Startup equity generates some of the most complex tax situations an individual can face. The type of equity you hold, when you exercise or vest, and when the company achieves a liquidity event all interact to determine your ultimate tax outcome. This guide covers the most common situations for employees at late-stage private companies.
RSU taxation: simple but powerful
Restricted Stock Units vest on a schedule. When they vest, you receive shares (or cash equivalent in a liquidity event). The fair market value on the vest date is ordinary income — added to your W-2 for that year.
The brutal part: you owe income tax at vest even if you can't sell. For employees at private companies, this means writing a check to the IRS while holding illiquid stock. Many companies withhold shares to cover the tax (a 'sell-to-cover' at vest), but private companies can't do this — the shares aren't publicly tradeable. Result: employees must pay cash to cover the RSU tax while holding restricted stock.
ISO taxation: the good and the bad
Incentive Stock Options have two favorable features: (1) no income tax at exercise for regular tax purposes, and (2) if held long enough, qualifies for long-term capital gains rates. The bad part: the alternative minimum tax (AMT) applies the spread (FMV − strike) at exercise as an adjustment.
The ISO tax strategy: exercise early (while the spread is small), pay the (hopefully small) AMT, hold for 2 years from grant and 1 year from exercise, then sell with capital gains treatment. This works well if the company grows. If the company's value drops after exercise, you may have paid AMT on phantom gains.
NSO taxation: ordinary income all the way
Non-Qualified Stock Options are taxed as ordinary income at exercise on the spread. Your employer withholds income tax. There's no AMT complexity, no preferred holding period — but also no capital gains benefit. The tax rate on the spread is your marginal income tax rate.
PPU taxation: like RSUs
OpenAI's Profit Participation Units are taxed as ordinary income at distribution — the point at which you receive cash or shares. For PPU holders, there's no exercise decision and no AMT. The tax timing tracks the distribution event (tender offer, IPO, or other liquidity).
California specifics
California taxes ISO exercise spread as ordinary income for state tax purposes — eliminating the AMT advantage for California residents. The state also taxes RSU vest, NSO exercise, and all equity income at ordinary income rates up to 13.3%. High-income startup employees in California face some of the highest marginal effective equity tax rates in the world.
Tax optimization matters more than equity optimization for many employees. A well-timed ISO exercise at low spread can save 20+ percentage points of taxes vs. waiting for an IPO and exercising then. A CPA who specializes in startup equity is one of the best investments you can make.