Tax Basics

11 minutes, 46 links


Updated September 12, 2022
Equity Compensation

The awarding of equity compensation can give rise to multiple types of taxes for the recipient, including federal and state income taxes and employment taxes. Skip ahead to understand how taxes on equity work, but if you have time, this section gives a technical summary of tax fundamentals, just in case you (like most people!) never really figured out all the numbers on your pay stub.

Given the complexity, most taxpayers aren’t aware of how their tax is calculated. It does take up thousands of pages* of the federal tax code and involves the intricate diversity of state tax law as well.*

You don’t need to know every detail, and can rely on software and professionals to determine the tax you owe, but we do suggest understanding the different kinds of taxes, how large they can be, and how each is “triggered” by different events.

confusion For those not already familiar with tax terminology, watch out: Many terms sound like regular English, but they’re not. Ordinary income, long-term and short-term, election, qualified small business, and other phrases have very specific meanings we’ll do our best to spell out.

Kinds of Income

Definition Income is the money an individual makes. For tax purposes, there are two main types of income, which are taxed differently. Ordinary income includes wages, salary, bonuses and interest made on investments. Capital gains are the profits an individual makes from selling assets, including stock.

One key difference between ordinary income and capital gains is that when capital gains taxes are calculated, consideration is given not just to the sale price of the asset but to the total gain or loss the investment incurred, each outcome having significantly different tax consequences.

Definition Capital gains are classified as long-term or short-term. Long-term capital gains are the profits an individual makes from selling assets, such as stock, a business, a house, or land, that were held for more than a year. Short-term capital gains are profits from the sale of assets held for less than a year.

Although this topic is not without paidcontroversy, the general idea is, if you are selling something you’ve owned for a long time, you can be taxed at a lower rate.

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All these rates have evolved over time based on economic and political factors,* so you can be confident they will change again in the future.

new In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), which made many changes to tax rates for the 2018 tax year. Long-term capital gains taxes did not change significantly.


Federal Taxes

Definition Income tax is the money paid by individuals to federal, state, and, in some cases, local governments, and includes taxation of ordinary income and capital gains. Generally, U.S. citizens, residents, and some foreigners must file and pay federal income tax.

important In general, federal tax applies to many kinds of income. If you’re an employee at a startup, you need to consider four kinds of federal tax, each of which is computed differently.

confusion When it comes to equity compensation, it’s possible that you’ll have to worry about all of these, depending on your situation. That’s why we have a lot to cover here:

Definition Ordinary income tax is the tax on wages or salary income, and short-term investment income. The term short-term capital gains tax may be applied to taxes on assets sold less than a year from purchase, but profits from these sales are taxed as ordinary income. For a lot of people who make most of their money by working, ordinary income tax is the biggest chunk of tax they pay.

Definition Employment taxes are an additional kind of federal tax beyond ordinary income tax, and consist of Social Security and Medicare taxes that are withheld from a person’s paycheck. Employment taxes are also referred to as payroll taxes as they often show up on employee pay stubs. The Social Security wage withholding rate in 2020 is 6.2% up to the FICA wage base of $137,700. The Medicare component is 1.45%, and it does not phase out above the FICA wage base.

Definition Long-term capital gains tax is a tax on the sale of assets held longer than a year. Long-term capital gains tax is often lower than ordinary income tax. Many investors hold assets for longer than a year in order to qualify for the lesser tax burden of long-term capital gains.

Definition Alternative minimum tax (AMT) is a supplemental income tax that applies to certain individuals in some situations. This type of tax does not come up for many taxpayers, but higher income earners and people in special situations may have to pay large AMT bills. AMT was first enacted in 1979 in response to reports that 155 wealthy individuals had paid no income tax in 1966.* It is not the same as ordinary income tax or employment tax, and is calculated according to its own rules.


danger AMT is relevant to you if you’re reading this. It’s important to understand because exercising ISOs can trigger AMT. In some cases a lot of AMT, even when you haven’t sold the stock and have no money to pay. We discuss this later.

Figure: Bracket Rates, Income, and Taxes

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Source: IRS and the Tax Foundation

A bit on how all this fits together:

  • Ordinary income tax applies in the situations you’re probably already familiar with, where you pay taxes on salaries or wages. Tax rates are based on filing status (if you are single, married, or support a family), and on which income bracket you fall under.

  • Income brackets. For ordinary income, since the 2018 tax year, the income brackets are at 10%, 12%, 22%, 24%, 32%, 35%, and 37% marginal tax rates—see Notice 1036 or a Tax Foundation summary for 2021. Be sure you understand how these brackets work, and what bracket you’re likely to be in.

    • confusion There is a popular misconception that if you move to a higher bracket, you’ll make less money.* What actually happens is when you cross certain thresholds, each additional (marginal) dollar you make is taxed at a slightly higher rate, equal to the bracket you’re in. After you earn more than your deduction, on which you pay no tax, your post-tax income looks like the diagram above. (More discussion on such misconceptions are in this Reddit thread.)
  • Investment gains, such as buying and selling a stock, are similarly taxed at “ordinary” rates, unless they are long-term, which means you held the asset for more than a year.

  • You also pay a number of other federal taxes (see a document summary for all states), notably:

    • 6.2% for Social Security up to the FICA base wage (your first $137,700 in 2020)

    • 1.45% for Medicare

    • 0.9% Additional Medicare Tax on income over $200K (single) or $250K (married filing jointly)

    • 3.8% Net Investment Income Tax (NII) (enacted as part of the Affordable Care Act,* also called “Obamacare”) on investment income if you make over $200K (single) or $250K (married filing jointly).*

  • Ordinary federal income tax, Social Security, and Medicare taxes are withheld from your paycheck by your employer and are called employment taxes.

  • important Long-term capital gains are taxed at a lower rate than ordinary income tax: 0%, 15%, or 20%.* This covers cases where you get dividends or sell stock after holding it a year. If you are in the middle brackets (more than about $40K and less than $445K of ordinary income for 2021), your long-term capital gains rate is 15%. You can find more detail on tax brackets at the Tax Foundation.

  • AMT is a complex part of the federal tax code most taxpayers don’t worry about. But it comes into play when exercising ISOs. Most people do not pay AMT unless it is “triggered” by specific situations, typically high income (more than $500K) or high deductions. Whether you pay AMT also depends on the state in which you file, since your state taxes can significantly affect your deductions. If you are affected, AMT tax rates are usually at 26% or 28% marginal tax rate, but effectively 35% for some ranges, meaning it is higher than ordinary income tax for some incomes and lower for others.* AMT rules are so complicated you often need professional tax help if they might apply to you. The IRS’s AMT Assistant might also help.

  • important Section 1202 of the Internal Revenue Code provides a special tax break for qualified small business stock held for more than five years.* Currently, this tax break is a 100% exclusion from income for up to $10M in gain. There are also special rules that enable you to rollover gain on qualified small business stock you have held for less than five years. Stock received on the exercise of options can qualify for the Section 1202 stock benefit.

  • ···

State Taxes

State tax rates and rules vary significantly. Since federal rates are much higher than state rates, you usually think of federal tax planning first. But you should also know a bit about tax rates in your state.

State long-term capital gains rates range widely. California has the highest, at 13.3%; several states have none.*

important For this reason, some people even consider moving to another state if they are likely to have a windfall gain, like selling a lot of stock after an IPO.


Taxes on Equity Compensation19 minutes, 29 links

Equity and taxes interact in complicated ways, and the tax consequences for an employee receiving restricted stock, stock options, or RSUs are dramatically different. This section will cover these messy details and help you make decisions that reduce the tax burden of your equity compensation.

83(b) Elections

This section covers one of the most important and complex decisions you may need to make regarding stock awards and stock options: paying taxes early with an 83(b) election.

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