If your job offer, raise, or annual bonus includes more than just a paycheck—say, stock options, RSUs, or even the chance to buy company shares at a discount—congrats! You’re officially part of the “equity compensation” club. This guide to equity compensation for employees will help you understand what that means.

But before you pop the champagne or count your stock-based chickens, it’s crucial to understand what you’ve got. Also, consider how the IRS treats it when tax season rolls around.

Let’s decode the alphabet soup of different types of equity compensation so you can make smart, informed decisions.

What Is Equity Compensation?

Equity compensation is really just a fancy term for a type of non-cash payment that gives you an ownership interest in your company. It’s a common way for startups, public companies, and fast-growing firms to attract and retain talent without draining their bank accounts.

The main types of equity compensation include:

• Stock options (incentive stock options and non-qualified stock options)
• Restricted stock units (RSUs)
• Restricted stock awards (RSAs)
• Employee stock ownership plans (ESOPs)
• Direct stock grants

Each comes with different rules, perks, and tax treatments (because of course they do).

You can find more details about the tax consequences of different types of equity compensation in IRS Publication 525. Here’s a high-level overview of some of the most common types of equity compensation.

1. Incentive stock options (ISOs)

Companies typically offer ISOs to key employees or executives. Incentive stock options let you buy company stock at a fixed price (called the exercise price) after a certain period (called the vesting schedule).

With ISOs, you won’t owe any regular income tax when you receive the option grant or exercise it. However, to qualify for the most favorable tax treatment, you’ll need to hold the shares for at least two years from the grant date and one year from the exercise date, i.e., the date you purchased the shares. If you meet those conditions, any profit will be taxed as long-term capital gains, which is typically at a lower rate than ordinary income.

If you don’t meet the holding period for a qualified disposition, you’ll pay tax on the gain at your ordinary income tax rates.

Your taxable gain is the difference between the strike price and the fair market value (FMV) of the stock units when you sold them.

But there’s a twist: exercising incentive stock options may trigger the Alternative Minimum Tax (AMT). This parallel tax system can increase your tax bill in certain situations, even if you haven’t sold the shares. It’s a good idea to talk to a tax professional before exercising a large number of ISOs. This way you don’t get hit with an unexpected tax surprise.

2. Non-qualified stock options (NSOs or NQSOs)

Companies can offer non-qualified stock options to employees, independent contractors, and board members.

NSOs don’t trigger any tax when the company grants them. But when you exercise the options, the difference between the exercise price and the fair market value on that date is treated as ordinary income. It’s taxable, even if you don’t sell the shares right away.

If you choose to hold the stock after exercising and it increases in value, any additional gain is taxed as capital gains when you eventually sell. In other words, you could owe taxes upfront even if you still hold the stock, so timing matters.

3. Restricted stock units (RSUs)

Think of RSUs as promises: “You’ll get stock…eventually.” Once your stock units vest, they convert into shares you own outright.

With RSUs, you don’t owe any taxes when the company grants shares of stock. Instead, you’re taxed when they vest, that is, when the shares officially become yours. At that point, the IRS treats the stock’s fair market value as ordinary income, and you’ll pay taxes accordingly.

If you decide to hold onto the shares and the value goes up, any additional gain will be taxed as capital gains when you sell. Keep in mind that many companies use a “sell to cover” approach. They automatically withhold a portion of your vested shares to cover taxes. So don’t be alarmed if the number of shares in your account is a little lower than expected.

4. Restricted stock awards (RSAs)

RSAs are actual shares granted to you, subject to vesting conditions. If you leave the company before they vest, you forfeit them.

With restricted stock units, you generally pay taxes when the shares vest. The IRS treats the fair market value of the stock as ordinary income at that point.

However, there’s a potential tax strategy called an 83(b) election. If you make this election within 30 days of the grant, you can choose to pay tax on the FMV of the stock in the year it’s granted, even though the shares haven’t vested yet.

This can be a smart move if the stock’s value is low and you expect it to rise significantly. But there’s a risk: if you leave the company or the stock loses value, you won’t get that tax back. Therefore, weigh the decision carefully.

5. Employee stock ownership plans (ESOPs)

ESOPs, also known as employee stock purchase plans (ESPPs), allow you to purchase company stock (often at a discount) through payroll deductions.

With these plans, the tax treatment depends on whether the plan is qualified under IRS rules. In a qualified plan, there’s no tax due when you purchase the shares, even if you buy them at a discount. Instead, you’re taxed when you sell the stock. The discount may be treated as ordinary income, while any additional gain is taxed as capital gains. To qualify for favorable tax treatment, you typically need to hold the shares for at least two years from the grant date and one year from the purchase date. Therefore, timing matters here. Knowing when you bought and sold your shares can have a big impact on your tax bill.

6. Direct stock grants

Sometimes a company just gives you company stock outright. If so, congratulations! You now have an ownership stake in the company.

When you receive a direct stock grant, the shares are yours immediately. No vesting period required.

The catch? The IRS treats the fair market value of the shares on the day you receive them as ordinary income. You’ll owe taxes on that value even if you don’t sell the stock right away.

If the stock appreciates and you later sell it for more, the additional gain is taxed as capital gains. While it might feel like a windfall, keep in mind that this type of grant can increase your taxable income for the year, which could affect things like tax credits or income-based repayment plans.

Need help navigating your equity compensation?

Equity compensation can be a powerful tool for building wealth, but only if you understand what you’re working with.

Make sure you understand the vesting schedule, the tax considerations, and your company’s policies before you make big moves. Talk to your tax advisor because the IRS sees your equity compensation as income, even if it doesn’t show up as cash in your bank account. Plan ahead so you’re not scrambling come tax season.

At Countless, we help employees like you decode the fine print, avoid surprise tax bills, and make confident decisions about equity compensation plans.

Not sure where to start? Reach out today. We’ll help you make the most of your equity compensation without the headache.