Written By:
Max Michalczik CFP® | Space & Defense
Kekoa Pfau ChFC® | Space & Defense

Why is equity compensation so complicated to tax?

Your paycheck gets taxed once. Equity can be taxed at grant, at vesting, at exercise, and again when you sell. Different types of equity follow different rules, and the timing of each taxable event is something you can sometimes control and sometimes cannot.

Defense and aerospace professionals often hold equity from multiple sources at the same time: RSUs from a large prime, options from a prior startup stint, ESPP shares from the current employer. Each piece has different tax timing. Without a coordinated plan, the cumulative exposure in a single year can be genuinely surprising.

How are RSUs taxed?

When RSUs vest, the fair market value of the shares on that day gets added to your W-2 as ordinary income. Your employer withholds taxes, typically by selling a portion of the vesting shares automatically.

Watch out: many employers default to withholding at the 22% supplemental rate. If your total income puts you in the 32% or 37% bracket, you will owe the difference at filing. Budget for it.

Senior engineers, program managers, and executives at defense primes can easily have large RSU tranches vest in the same tax year. Add base salary, a bonus, and possibly clearance pay differentials, and the combined W-2 can push well into the upper brackets. The 22% default withholding is not enough in those situations. Set aside the difference before it becomes a tax-time problem.

How are Non-Qualified Stock Options (NSOs) taxed?

NSOs are taxed when you exercise them, not when they were granted or when they vest. The spread between the current market price and your strike price is treated as ordinary income in the year you exercise, subject to income and payroll taxes.

• At exercise: the spread is ordinary income.
• At sale: any additional gain above the exercise price is a capital gain.
• Hold for more than a year after exercising to qualify for long-term capital gains rates.

How are Incentive Stock Options (ISOs) taxed?

ISOs have a more favorable tax structure. There is no ordinary income tax at exercise. However, the spread at exercise is counted as an AMT preference item, which can trigger the Alternative Minimum Tax even if you have not sold a single share.

If you hold ISO shares for at least two years from the grant date and one year from the exercise date, all the gain gets taxed at long-term capital gains rates. Sell too early and you trigger a disqualifying disposition, which means the spread gets taxed as ordinary income.

Engineers at commercial space and defense tech companies who received early ISO grants at low strike prices are sitting on a common and dangerous situation. If the company valuation has grown significantly since your grant date, exercising a large ISO block in a single year can generate a six-figure AMT bill before you have seen a cent of liquidity. Model the AMT before exercising. Talk to a CPA who has handled this before.

How are ESPP shares taxed?

ESPP taxation depends on whether your sale qualifies as a qualifying or disqualifying disposition. The main variable is how long you held the shares after purchase. Qualifying dispositions get partial capital gains treatment on the discount. Sell too early and the discount is taxed as ordinary income.

Most major defense primes offer ESPPs with a 10 to 15 percent discount. Even if you sell immediately after purchase, a disqualifying disposition, the guaranteed discount is still a meaningful return. Most defense professionals should participate at a reasonable level. The optimal holding period for tax purposes is worth understanding before you make that decision.

What are the most important equity tax planning moves?

Most equity tax mistakes are preventable. They come from not knowing when a tax event is coming and not having cash available when it arrives.

• Always reserve cash for taxes when RSUs vest, especially if employer withholding falls short of your actual bracket.
• Model the AMT before exercising ISOs. This is non-negotiable for large grants.
• Think about holding periods before you sell. The difference between short and long-term capital gains rates adds up.
• Low-income years are good times to exercise options. Transitions, gaps between contracts, and early retirement windows all qualify.
• Keep records of every grant date, exercise date, vesting date, and price. You will need them for your tax return.
• Work with a CPA who understands equity, not just a general tax preparer.

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This content is for educational and informational purposes only and should not be considered personalized investment, tax, or legal advice. The information provided is general in nature and may not apply to your individual circumstances. All investments involve risk, including the potential loss of principal.
The Freyr Group, LLC does not provide legal or tax advice. Any references to tax-related topics are provided for general informational purposes only, and individuals should consult with a qualified tax professional regarding their specific situation.
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