exercise an ISO, the difference between the exercise price and the fair market value (FMV) of the stock at the time of exercise—known as the “bargain element”—is not taxed as ordinary income under regular tax rules. However, IRC §56(b)(3) requires that you include this bargain element in your income for calculating the Alternative Minimum Tax (AMT). This can lead to an AMT liability even if you owe no regular income tax at the time of exercise. The AMT is a separate tax system designed to ensure individuals with higher incomes (including those earning through ISOs) pay a baseline level of tax. You can sometimes use AMT payments as a credit against future regular tax liabilities, but it might take years to fully recoup, depending on your financial situation. If you expect a significant spread between the exercise price and the FMV, consulting a tax professional beforehand is highly recommended to manage potential AMT impacts effectively.
Stock Appreciation Rights (SAR)
What Are Stock Appreciation Rights?
Stock Appreciation Rights (SARs) are a type of employee compensation that grants the recipient the right to receive a payment equivalent to the increase in the value of a company’s stock over a specific period. Employers often use SARs as a way to reward employees for the company’s success without requiring them to purchase or own shares outright.
When Is the Taxable Event?
No taxes are due when SARs are granted. At exercise, the difference between the base price and the market value (referred to as the “incremental value”) is taxed as ordinary income under IRC §61(a), which includes all income from whatever source derived. You also must report this income on your W-2 for the tax year of exercise.
Example: You are granted SARs with a base price of $10. When you exercise them, the stock price is $18. The $8 per share is taxed as ordinary income.
Does It Matter if I Receive Payment in Cash or Shares?
The taxable amount remains the same whether SARs are settled in cash or shares. The “incremental value” is determined by subtracting the base price of the SAR from the fair market value of the stock on the exercise date.
What Taxes Will Be Withheld?
The company is required to withhold income and employment taxes, including federal income tax, Social Security, and Medicare taxes, at the time of exercise. Employees should ensure they have sufficient liquidity to cover any tax liabilities incurred upon exercise.
Restricted Stock
What Is Restricted Stock?
Restricted Stock refers to shares of a company’s stock granted to employees, executives, or directors as part of their compensation, but with conditions or restrictions that must be met before the recipient fully owns or can freely transfer the shares. These restrictions typically include a vesting period or the achievement of specific performance goals.
When Is the Taxable Event?
Restricted Stock is generally taxed as ordinary income when the restrictions lapse (vesting) under IRC §83(a). This means you will owe taxes on the fair market value of the stock at the time it becomes fully vested and free of restrictions.
Example: You are granted 1,000 shares of restricted stock that vest over four years. When 250 shares vest, their market value is $15 per share. The $3,750 is taxed as ordinary income.
What Is an 83(b) Election?
Under IRC §83(b), you can elect to pay taxes on the fair market value of the shares at the time of grant, even though the shares are unvested and subject to forfeiture. By making this election, any future appreciation in the stock’s value will be taxed at the lower capital gains rate when you sell the stock rather than as ordinary income upon vesting. You must file the election with the IRS within 30 days of the grant date.
Example: Using the same scenario, you file an 83(b) election when the shares are worth $10 per share. You pay taxes on $10,000 at the time of grant. When you sell the stock for $30 per share after vesting, the $20,000 gain is taxed at capital gains rates.
What Happens if I Forfeit Restricted Stock After an 83(b) Election?
If you make an 83(b) election and later forfeit the stock (e.g., by leaving the company before it vests), you cannot recover the taxes already paid on the stock’s initial value. This risk makes the 83(b) election a decision that requires careful consideration of your personal financial situation and the likelihood of meeting vesting conditions.
If you have questions about this notice or retirement plan contribution limits generally, please contact Gary Remer or Nolan De Jong at Maddin Hauser.