Equity Compensation Planning: ISOs, NSOs, RSUs, and the AMT Trap

The three main forms of equity compensation are taxed at three different moments. Restricted stock units (RSUs) are taxed as ordinary wage income when they vest, with nothing for you to elect. Non-qualified stock options (NSOs) are taxed as ordinary income on the spread when you exercise. Incentive stock options (ISOs) trigger no regular tax at exercise, but the spread counts as income for the alternative minimum tax (AMT), which can produce a large surprise bill, especially in 2026, when the AMT exemption begins phasing out at $500,000 of AMT income for single filers and $1,000,000 for joint filers. Good planning sequences exercises and sales around these rules.

How are RSUs taxed?

RSUs are a promise of shares (or their cash value) delivered when vesting conditions are met. At vesting, the full market value of the delivered shares is ordinary wage income, subject to income tax and payroll taxes, and it appears on your W-2. Your basis equals the value at vesting, and any later movement in the stock is capital gain or loss, long term if you hold more than a year after vesting.

Two practical points matter. First, employers typically withhold on RSU income at a flat supplemental rate that is often below a high earner's actual marginal rate, so large vests frequently create an April balance due unless estimated payments fill the gap. Second, holding vested shares is an investment decision, not a tax one: there is no tax benefit to holding RSU shares after vesting, only single-stock risk. Many executives adopt a default of selling at vest and diversifying, keeping company exposure deliberate rather than accidental.

How are NSOs taxed?

NSOs may be granted to employees, directors, and contractors. There is generally no tax at grant. At exercise, the spread between the stock's market value and your strike price is ordinary compensation income, with withholding and payroll taxes, and your basis becomes the market value at exercise. Later appreciation is capital gain.

NSO planning is mostly about timing the ordinary income: exercising across multiple years to manage brackets, coordinating with other income spikes such as a bonus or a business sale, and avoiding the common error of exercising and holding through a decline, which leaves the tax bill intact while the shares fall. NSOs do not create AMT issues the way ISOs do, because the income is recognized for regular tax immediately.

How are ISOs taxed, and what is the AMT trap?

ISOs receive favored treatment under the regular tax. No income is recognized at exercise, and if you hold the shares at least two years from grant and one year from exercise (a qualifying disposition), the entire gain from strike price to sale price is long-term capital gain. Selling earlier (a disqualifying disposition) converts the exercise-date spread into ordinary income. ISOs are limited by the rule that no more than $100,000 of underlying stock value, measured at grant, can first become exercisable in any calendar year; amounts beyond that are treated as NSOs.

The trap is the AMT, a parallel tax system that adds back certain items, applies its own exemption, and taxes the result at 26 and 28 percent; you pay the higher of the regular tax or this tentative minimum tax. The ISO exercise spread is an AMT adjustment: exercising and holding past year end can create AMT liability on paper gains you have not sold, and if the stock then falls, you may owe real tax on value that no longer exists. This is how option holders in past downturns ended up with tax bills exceeding the value of their shares.

For 2026, the AMT exemption is $90,100 for single filers and $140,200 for married couples filing jointly, and the 28 percent AMT rate begins above $244,500 of income subject to AMT after the exemption (IRS Revenue Procedure 2025-32). The One Big Beautiful Bill Act lowered the exemption phase-out thresholds to $500,000 of AMT income for singles and $1,000,000 for joint filers beginning in 2026 and doubled the phase-out speed to 50 cents per dollar, so the exemption disappears entirely at $1,280,400 of AMT income for joint filers. The practical effect: large ISO exercises hit the AMT harder in 2026 than they did in 2025.

There is partial consolation. AMT paid because of an ISO exercise is a timing difference, not a permanent cost; it generates a minimum tax credit you can use in later years when your regular tax exceeds your tentative minimum tax, often in the year you finally sell the shares. The cash flow problem, however, is immediate and real.

A hypothetical worked example: the AMT math

Consider a hypothetical married couple filing jointly with $600,000 of taxable income from salary and investments. In 2026 one spouse exercises 20,000 ISOs with a $5 strike when the stock trades at $40, and holds the shares. The spread is $35 per share, or $700,000, which is added to income for AMT purposes only.

Simplified, their AMT income is roughly $1,300,000. Because that exceeds the $1,000,000 phase-out threshold by $300,000, the exemption is reduced by 50 cents per dollar, or $150,000, which is more than the full $140,200 exemption, so the exemption is eliminated. Tentative minimum tax is 26 percent of the first $244,500 plus 28 percent of the remaining $1,055,500, roughly $63,600 plus $295,500, or about $359,100. Their regular tax on $600,000 is approximately $148,000. The difference, roughly $211,000, is owed as AMT for 2026, in cash, with no shares sold. Most of it becomes a minimum tax credit usable in later years, and a qualifying sale in 2027 or beyond would convert the $700,000 spread plus any further gain into long-term capital gain. This example is hypothetical and simplified; it ignores state tax, the exact computation of AMT income, and other adjustments.

The planning responses follow directly from the math. Exercise in tranches sized to stay below or only modestly above the point where tentative minimum tax overtakes regular tax. Exercise early in the year, so you can sell before December 31 in a disqualifying disposition if the stock collapses, which removes the AMT adjustment for that year. And never exercise and hold without modeling the AMT first.

What is an 83(b) election and when does it apply?

An 83(b) election applies to restricted stock (actual shares subject to vesting), to early-exercised options where the company permits exercise before vesting, and to founder stock subject to vesting. Filing the election with the IRS within 30 days of the transfer lets you pay ordinary income tax on the value at grant or early exercise, when the spread may be zero or small, and start the capital gains and QSBS holding clocks immediately. All later appreciation becomes capital gain.

The 30-day deadline is rigid, and the election cannot be revoked if the stock later falls or is forfeited; tax paid on forfeited shares is generally lost. Standard RSUs are not eligible, because no property is transferred until vesting. For early-stage employees with low current valuations, 83(b) elections paired with early exercise are among the most valuable moves in equity compensation, and among the most frequently missed.

Sell-to-cover, withholding, and cash planning

Most RSU plans default to sell-to-cover: enough vested shares are sold to fund withholding, and you keep the rest. Check the withholding rate behind that default. Supplemental withholding at the standard flat rate often runs well below a top-bracket executive's true marginal rate, so a large vest can leave a six-figure shortfall for April. Quarterly estimated payments, or electing higher withholding where the plan allows, prevents the surprise and any underpayment penalties.

Option exercises raise the same question plus a financing one: cashless exercise, sell-to-cover, or cash exercise and hold. The right answer depends on concentration, AMT modeling for ISOs, and the family's liquidity plan, not on a single rule of thumb.

From tax plan to portfolio plan

Equity compensation planning does not end with taxes. Vesting schedules, exercises, and holding periods continuously feed a growing single-stock position, and at some point the concentration question becomes more important than the tax question. A written program, often combining scheduled sales, 10b5-1 plans for insiders, charitable gifts of low-basis shares, and diversification of the proceeds, turns equity compensation from a standing risk into funded goals. We cover that handoff in detail in our article on managing a concentrated stock position.

How should exercises be sequenced across years?

The unit of planning is the calendar, not the grant. Each year has a certain amount of room: the gap between your regular tax and the AMT crossover for ISO exercises, and the distance to the next bracket or surtax threshold for NSO exercises and RSU vests. Filling that room deliberately, year after year, usually beats both extremes of exercising everything at once and waiting until expiration forces your hand.

Expiration dates deserve more respect than they get. Options typically lapse ten years from grant, and sooner, often 90 days, after leaving the company. A surprising amount of equity compensation value is lost to options that expire unexercised or to departures that compress a multi-year plan into one taxable quarter. A grant inventory, with strikes, vesting dates, expiration dates, and post-termination windows, is the foundation document of any plan.

State taxes add a final layer. Equity compensation is generally sourced to where you worked during the period you earned it, so moving to a low-tax state before a vest or exercise does not necessarily move the income with you; states such as California and New York apportion and pursue it. Executives planning relocation, retirement, or a sabbatical year should map vests and exercises against residency timelines with their tax adviser before assuming a rate.

Key numbers

Frequently asked questions

Should I hold RSU shares after they vest?Only if you would buy the stock with cash that day. Vesting already taxed the value as ordinary income; holding adds single-stock risk without any tax advantage.

Do ISOs always trigger AMT?No. Small exercises relative to your income often fit under the threshold where tentative minimum tax stays below regular tax. The exposure depends on the spread, your other income, and the year's AMT parameters, which is why modeling before exercise matters.

What happens to AMT I pay on an ISO exercise?It generally becomes a minimum tax credit that offsets regular tax in future years, often when you sell the shares. The cost is timing and cash flow rather than a permanent loss, provided the stock holds its value.

Can I file an 83(b) election on RSUs?No. RSUs transfer no property until vesting, so there is nothing to elect on. 83(b) applies to restricted stock and early-exercised options.

What is a disqualifying disposition, and is it always bad?Selling ISO shares before the two-year and one-year marks converts the spread to ordinary income. It is sometimes the right move, such as selling before year end to erase an AMT adjustment on a stock that has fallen since exercise.

How does equity compensation interact with QSBS?Shares acquired by exercising options in a qualifying C corporation can be QSBS, with the holding period starting at exercise, not grant. Early exercise with an 83(b) election can start that clock years sooner.