How RSUs, stock options and ESPP shares are taxed in Virginia

Restricted stock units are taxed when they vest

Equity pay is taxed in two stages: first as wages when you receive value from your employer, and later as capital gain or loss when you sell the shares. An RSU is the plainest case.

An RSU is a promise of shares. Nothing is taxed when the grant is made. Most RSUs are taxed when they vest and the shares are delivered. The taxable amount is the value of the shares at that time, and it is reported as wages in box 1 of your W-2. If your company sells shares to cover withholding, that only covers the tax withheld by payroll. It may not cover your full federal and state tax.

The reason it can fall short is the rate. The IRS treats stock compensation as supplemental wages. Employers generally may use the optional flat rate of 22% on supplemental wages up to $1 million in the year, and most do, though they can instead withhold under the aggregate method with your regular wages. Amounts over $1 million are subject to mandatory withholding at 37%. If your income already puts you in a higher bracket than 22%, the flat-rate withholding is short and the difference is due when you file. Two or three vesting dates in a year can leave a balance large enough to carry an underpayment penalty. We look at the vesting schedule in the fall and recommend a change to estimated payments or your W-4, the withholding form on file with your employer, ahead of a vest.

Stock options come in two kinds, with two sets of rules

The IRS draws a line between statutory options and nonstatutory options. Incentive stock options (ISOs) and options under a qualifying employee stock purchase plan (ESPP) are statutory. Everything else is a nonstatutory option, usually called an NSO or NQSO.

With a nonstatutory option you owe nothing at grant. When you exercise, the difference between what the shares are worth that day and what you paid, called the spread, is ordinary income, taxed and withheld like wages. When you later sell, the change in value since the exercise date is a capital gain or loss.

With a statutory option there is generally no regular income at grant or at exercise. The tax comes when you sell the shares. If you hold them long enough to meet the special holding period rules, the gain is capital gain, with a limited exception for ESPP shares described below. If you sell early, part of the gain is ordinary income, treated as wages and added to your basis. Your employer sends Form 3921 for ISO exercises and Form 3922 for the first transfer of ESPP shares, and both carry the dates and values the return needs.

Incentive stock options and the alternative minimum tax

This is where people get surprised. An ISO exercise creates no regular income, but for the alternative minimum tax (AMT), a second calculation of your tax that applies when it comes out higher than the regular one, the spread counts. The AMT form, Form 6251, adds the excess of the shares' fair market value over the price you paid, as of the date your rights in the stock are no longer restricted. Exercise enough options in one year and the AMT can exceed your regular tax, so you pay the difference in a year when you have not sold anything.

Two things soften it. If you sell the shares in the same year you exercise, the regular tax and the AMT treat it the same way and there is no adjustment. AMT paid because of an ISO exercise can also come back as a credit in later years, claimed on Form 8801. The planning question is how many options to exercise in a given year, and it is answered before the exercise rather than in April.

ESPP shares

An employee stock purchase plan lets you buy company shares at a discount through payroll. The favorable rules here apply only to a qualifying ESPP, one that meets the requirements of section 423 of the tax code, and not to every employee stock purchase arrangement. Under a qualifying plan the purchase itself is not taxed. What happens at sale depends on how long you held the shares. Meet the holding period and the ordinary income is the lesser of the grant-date discount or the gain at sale over the purchase price, and the rest is capital gain. Sell early and the discount at purchase is ordinary income in full, with the rest capital gain or loss. Form 3922 records the purchase, and the same basis problem described next applies here more than anywhere.

Selling: the basis mistake that taxes the same dollars twice

Whatever amount was included in your wages at vesting or exercise is part of your cost basis in those shares. When you sell, the gain is the sale price minus that basis. The broker's Form 1099-B often reports a basis that leaves out the wage portion, because the broker does not see your W-2. A return prepared from the 1099-B as printed reports the vesting income twice, once as wages and again as gain.

The fix is a basis adjustment on Form 8949, the form where stock sales are reported, with the wage amount added back, supported by the supplemental statement most brokers publish. We check every equity sale against the W-2 and the 3921 or 3922 before the return goes out.

If you moved into or out of Virginia

If you moved into or out of Virginia, the answer depends on your move date, where you worked during the earning period, and the type of equity involved. Virginia taxes residents on their income during the Virginia-resident period, and it taxes nonresidents on Virginia-source income, which includes wages for services performed in Virginia. Virginia also has reciprocity with Maryland, the District of Columbia, West Virginia, Kentucky and Pennsylvania, an agreement under which wages are taxed by the state you live in rather than the one you work in, which matters if you live in one and work in another. Someone who moves in or out during the year files a part-year return, Form 760PY, and prorates the exemptions and standard deduction. RSUs, NSOs, ISOs and ESPP shares can be sourced differently, so we review the vesting, exercise and sale dates before deciding how much belongs on the Virginia return.