The Three Kinds of Equity Pay
Equity pay is a deal about timing. All three instruments hand you a piece of the company; the tax code cares mostly about when that piece counts as income, and at what rate. An incentive stock option (ISO) is an option to buy shares at a fixed strike price that carries special federal tax status, available only to employees. A nonqualified stock option (NSO, sometimes NQSO) is the same right to buy without the special status, and it can go to anyone, including contractors, advisors, and directors. A restricted stock unit (RSU) is not an option at all. It is a promise that shares will be delivered to you once you vest, with nothing to buy and no decision to make.
| Feature | ISO | NSO | RSU |
|---|---|---|---|
| What you hold | An option to buy at a fixed strike price, with special tax status | The same option, without the special status | A promise of shares once you vest; nothing to buy |
| Tax at grant | None | None, for a typical grant | None |
| Tax at exercise or vesting | No regular income tax at exercise, but the spread counts for the alternative minimum tax | Ordinary income on the spread at exercise, with payroll withholding | Ordinary income on the full share value at vesting and settlement, as W-2 wages |
| Tax at sale | All capital gain if held 2 years from grant and 1 year from exercise; sell sooner and the spread becomes ordinary income | Capital gain on growth after exercise, long-term after 1 year | Capital gain on growth after vesting, long-term after 1 year |
| Who can receive it | Employees only | Employees, contractors, directors, advisors | Anyone the plan covers |
| The built-in catch | AMT at exercise, a $100,000 annual limit, and a 3-month clock after you leave | The tax bill lands at exercise whether or not you can sell | Tax can arrive before there is a market to sell into, and no 83(b) election is possible |
Swipe the table sideways to compare.
The pattern to hold onto is that options give you a decision and RSUs give you a schedule. An option holder chooses when to exercise, which means choosing when the tax event happens and, with an ISO, which kind of tax it is. An RSU holder is taxed when the vesting calendar says so, ready or not. That single difference drives most of what follows.
The ISO Fine Print
The ISO bargain is generous and fragile. Exercise triggers no regular income tax, and if you then hold the shares at least 2 years from the grant date and 1 year from the exercise date, everything between your strike price and the sale price is long-term capital gain. Sell before either mark and you have what the rules call a disqualifying disposition. The spread converts to ordinary compensation income in the year of the sale, and the special treatment evaporates for those shares.
The alternative minimum tax is the part nobody warns you about. The AMT is a parallel tax computation that runs alongside the regular one, and while the regular computation ignores an ISO exercise, the AMT counts the spread as income that year even though you received no cash. A large exercise at a high valuation can produce a five- or six-figure AMT bill on paper gain. The tax you pay generates a credit that offsets regular tax in later years, but the credit trickles back slowly, and the cash is due now. This is the single most common ISO planning conversation, and it is a modeling exercise that belongs with your CPA before the exercise, not after.
Two structural limits round out the picture. First, the $100,000 limit. Only the first $100,000 of shares, measured by their value on the grant date, that first become exercisable in any calendar year can be ISOs; anything above that line is automatically treated as an NSO. Companies track this, but grant letters do not always make the split obvious. Second, the employment rule. ISOs go only to employees, and the special treatment survives only if you exercise while employed or within 3 months after leaving (12 months if you leave due to disability, with different rules at death). Your plan may contractually give you longer to exercise, and some companies now advertise multi-year windows, but the tax status quietly converts to NSO treatment once the 3 months pass. The company reports each ISO exercise to you and the IRS on Form 3921, which is also the document your accountant will want at filing time.
Restricted Stock and the 83(b) Election
Restricted stock is different from an RSU in a way that matters enormously. With restricted stock you receive actual shares on day one, subject to forfeiture if you leave before vesting. With an RSU you receive nothing on day one except a promise. Because restricted stock is real property in your hands, the tax rules give you a choice that RSU holders never get.
The default rule taxes restricted stock as it vests, at each vesting date's value, as ordinary income. For a company that is growing, that means paying ordinary rates on ever-larger amounts, year after year. The 83(b) election flips the timing. You elect to be taxed once, now, on the value at grant, and everything after that is capital gain when you eventually sell, with the holding clock running from day one. For a founder whose shares are worth a fraction of a cent each, the election often costs almost nothing and converts the entire future of the company into capital gain. It also starts the clock for the federal small business stock exclusion, which is measured in years and rewards an early start.
The deadline is the famous part. The election must be filed within 30 days of the date the stock is transferred to you. Not postmarked eventually, not fixed on your tax return, not excused because your lawyer was on vacation. Thirty days, no extensions, and a missed deadline cannot be repaired. The mechanics improved recently. In late 2024 the IRS introduced a standard form for the election, Form 15620, and since mid-2025 the form can be filed online through the IRS website with a time-stamped confirmation of receipt, replacing the old ritual of certified mail and crossed fingers. A copy still goes to the company. The election has a real cost to weigh, since you are paying tax today on shares you may forfeit if you leave before vesting, and the tax paid on forfeited value does not come back as a deduction. When the grant-date value is small, the trade is usually easy; when you are buying in at a meaningful price, it deserves an actual conversation.
And to say it plainly, because the confusion is everywhere, there is no 83(b) election for RSUs. Nothing is transferred at grant, so there is nothing to elect on.
What 409A Does to Your Strike Price
Every private-company option you will ever see has a strike price traceable to something called a 409A valuation, and it exists because of the federal deferred-compensation rules. Those rules treat a stock option granted with a strike price below the stock's fair market value as a deferred-compensation arrangement that violates the statute, and the consequences fall on the option holder, not the company. A violation means the deferred amounts become taxable immediately as they vest, plus a 20% additional federal tax on top of regular rates, plus an interest charge, and some states pile on further. It is one of the harshest penalty structures in the compensation world, which is why no competent company guesses at its stock price.
The fix is the safe harbor. A private company hires a qualified independent appraiser to value its common stock, refreshes that appraisal at least every 12 months or whenever something material happens (a financing round, a term sheet, a big customer), and grants options at or above the appraised number. A valuation done that way carries a presumption of reasonableness, meaning the IRS bears the burden of proving it wrong rather than the taxpayer bearing the burden of defending it. For the employee reading an offer, the 409A valuation is also useful intelligence, since it is the company's own supportable answer to what a common share is worth today, and it is usually far below the preferred-stock price quoted in funding headlines. Whether a particular arrangement stays inside these rules is a question we flag in document review and run to ground with your CPA, because the computation and the return position live in their lane.
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Book your free consultWhat Happens at an Exit
An acquisition is where equity compensation stops being theoretical, and the first surprise is how little say you have. The equity plan and the merger agreement decide what happens to your awards, and both were negotiated by other people. Vested options are typically either cashed out, meaning you are paid the spread and, for NSOs, taxed on it as ordinary compensation through payroll, or assumed, meaning they are converted into options on the buyer's stock on adjusted terms. Unvested awards may be assumed, accelerated, or cancelled outright, and options that are underwater at the deal price are usually cancelled for nothing. Acceleration is its own vocabulary lesson. Single-trigger acceleration (vesting on the deal alone) is rare; double-trigger acceleration (vesting if you are terminated within a window after the deal) is the market norm, and which one you have is written in documents you can read today.
RSUs at private companies carry a structural problem the industry solved with the same phrase. If an RSU vested on time alone, employees of a private company would owe ordinary income tax on shares they cannot sell, a genuine cash crisis and a cousin of the phantom income problem partnership owners know well. So private-company RSUs are typically double-trigger for vesting itself, requiring both the time condition and a liquidity event such as an acquisition or IPO before they settle. The design works, but it back-loads the taxes. At the closing, years of accumulated units settle at once, all of it ordinary W-2 income in a single year, and the flat supplemental withholding rate applied to it frequently under-collects, leaving a second bill at filing time that catches people who thought the withholding had it covered.
The ISO version of exit pain runs the other direction. The classic trap is exercising a large ISO block while the paper valuation is high, on the logic that the clock should start early, and then watching the stock crater or the exit stall. The AMT was computed on the spread at exercise, the cash tax was real, and the value it was measured against no longer exists; the credit mechanism returns the money only gradually over later years. People have owed six-figure tax bills on gains that never became spendable. None of this means never exercise early. It means the decision is a modeling problem involving the AMT, the calendar, and your own liquidity, and it deserves numbers before conviction. One more clock worth knowing about, and a point in early exercise's favor, is that for option holders the holding period for the federal small business stock exclusion starts only when you exercise and actually acquire the shares. Holding the option, for however many years, starts nothing.
What the Plan Documents Actually Control
Most of what ranks on this topic is written by brokerages and tax shops, and it stops at the tax matrix. The part they skip is that your outcome is governed by a stack of contracts, and the contracts are where the money is won and lost. The equity plan, your grant agreement, and often a stockholders agreement you signed at exercise control things the tax code never mentions.
- The post-termination window. Most plans give a departing employee 90 days to exercise vested options before they are forfeited forever. The number is contractual, it varies, and it is negotiable on the way out. If you are leaving with vested options and a severance offer on the table, the window belongs in that negotiation alongside the money, which is exactly the kind of term we press on in a severance agreement review. Remember the tax overlay from above, though. A contract extension does not extend ISO status past the 3-month statutory mark; it extends your right to exercise as an NSO.
- Repurchase rights. Many private-company plans let the company buy back shares when you leave, unvested shares at your cost and, in some plans, vested shares at fair market value. A repurchase right that reaches vested shares changes what your equity is really worth, and people routinely discover it only at departure.
- Transfer restrictions and the right of first refusal. Private shares generally cannot be sold, pledged, or moved into your trust without company consent, and the company usually holds a right to match any buyer you find. This is why "I will just sell some on a secondary platform" often dies in the legal department.
- Drag-along rights. If the majority sells, you sell too, on their terms and their timeline. Standard, and worth knowing before you imagine holding out.
- Clawbacks and forfeiture triggers. Some plans reach beyond unvested equity and claw back delivered value for misconduct or competition after departure, and the definitions of both are drafted by the company.
- Board discretion at a change of control. Plans commonly give the board latitude to cash out, substitute, or cancel awards in a deal. What reads as boilerplate is the clause that decides your exit.
- Early-exercise provisions. Some plans let you exercise options before they vest, take restricted stock, and file the 83(b) election, starting every clock at the cheapest possible moment. Whether your plan allows it is a document question with a large tax answer.
This is the lawyer's half of the equity problem. We review offer packages, grant agreements, and plan documents flat fee, quoted at the free consult, priced the same transparent way as the rest of the practice, and we coordinate the exercise and AMT modeling with your CPA so the legal reading and the math arrive together.
For Founders: Choosing What to Grant
The founder's version of this page is a design decision, and the honest starting point is your entity. A corporation can grant the full menu. ISOs for employees you want to favor, within the $100,000 limit and the employee-only rule; NSOs for advisors, contractors, and everyone past the ISO lines; restricted stock in the earliest days, while the value is low enough that recipients can take shares outright and file 83(b) elections for pennies; RSUs later, once the stock is valuable enough that asking employees to pay a strike price stops making sense, with double-trigger settlement if you are private. An LLC taxed as a partnership cannot grant ISOs or any qualified option, because those require corporate stock. The partnership world's instrument for equity-for-work is the profits interest, a different tool with its own logic, and pretending an LLC can run a startup-style option plan is a recurring and expensive mistake in sweat equity deals. Sometimes the equity plan you want is itself the reason to choose or convert to a corporation, a structuring decision with its own tax timeline.
Whatever you grant, three disciplines from day one save real money later. Get the 409A valuation before the first option grant, not after, because a below-market strike is a penalty on your own team. Paper the plan deliberately, since the window lengths, repurchase rights, and change-of-control mechanics you adopt now will be applied to people for a decade. And put the 83(b) calendar in writing for every restricted-stock recipient, because the 30 days forgive no one. We build equity plans and grant paperwork with counsel-level structure, coordinate the valuation and the elections with your accountant, and the free 30-minute consult is the right place to start whether you are issuing the first grant or untangling an old one.
Frequently Asked Questions
What Is the Difference Between an ISO, an NSO, and an RSU?
An incentive stock option (ISO) and a nonqualified stock option (NSO) both give you the right to buy shares at a fixed strike price; a restricted stock unit (RSU) is a promise that shares will simply be delivered to you once you vest, with nothing to buy. The tax treatment is where they part ways. An ISO can defer tax until you sell and convert the gain to capital-gain rates if you meet its holding rules. An NSO is taxed as ordinary income on the spread the day you exercise. An RSU is taxed as wages on the full share value the day it vests and settles.
When Do I Pay Tax on Stock Options?
For a typical grant, never at grant. For an NSO, you pay ordinary income tax on the spread (the share value minus your strike price) the day you exercise, through payroll withholding, and capital gains tax on any later growth when you sell. For an ISO, exercise triggers no regular income tax, but the spread counts as income under the alternative minimum tax, and if you hold the shares 2 years from grant and 1 year from exercise the entire gain at sale is capital gain. Sell earlier and the spread converts to ordinary income in the year of the sale.
What Is an 83(b) Election and When Is It Due?
It is an election to pay tax on restricted stock at its value on the day you receive it, rather than as it vests. For a founder whose shares are worth almost nothing at grant, that usually means a tiny tax bill now in exchange for capital-gain treatment on everything the shares become later, with the holding clock running from day one. The deadline is 30 days from the date the stock is transferred to you, with no extensions and no do-overs. Since late 2024 the IRS has a standard form for it, Form 15620, and since mid-2025 it can be filed online with a time-stamped confirmation.
Can I File an 83(b) Election for RSUs?
No. The election only applies to property actually transferred to you, and an RSU transfers nothing at grant; it is a promise to deliver shares later. By the time the shares arrive at settlement they are already vested, so there is no restricted period left for the election to change. This is one of the most common points of confusion in equity compensation, and it means the RSU holder has essentially no lever to pull on timing. The tax arrives at vesting, at ordinary rates, on whatever the shares are worth that day.
What Is a 409A Valuation?
It is the independent appraisal a private company obtains to establish the fair market value of its common stock, so that options can be granted with a strike price at or above that value. The name comes from the federal deferred-compensation rules, which treat a below-market strike price as a violation, with harsh consequences for the option holder. A valuation from a qualified independent appraiser, refreshed at least every 12 months or after a material event, gives the price a presumption of reasonableness that the IRS bears the burden of overcoming.
What Happens to My Options If I Leave the Company?
Two clocks start. The plan clock is contractual, and most plans give you 90 days to exercise vested options before they are forfeited, though the window is set by the document and can be longer or shorter. The tax clock is statutory, and an ISO exercised more than 3 months after your employment ends loses its special treatment and is taxed as an NSO, even if the plan gave you years. Unvested equity is generally forfeited at departure. All of this is negotiable on the way out, which is why the exercise window belongs on the list in any severance negotiation.
What Happens to My Equity If the Company Is Acquired?
Whatever the equity plan and the merger agreement say, and you get very little vote. Vested options are typically either cashed out for the spread, which is taxed as ordinary compensation for NSOs, or converted into options on the buyer’s stock. Unvested awards may be assumed, accelerated, or cancelled, and underwater options are often simply cancelled for nothing. Double-trigger RSUs settle at the closing, which can compress years of accumulated value into one large W-2 year where the standard withholding rate often under-collects the actual tax.
Common Situations
The engineer deciding whether to exercise. A senior engineer holds ISOs with a low strike and a 409A valuation that has tripled. Exercising everything now would start the capital-gain and small-business-stock clocks, but the AMT model shows a tax bill she would have to fund from savings against shares she cannot sell. She exercises in measured annual slices sized to the AMT threshold with her CPA, and when she later changes jobs, her severance negotiation adds an extended exercise window, taken with eyes open that the extension runs as NSO treatment after the 3-month mark.
The two founders and the 30 days. Two founders receive restricted stock at incorporation, worth a few hundred dollars in total. One files Form 15620 online in week two and pays a trivial tax. The other assumes his accountant will handle it in April, which is months too late, and every vesting date afterward becomes an ordinary-income event at an ever-higher valuation. Same company, same shares, and the difference compounds for years. The fix cost the first founder an afternoon.
The executive's acquisition year. An executive at a private company has four years of double-trigger RSUs when the acquisition closes. Every unit settles at once, producing the largest W-2 of her life, and the flat withholding rate applied at closing under-collects by a wide margin. Because she had the plan and merger treatment reviewed while the deal was still pending, the shortfall was estimated in advance, the estimated-tax payment was planned with her CPA, and the drag-along in her stockholders agreement held no surprises at the closing table.
Sources of Law
- Statutory (incentive) stock options: 26 U.S.C. §§421 to 424, especially §422(a)(1) (no disposition within 2 years of grant or 1 year of exercise), §422(a)(2) (employment through 3 months before exercise; §422(c)(6) extends to 12 months for disability), §422(b) (employees only; strike price not less than fair market value at grant), and §422(d) ($100,000 per-year first-exercisable limit, measured at grant-date value, excess treated as nonqualified). law.cornell.edu
- Nonqualified options and restricted stock: 26 U.S.C. §83 and Treas. Reg. §1.83-7 (options without a readily ascertainable value taxed at exercise; property taxed as it vests); §83(b) (election within 30 days of transfer; no deduction if the property is later forfeited). law.cornell.edu
- The 83(b) filing: IRS Form 15620 (introduced November 2024; Rev. 4-2025), accepted for online submission through irs.gov since July 2025, with a copy to the issuer still required. irs.gov
- Deferred compensation: 26 U.S.C. §409A and Treas. Reg. §1.409A-1(b)(5) (fair-market-value strike requirement; presumption of reasonableness for a qualified independent appraisal not more than 12 months old); §409A(a)(1)(B) (immediate inclusion, 20% additional tax, and premium interest on violation).
- Alternative minimum tax: 26 U.S.C. §56(b)(3) (ISO spread as an AMT adjustment) and §53 (minimum tax credit); IRS Topic No. 427 (statutory vs nonstatutory options; Forms 3921 and 6251). irs.gov
- Qualified small business stock: 26 U.S.C. §1202 (original-issuance and holding requirements; for compensatory options the stock is acquired, and the holding period begins, at exercise). (All authorities retrieved 2026-08-08.)
Updated on August 8, 2026. Reviewed by Kevin D. Klagge, Esq., Fla. Bar No. 99502. Attorney Kevin Klagge represents families, businesses, and international clients in estate and tax planning, business structuring, and international law, with a focus on Florida legal tools. He litigates estate and business issues in court. This article is general information about US federal law, not legal or tax advice, and does not create an attorney-client relationship. AMT modeling, election mechanics, withholding, and the positions taken on your return are handled with and through your CPA or return preparer; federal figures change periodically and state rules vary. Your result depends on your documents and your facts. Do not send confidential information until we have agreed to represent you.