Equity compensation - like RSUs, ISOs, and NSOs - can lead to significant financial gains, but it comes with complex tax rules, especially in high-tax states like California, New York, and Massachusetts. Here’s what you need to know:
- RSUs: Taxed as ordinary income at vesting; capital gains at sale.
- ISOs: May trigger AMT at exercise; taxed as capital gains if holding periods are met.
- NSOs: Taxed as ordinary income at exercise; capital gains at sale.
Key Takeaways:
- State Tax Rules: High-tax states use formulas to tax equity income based on where and when it was earned. For example, California taxes a percentage of equity income based on workdays spent in the state.
- Remote Work Impact: Some states tax income based on your employer’s location, even if you work remotely.
- Minimizing Taxes: Strategies include moving to lower-tax states before vesting/exercise, choosing sell-to-cover or net settlement for RSUs, and using tools like Mezzi for tax optimization.
- Audit Risks: Multi-state equity holders face increased audits; proper documentation and proactive planning are essential.
Quick Comparison of Equity Types
| Equity Type | Taxation at Exercise | Taxation at Sale |
|---|---|---|
| RSUs | Ordinary income | Capital gains (short- or long-term) |
| ISOs | Possible AMT liability | Capital gains if holding periods met |
| NSOs | Ordinary income (spread taxed) | Capital gains (short- or long-term) |
Stock Compensation Tax Traps & How to Avoid Them | RSUs, Stock Options, and Performance Shares
How Equity Compensation Is Taxed
Knowing how your equity compensation is taxed is crucial for making smart financial decisions. Taxes on equity compensation vary depending on the type of equity and are influenced by both federal and state tax rules.
Federal Tax Rules for Equity Compensation
At the federal level, Restricted Stock Units (RSUs) are the simplest to understand. When RSUs vest, their fair market value is treated as ordinary income. For example, if $50,000 worth of RSUs vest in 2025, that amount will appear on your W-2 as taxable income. To cover federal taxes, a portion of your shares is usually withheld automatically.
Incentive Stock Options (ISOs) come with more intricate rules but can be advantageous with proper planning. Exercising ISOs doesn’t immediately trigger regular income tax, but it could activate the Alternative Minimum Tax (AMT). The annual exercisable value is capped at $100,000 under the ISO rules. If you hold the shares for at least two years from the grant date and one year from the exercise date, any gains qualify for long-term capital gains tax rates, which ranged from 0% to 20% in 2022.
Non-Qualified Stock Options (NSOs) are taxed differently. When you exercise NSOs, the difference between the stock’s market price and your strike price is treated as ordinary income. For instance, if your strike price is $10 and the stock is trading at $40, the $30 spread is taxable, and withholding is applied at the time of exercise.
Here’s a quick breakdown of how different equity types are taxed:
| Equity Type | Taxation at Exercise | Taxation at Sale |
|---|---|---|
| RSUs | Fair market value taxed as ordinary income | Capital gains (short-term or long-term) |
| ISOs | Possible AMT liability | Ordinary income or capital gains, based on holding period |
| NSOs | Spread (market price - strike price) taxed as ordinary income | Capital gains (short-term or long-term) |
These federal rules provide a baseline, but state taxes - especially in high-tax areas - can make things even more complex.
State Tax Rules in High-Tax States
State taxes add another layer of complexity, particularly in high-tax states like California (up to 13.3%), New Jersey (up to 10.75%), New York (up to 10.9%), and Massachusetts (up to 9%).
Most states with income taxes use sourcing rules to determine how much of your equity compensation is taxable based on when and where it was earned. Relocating to a state with no income tax doesn’t necessarily eliminate your state tax liability.
For example, if your RSUs are worth $750,000 at vesting after a company acquisition, and you lived in a high-tax state for four of the five years leading up to the vesting, that state may tax 80% of the payout - or $600,000. At a 10% tax rate, this means a $60,000 tax bill, even if you’ve since moved elsewhere. This scenario highlights the importance of planning ahead when your equity income spans multiple states.
Remote work can further complicate matters. Some states tax income based on both where you live and where you work. States like Connecticut, Delaware, Nebraska, New Jersey, New York, and Pennsylvania enforce "convenience of the employer" rules, which tax you based on your employer’s location even if you work remotely from another state.
If you owe taxes in more than one state, you can typically claim a credit in your home state for taxes paid to other states. However, this doesn’t guarantee your employer will withhold the correct amounts, so you may need to make quarterly estimated tax payments.
Planning becomes essential when your equity compensation involves multiple states. Before making major decisions - like moving or exercising options - it's critical to understand your former state’s allocation formulas and whether they might claim taxes on 100% of the income earned during your residency.
State-by-State Tax Rules for Equity Compensation
Navigating state tax rules for equity compensation can feel like solving a puzzle, especially if you've worked across multiple states. Each high-tax state has its own way of handling stock options or RSUs, making it crucial to understand the rules that apply to your specific situation.
California: Two-Factor Sourcing Formula
California is known for taxing nonresidents on income earned from services performed within the state. When it comes to equity compensation, California uses a formula based on the ratio of workdays spent in the state to total workdays between the grant date and the exercise or vesting date. This means that if you worked in California during this period, the state can claim a share of your equity income, with tax rates reaching up to 13.3%.
For instance, let’s say you worked 700 out of 1,000 total workdays in California during the relevant timeframe. In this case, California would tax 70% of your stock option income. Even if you’ve moved out of state, California may still tax a portion of the income from ISOs or NSOs if those options were earned while you were a resident. Timing matters - a strategic decision to exercise options or let RSUs vest after leaving California could potentially reduce or eliminate your tax liability. However, given the complexities, consulting a tax advisor is highly recommended.
New York: Mobile Workforce Doctrine
New York takes a different approach, focusing on its "convenience of the employer" rule. According to this rule, if a nonresident works remotely for personal reasons rather than because of an employer's requirement, those remote workdays are treated as New York workdays and are subject to state income tax. However, if the remote work is mandated by the employer, this taxation method may not apply in the same way. This principle extends to equity compensation, meaning RSU income tied to work performed in New York is taxable.
In 2020, nonresidents contributed significantly to New York's tax revenue. For example, residents of New Jersey and Connecticut alone paid a combined $5.2 billion in New York taxes, out of the state’s $54.5 billion total personal income tax receipts. To avoid unexpected tax bills, employers are encouraged to specify that remote work is a business necessity in employment contracts.
Massachusetts: Service Connection Test
Massachusetts uses what’s called a "service connection test" to determine whether equity compensation is taxable. The state taxes nonresidents on income that is tied to work performed within Massachusetts, including stock options or RSUs. Essentially, if your equity compensation is linked to services you provided in Massachusetts, it’s considered taxable income.
One notable case involved Craig Welch, who moved to New Hampshire but later sold shares tied to his work at AcadiaSoft, a Massachusetts-based company. Despite his relocation, Massachusetts ruled that his stock compensation was taxable because it was directly connected to the work he performed in-state. The Massachusetts Appellate Court emphasized that the shares were compensatory in nature, as they were tied to Welch’s contributions to the company’s growth. This decision highlights the importance of reviewing your equity agreements if you’ve worked for a Massachusetts employer. Consulting a tax advisor can help you understand any potential tax exposure.
These examples illustrate just how varied state tax rules can be when it comes to equity compensation. Proactive tax planning is essential to avoid surprises and to make the most of your stock options or RSUs.
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How to Reduce Your Tax Bill
Strategic tax planning can make a big difference when managing equity compensation, especially if you live in a high-tax state. The trick lies in understanding your options and timing your decisions wisely.
Moving Before Vesting or Exercise
Relocating to a state with lower taxes before your equity vests can substantially reduce your tax liability. Timing is everything here because many states use pro-rata rules to calculate how much of your equity income they can tax.
Take Mona, for example. She was granted NSOs while working in Minnesota. In her fifth year, she moved to Texas before her options vested. When the stock reached $200 per share on the vesting date, Minnesota could only tax 80% of her option income since she worked there for 4 out of the 5 years of the vesting period. Had she stayed in Minnesota for the entire vesting period, the entire income would have been subject to Minnesota's state tax.
ISOs (Incentive Stock Options) present even better opportunities for tax savings when relocating. They are taxed as capital gains, meaning only the state where you live at the time of sale can tax them. On the other hand, RSUs and NSOs are taxed based on where you worked during their vesting period, using a pro-rata approach.
To make your move count, you’ll need to establish genuine residency in your new state. This includes updating your driver's license, voter registration, and vehicle registration.
Next, let’s explore how the way you settle your RSUs can further impact your taxes.
Sell-to-Cover vs. Net Settlement for RSUs
When your RSUs vest, you’ll need to cover the taxes, and the method you choose can influence your overall financial situation. Most companies offer two main options: sell-to-cover and net settlement.
- Sell-to-cover: Your company sells enough of your shares to cover the tax withholding. For instance, if you have 250 RSUs valued at $10 each and a 22% tax rate, 55 shares would be sold to cover $550 in taxes, leaving you with 195 shares.
- Net settlement: Instead of selling shares on the market, your company withholds a portion of the shares to cover taxes. While the fair market value of the shares is still reported as ordinary income on your W-2, sell-to-cover avoids triggering capital gains since the shares are sold immediately upon vesting.
Your choice depends on your financial preferences. If you’d rather keep more shares and have cash on hand to pay the taxes, net settlement might be the better route. On the flip side, if you’d prefer not to dip into your own cash reserves, sell-to-cover is more practical.
Using Mezzi for Tax Optimization
Beyond relocation and settlement choices, advanced tools like Mezzi can take your tax planning to the next level. Mezzi’s AI framework simplifies the complexities of tax planning for equity compensation, offering personalized strategies tailored to your situation.
Mezzi can simulate different scenarios, such as the tax implications of exercising stock options before or after a move, or the best timing for RSU sales to minimize your tax burden. For example, if you’re considering relocating, Mezzi analyzes your equity grants, vesting schedules, and the tax rules of potential states to help you decide if a move could save you money.
One standout feature of Mezzi is its ability to prevent wash sales across multiple investment accounts. By providing a unified view of your finances, it identifies tax-saving opportunities that might otherwise go unnoticed.
"A Financial Advisor can help you best determine when to sell or hold your equity award given your financial situation and goals, and a tax professional can help you identify your best tax moves."
Mezzi also supports advanced strategies like tax-loss harvesting to offset capital gains, timing stock option exercises in lower-income years, and coordinating equity compensation with other tax-advantaged accounts like 401(k)s. Its real-time AI alerts keep you informed about time-sensitive opportunities, such as exercising ISOs before year-end to manage AMT (Alternative Minimum Tax) or harvesting losses before the wash sale period begins.
For self-directed investors handling complex equity compensation, Mezzi’s AI-driven insights offer a powerful way to navigate multi-state tax challenges. Its sophisticated analysis can help you save significantly, often outpacing the cost of traditional financial advisor fees.
Recent Changes and Compliance Updates
Managing equity compensation in high-tax environments requires careful planning, especially as taxation rules evolve rapidly. Recent court decisions and regulatory updates are reshaping how multi-state equity management is handled, creating new challenges for both individuals and organizations.
Court Cases Affecting Equity Taxation
The Welch v. Commissioner of Revenue case in Massachusetts has had a major impact on equity compensation taxation. In 2025, the Massachusetts Appellate Court ruled against Craig Welch, a co-founder of AcadiaSoft, Inc. Welch had moved from Massachusetts to New Hampshire before selling his shares, but the court determined that Massachusetts could tax his capital gains. Why? The court concluded the shares were compensatory and directly tied to his employment while he resided in Massachusetts.
This ruling may encourage other high-tax states, like California and New York, to adopt similar approaches when taxing equity gains of former residents. For equity holders, this means increased scrutiny when realizing gains after relocating. To prepare, it’s critical to document service locations thoroughly and consult tax professionals before selling shares. These developments highlight the potential for changing state policies and increased audit risks for those working remotely.
State Rules on Remote Work and Equity Taxation
Remote work has complicated equity compensation taxation significantly. With fewer than 10% of employees wanting to return to the office full time and 52% willing to take pay cuts to work remotely, companies now face the challenge of tracking employee locations during vesting periods - especially when employees move between states.
Some states are adapting their policies to address these complexities. For instance:
- Colorado: The Job Growth Incentive Tax Credit (JGITC) now accounts for remote and hybrid workers.
- Wisconsin: Updated its Business Tax Credit (BDTC) in 2024 to include hybrid and remote arrangements.
- Tennessee: Introduced the Rural Economic Opportunity Act, which incentivizes businesses employing remote workers.
These policy changes aim to encourage remote work while ensuring tax compliance and supporting business growth. For organizations, this means updating location reporting policies and improving communication between HR, equity, and payroll teams. Regularly verifying employee location data is also key to avoiding tax errors and penalties. These adjustments are just the beginning, as stricter multi-state tax audits loom on the horizon.
Audit Risks for Multi-State Equity Holders
The regulatory landscape has also heightened audit risks for equity holders with interests across multiple states. State tax authorities are becoming more aggressive in their efforts to recover revenue, and this means equity holders must be prepared for increased scrutiny. Common audit triggers include:
- Inconsistent reporting of equity compensation across states.
- Errors in income allocation based on work location during vesting periods.
- Poor documentation of residency changes.
High-net-worth individuals who relocate after receiving equity grants are particularly vulnerable to these audits. Many organizations mistakenly believe that federal compliance covers all obligations, overlooking critical differences in state laws.
To reduce these risks, companies should take proactive measures:
- Perform regular HR audits to ensure compliance with both state and federal regulations.
- Use centralized compliance management systems to track state law changes and store essential documentation.
- Invest in compliance software that monitors state regulations in real time.
- Train HR teams regularly on updates and best practices, ensuring policies are clear and accessible to employees.
With states employing advanced audit techniques, staying ahead of equity compensation tax compliance is crucial to avoiding costly financial consequences. By taking these steps, organizations and individuals can better navigate the increasingly complex tax landscape.
Conclusion: Managing Equity Compensation Taxes in High-Tax States
Navigating equity compensation taxes in high-tax states demands thoughtful planning. With state-specific rules and the ever-changing landscape of remote work regulations, taking a proactive approach is critical for anyone managing RSUs, ISOs, or NSOs.
Understanding the nuances of state tax laws is a vital step in avoiding surprise tax liabilities. Different states have unique sourcing formulas that can lead to unexpected tax bills, especially on significant equity payouts. Knowing these rules and how they apply to your situation is your first line of defense.
Strategic decisions - like timing a move, selecting how shares are settled, or planning ISO exercises - can make a big difference. George Dimov, CPA, founder and CEO of Dimov Tax, underscores this point:
"The difference between tax preparation and tax planning is huge. The best time to do tax planning is May, June, and July." [29]
Technology also plays a key role. Platforms like Mezzi, which we discussed earlier, offer tools to simplify tax planning. Mezzi can identify tax-saving opportunities, such as avoiding wash sales across accounts, and provide real-time insights to guide your decisions throughout the year - not just during tax season. By integrating all your financial accounts into one platform, it delivers a comprehensive view that empowers better tax strategies, something traditionally available only through costly advisors. This blend of strategic planning and advanced technology is essential for tackling equity tax challenges effectively.
Accurate record-keeping and collaboration are equally important. Keeping detailed documentation of your work history and sourcing income based on where and when services were performed is crucial, especially as states ramp up audits. Dimov also highlights the importance of working closely with your tax advisor:
"Treat tax preparation and your tax advisor as a collaborative process - you're still responsible for your own taxes, so you do have to review and understand your returns."
As states adapt to the realities of remote work and become more aggressive in seeking revenue, combining a solid understanding of state-specific tax rules with careful timing and advanced tools like Mezzi will help you minimize tax burdens and maximize your equity gains. The key is to start early and view tax planning as an ongoing effort rather than a one-time task.
FAQs
How does moving to a different state affect the taxes on my equity compensation?
Relocating to a different state can have a big impact on how your equity compensation - like RSUs, ISOs, or NSOs - is taxed. Each state has its own approach to taxing equity income, and if you move to a state with no income tax or lower tax rates, you might see a decrease in your overall tax bill.
That said, if you were granted equity while living in a high-tax state, you could still owe taxes to that state when the income is realized. This often depends on factors like when the shares vest and your residency status at that time. Some states even calculate taxes based on how much of the year you spent living or working there.
To avoid any surprises, it’s a good idea to consult with a qualified tax advisor. They can help you understand your specific tax obligations and guide you through the complexities of multi-state tax rules, ensuring you stay compliant.
How can I reduce the risk of a tax audit when managing equity compensation across multiple states?
To lower the chances of a tax audit when handling equity compensation across different states, it’s crucial to maintain thorough records. Keep track of your work locations, vesting schedules, and any equity-related events. Many states base their taxation of equity compensation on where the work was performed during the grant, vesting, or exercise periods. States with higher taxes, like New York and California, even use specific formulas to calculate taxable income.
To remain compliant, prioritize making on-time estimated tax payments and familiarize yourself with the tax rules for every state where you’ve worked. If you’ve relocated to a new state, be mindful of any income that might still be taxable in the state you left. Working with a tax advisor or leveraging advanced financial tools can help you manage these challenges and steer clear of penalties.
How do state-specific tax rules impact my RSUs, ISOs, and NSOs?
State tax rules play a big role in how RSUs, ISOs, and NSOs are taxed, depending on where you lived and worked during key moments like vesting, exercising, or selling the shares. For instance, RSUs are typically taxed at the time they vest, and the taxable income is divided among the states where you worked during the vesting period. On the other hand, ISOs and NSOs are taxed based on your residency and work location at the time you exercise the options and later when you sell the shares.
States with higher tax rates, like California and New York, often have more intricate rules for determining where income is sourced. If you’ve moved between states, these rules can result in extra tax obligations. Knowing how these regulations work is essential to staying compliant and avoiding unexpected tax bills.
