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Capital gains and investment income are taxed at different rates than wage income, with their own rules for stock options, RSUs, the 3.8% Net Investment Income Tax, and loss harvesting. For small business owners with equity compensation from a current or prior employer, plus investment portfolios, plus business sale planning — the rules stack into significant planning opportunities. Here is the 2026 framework.
Stock options and equity compensation are taxed in three steps: at grant (usually no tax), at exercise or vesting (income tax event for most types), and at sale (capital gains tax). The tax treatment depends on whether the equity is an Incentive Stock Option (ISO), Non-Qualified Stock Option (NSO), Restricted Stock Unit (RSU), Employee Stock Purchase Plan (ESPP), or restricted stock with 83(b) election.
Each form has its own rules around timing of income recognition, withholding, and the favorable vs ordinary tax rate treatment. The wrong sequence of decisions can mean paying twice the federal tax on the same equity — once as ordinary income and again as capital gains because the basis wasn’t tracked correctly.
Restricted Stock Units (RSUs) are taxed as ordinary income on the date they vest, based on fair market value of the shares at vest. The vest value is added to W-2 wages and subject to federal income tax, FICA (7.65%), and state tax where applicable.
Employers typically withhold federal income tax at a flat 22% rate (37% on supplemental wages over $1 million). For most high earners, the flat 22% withholding is LOWER than their actual marginal tax rate (typically 32-37%), creating an underpayment at filing time. This is the RSU withholding gap — plan to make estimated tax payments to cover the gap.
If you hold RSU shares after vest, the cost basis equals the FMV at vest (the amount taxed as ordinary income). Any subsequent appreciation is taxed as capital gains at sale. Brokerages frequently report only the price you paid (often $0) — you must adjust the basis on Form 8949 to avoid being taxed twice on the same income.
ISOs (Incentive Stock Options) offer favorable tax treatment but require holding the shares at least 1 year past exercise AND 2 years past grant for a qualified disposition. If you meet both holding periods, the entire gain is taxed at long-term capital gains rates. Exercising ISOs and holding creates an AMT preference item — the spread between strike price and FMV at exercise is added to AMT income.
NSOs (Non-Qualified Stock Options) are taxed as ordinary income at exercise. The spread between strike price and FMV at exercise is added to W-2 wages (or Schedule C income for non-employees). Subsequent appreciation after exercise is taxed as capital gains at sale. NSOs don’t have ISO-style holding periods but also don’t qualify for the ordinary-income avoidance ISOs offer.
The choice between ISO and NSO is usually made by the granting company, not the employee. For pre-IPO employees with ISOs, the AMT mechanics around early exercise become critical planning territory.
The Net Investment Income Tax is an additional 3.8% federal tax on net investment income for high earners. Triggered when modified AGI exceeds $200,000 (single) or $250,000 (MFJ). Applies on top of regular capital gains rates, so a high earner pays an effective 23.8% on long-term capital gains (20% LTCG + 3.8% NIIT).
Items subject to NIIT: interest, dividends, capital gains (short and long), rental income (unless real estate professional), royalties, non-qualified annuity distributions. NOT subject to NIIT: salary, self-employment income, IRA/401(k) distributions, Social Security, municipal bond interest, gain from sale of active business interest.
Strategies to reduce NIIT exposure: increase pre-tax retirement contributions (reduces modified AGI), time capital gains for lower-income years, use municipal bonds for fixed-income allocation, harvest losses to offset gains, qualify for real estate professional status if applicable.
Capital losses are deductible against capital gains plus up to $3,000 against ordinary income per year (excess carries forward indefinitely). The rules:
Volatile investment portfolios can push high earners in and out of NIIT exposure year to year. Big gain years incur full NIIT; loss years can drop you below the threshold or trigger loss carryforward.
Tactical year-end harvesting matters: realizing $30,000 of losses to offset $30,000 of gains avoids $1,140 in NIIT (3.8%) plus the underlying capital gains tax. Realizing the same loss in a year you have NO gains converts the loss into ordinary income offset (up to $3,000) plus carryforward — less efficient.
For business owners with both active business income and investment portfolios, NIIT planning often overlaps with retirement contribution decisions. See our retirement tax guide for the broader high-income framework.
Year-end capital gains decisions are where most of the savings happen. Five common moves:
For Texas small business owners with concentrated stock positions (RSUs accumulated over years, ISO exercises, founder shares), proactive year-end planning typically beats reactive April filing by thousands. Let’s run the year-end model in October-November when there’s still time to act.
Until next time.
RSUs are taxed as ordinary income on the date they vest, based on fair market value at vest. The vest value is added to W-2 wages, subject to federal income tax, FICA, and state tax. If you hold the shares after vest, any subsequent appreciation is taxed as capital gains (long-term if held more than one year past vest). The cost basis equals the FMV at vest — important because brokerages frequently report only the price you paid (often $0), so you must adjust to avoid double taxation.
The Net Investment Income Tax is an additional 3.8% federal tax on investment income (interest, dividends, capital gains, rental income, royalties) for taxpayers above modified AGI thresholds: $200,000 single / $250,000 MFJ. Applies on top of regular capital gains rates. Strategies to reduce: increase pre-tax retirement contributions, time gains for lower-income years, use municipal bonds (NIIT-exempt interest), match gains with harvested losses.
ISOs are not taxed at exercise for regular income tax. The spread between strike price and fair market value at exercise is a preference item for Alternative Minimum Tax. If you hold the shares at least 1 year past exercise and 2 years past grant, any gain at sale qualifies for long-term capital gains treatment (qualified disposition). Selling earlier creates a disqualified disposition: the spread is taxed as ordinary income, with additional gain at capital gains rates.
Yes. Capital losses on stock sold for less than basis are deductible against capital gains plus up to $3,000 against ordinary income per year. Worthless stock losses are deductible in the year the stock becomes worthless (specific IRS rules apply). Long-term and short-term losses offset gains of the same type first, then cross-type, then offset ordinary income up to the $3,000 cap. Excess losses carry forward indefinitely.
NSOs are stock options that do not qualify for ISO tax treatment. The spread between strike price and fair market value at exercise is taxed as ordinary income — added to W-2 wages for employees, or Schedule C self-employment income for non-employees. Subsequent appreciation after exercise is taxed as capital gains when sold. Unlike ISOs, NSOs do not require holding periods for favorable tax treatment but also do not offer the ISO/AMT mechanics.
Adam Traywick, CPA is the President and founding CPA of Adam Traywick, LLC, a Fort Worth small-business accounting firm. He has over 20 years of experience helping small business owners across home-services trades, hair salons, real estate, and insurance agencies optimize taxes, run cleaner books, and avoid the surprises that come from once-a-year accountants.
