Equity Compensation Glossary: Clear Terms for Confident Decisions

Equity compensation can be a powerful way to build wealth and share in your company’s success. But the terms can be confusing, and the tax rules aren’t always clear. This glossary is here to help you understand the basics, without the jargon.

Whether you’re new to equity or just need a refresher, here are the key terms you should know:

General Terms

Before diving into the different types of stock and plans, it helps to understand some common terms you’ll see again and again. These are the building blocks of equity compensation. They are the definitions that can make everything else click into place.

Alternative Minimum Tax (AMT)

The Alternative Minimum Tax (AMT) is a separate way the IRS calculates your income tax to make sure people with certain kinds of income, especially from stock options, pay at least a minimum amount of tax.

The IRS calculates your tax two ways: first under the regular tax system and then under AMT rules. If the AMT amount is higher, you pay that instead.

Why it matters for equity:

Exercising Incentive Stock Options (ISOs) can trigger AMT because the IRS counts the difference between the price you pay and the current market price as income under AMT rules, even if you have not sold the shares yet. This can create a tax bill before you make any cash from selling the stock.

Example:

You have the right to buy shares at $5, which is your ISO strike price.

The shares are worth $20 today.

Even if you do not sell, the IRS may count that $15 difference as AMT income.

Bargain Element

The bargain element is the difference between the fair market value (FMV) of a company share and the strike price (the fixed price your company lets you buy it for through your stock option).

• Applies when you exercise (use your right to buy company stock)

• Counted as taxable income with NSOs (Non-Qualified Stock Options)

• May trigger AMT (Alternative Minimum Tax) with ISOs (Incentive Stock Options)

Example:

• Your strike price is $10 per share (the fixed price you can buy the stock for)

• The stock’s fair market value is $25 per share

• The bargain element is $15 per share ($25 minus $10)

• That $15 is considered income for tax purposes

Tax Tip: Always talk to a tax advisor before exercising ISOs (Incentive Stock Options). Even if you do not sell the stock, the IRS may treat the gain as income and apply AMT (Alternative Minimum Tax).

Exercise

Using your right to buy company stock under a stock option. When you exercise, you pay the strike price to receive the shares.

Reminder: Exercising doesn’t mean you have to sell immediately. You can hold onto shares or sell them, depending on your goals and tax strategy.

Fair Market Value (FMV)

The current price at which a share of company stock could be sold on the open market. This value is used to calculate taxes when you receive or sell equity.

Grant

The official offer of equity from your employer. For example, you might be granted 1,000 RSUs (Restricted Stock Units) or 5,000 stock options. The grant includes details like the type of equity, vesting schedule, and other terms.

Strike Price

The price you must pay to purchase a share of company stock when exercising a stock option. It’s usually set when the option is granted.

Tip: The lower your strike price compared to the stock’s fair market value, the more your shares may be worth when you exercise.

Vesting Schedule

A timeline that shows when you officially earn ownership of your equity. You don’t own or control your shares until they vest.

Example: A typical schedule might be four years with a one-year cliff, meaning no shares vest until the one-year mark, then monthly thereafter.

Stock and Option Types

The core types of equity people receive:

Incentive Stock Option (ISO)

An ISO (Incentive Stock Option) is a type of stock option that lets you buy company stock at a set price. It comes with special tax treatment if certain rules are followed.

When you exercise ISOs (Incentive Stock Options), you do not owe ordinary income tax right away. However, the bargain element (the difference between the stock’s value and the price you paid) may be counted for Alternative Minimum Tax (AMT) purposes.

If you hold the shares for at least two years from the grant date and one year from the exercise date, you may qualify for long-term capital gains treatment when you sell. That means you could pay a lower tax rate on the full gain.

Example:

You are granted the option to buy stock at $5 per share. That is your strike price. Two years later, the stock is worth $15, and you decide to buy it.

• You pay $5, and the stock is worth $15

• You do not owe regular income tax at exercise

• However, the $10 difference may count toward AMT

• If you hold the stock and sell it later for $20, the full $15 gain (from $5 to $20) can be taxed as a long-term capital gain if you meet the holding periods

Tip: ISOs (Incentive Stock Options) can lead to favorable tax treatment, but the AMT rules can be tricky. It is smart to talk with a tax advisor before exercising.

Non-Qualified Stock Option (NSO)

An NSO is a type of stock option that lets you buy company stock at a fixed price, even if the stock becomes more valuable later.

You pay ordinary income tax when you exercise the option, based on the bargain element, which is the difference between the stock’s market value and the price you paid (called the strike price). If you later sell the stock for more than it was worth when you exercised, that additional profit is treated as a capital gain.

Example:

Your company lets you buy stock at $5 per share. That is your strike price. Two years later, the stock is worth $15, and you decide to buy it.

• You pay $5, but the stock is worth $15

• The $10 difference is your bargain element, and it is taxed as ordinary income

• If you sell the stock later at $20, the $5 gain (from $15 to $20) is a capital gain

Tip: You may owe taxes when you exercise NSOs, even if you do not sell the stock right away. It is a good idea to understand the tax impact ahead of time.

Qualified Employee Stock Purchase Plan (ESPP)

A benefit that allows employees to buy company stock at a discount, often up to 15% off, using automatic payroll deductions. You contribute a portion of your paycheck, and at the end of a set period (called the purchase period), your company uses that money to buy shares on your behalf.

You do not pay taxes when you buy the shares, but the way your gain is taxed when you sell depends on how long you hold the stock.

Tax Tip: If you hold the shares for at least one year after purchase and two years after the start of the offering period, your gain may qualify for long-term capital gains treatment. If you sell too soon, part of the gain will be taxed as regular income.

Example:

Let’s say your company offers a 15% discount and the stock is trading at $20 per share on the purchase date.

• You buy the shares for $17 each through payroll deductions.

• If you sell them right away at $20, the $3 difference per share is taxed as ordinary income.

• If you hold the stock for at least one year after the purchase and two years after the offering began, then most or all of the gain could be taxed at the lower long-term capital gains rate instead.

Holding the stock longer may reduce your taxes, but it also means more exposure to stock price changes. It’s important to understand both the risks and tax benefits.

Restricted Stock Award (RSA)

A type of stock grant where you receive shares of company stock upfront, but they come with restrictions. Usually, you must stay with the company for a certain period or meet specific goals for the shares to fully become yours (this is called vesting). Until then, the company can take them back if you leave early.

With RSAs, you may get dividends and voting rights right away, even before the shares vest.

Tax Tip: You can choose to be taxed when the stock is granted instead of when it vests by filing an 83(b) election within 30 days of receiving the shares. This might save you money if the stock’s value increases later.

Example:

Let’s say your company gives you 1,000 shares of stock today, but they say you must stay at the company for four years to keep them all.

• You get the shares now, but if you quit in one year, you might only keep 250 shares and lose the rest.

• Because you receive the shares upfront, you can vote as a shareholder and even get dividends while you’re waiting for them to vest.

Restricted Stock Unit (RSU)

An RSU (Restricted Stock Unit) is a promise from your company to give you stock in the future if you meet certain conditions, usually by staying employed for a set period of time. You do not own the shares right away. They become yours as they vest over time.

You owe ordinary income tax when the RSUs (Restricted Stock Unit) vest, based on the market value of the stock at that time. Your company may withhold some shares to cover taxes automatically.

If you later sell the shares for more than they were worth when they vested, the extra amount is treated as a capital gain.

Example:

Your company grants you 100 RSUs. They vest gradually over 4 years, so 25 shares vest each year.

• In year one, 25 shares vest when the stock is worth $10 per share

• You owe ordinary income tax on $250 (25 x $10), even if you do not sell the stock

• If you sell those shares later for $15 each, the $5 per share gain is taxed as a capital gain

Tip: You cannot control when you are taxed on RSUs. Taxes are triggered automatically when the shares vest and become yours, even if you do not sell them. This means your income might go up that year, which could affect your tax bracket or how much you owe at tax time. Planning ahead can help you avoid surprises.

Equity Planning Tools & Elections

Tools, strategies, and tax elections people can use with or after receiving equity:

Rule 10b5-1 Plan

A pre-set schedule for selling your company stock, often used by employees or executives who may have access to inside information. It allows you to sell shares on a regular basis without violating insider trading rules, as long as the plan is created when you do not have material nonpublic information (MNPI).

These plans help you sell shares in a consistent, compliant way and add a layer of legal protection.

Tip: Especially useful during blackout periods when you would not otherwise be allowed to trade.

Section 83(b) Election

An optional tax election you can file within 30 days of receiving certain types of equity, like RSAs, to pay taxes upfront rather than waiting until the shares vest. This can be a smart move if the stock’s value is low now and you expect it to grow. But it carries risk if the stock loses value or if you leave the company before vesting.

Tip: This election is not available for RSUs. It only applies to equity that is considered “substantially unvested” at the time of the grant, like RSAs.

Tax Terms

Income Tax

A tax you pay on the money you earn, including salary, bonuses, and certain types of equity compensation. The amount depends on your total income and your tax bracket. This is the same kind of tax you pay when RSUs vest or when you exercise NSOs.

Short-Term Capital Gains Tax

A tax on profits from selling an investment you’ve held for one year or less. These gains are taxed at the same rates as ordinary income, which can be much higher than long-term capital gains rates.

Tip: If you sell stock less than a year after exercising or receiving it, your gain may be taxed as short-term.

Long-Term Capital Gains Tax

A lower tax rate on profits from selling an investment you’ve held for more than one year. With some types of equity, like ISOs or ESPP shares, you may qualify for this lower rate if you meet specific holding requirements.

Tax Tip: Holding your shares longer may reduce the tax you owe, but be sure to balance that with other financial goals or risks.

Need help understanding your equity compensation package or how to make a plan around it?

Equity compensation can feel overwhelming, but it doesn’t have to be. At Plan Forward Finance, we help you make sense of it all so you can make decisions that fit your life, your values, and your goals.

Let’s figure it out together.

Book a free 30-minute Initial Planning Meeting to see if we’re a good fit.

Thanks for reading!

Marla @ Plan Forward Finance