In short
When you receive equity in an AI startup, federal tax law treats each type differently. Restricted stock is taxed at vesting unless you file a Section 83(b) election within 30 days to be taxed at grant. Restricted stock units (RSUs) are always taxed at vesting. Nonqualified stock options (NSOs) are taxed when you exercise them. Incentive stock options (ISOs) let you defer tax until you sell the shares, but exercising them can trigger the alternative minimum tax (AMT) on the paper gain. Profits interests in LLCs are usually tax free at grant if structured correctly. If you hold qualified small business stock in a C corporation for five years, the Section 1202 exclusion can wipe out federal tax on up to $15 million of gain (for stock acquired after July 4, 2025). 26 U.S.C. § 1202
When does the IRS tax you on equity?
The general rule comes from Section 83. It says that when you get property, including stock, for services, you include the excess of its fair market value over the amount paid for it in your gross income in the first taxable year the property is transferable or no longer subject to a substantial risk of forfeiture, whichever is applicable. 26 U.S.C. § 83(a) A substantial risk of forfeiture means you could lose the shares if you leave the company before they vest. In plain words, the IRS taxes you when the shares vest. You pay tax on the value of the shares on that vesting date, minus any amount you paid for them.
But you can elect a different timing. Section 83(b) lets you choose to be taxed at the grant date instead of at each vesting date. To do so, you must file the election with the IRS within 30 calendar days after you receive the shares. 26 U.S.C. § 83(b) The election is irrevocable. You cannot change your mind later. Because you use the fair market value on the grant date, which is often much lower, this can save a great deal of tax.
The risk is that if you leave the company before vesting and forfeit the stock, you do not get a refund of the tax you paid at grant. IRS Revenue Procedure 2012-29 So you should only elect 83(b) if you believe the company will succeed and you will stay.
The IRS now has a standard form for this election, Form 15620. You must also give a copy to your employer. IRS Form 15620
How is restricted stock taxed?
Restricted stock is common for founders. You may receive shares subject to a vesting schedule, sometimes for a low purchase price. Consider an example. A founder receives 1 million restricted shares with a grant date value of 5 cents per share, vesting over four years. If the founder files an 83(b) election, they report $50,000 of ordinary income at grant. At a 35 percent tax rate, that costs $17,500. If the founder does not file, each vesting tranche is taxed at the then current value. By the later vesting dates, the shares might be worth several dollars each, creating hundreds of thousands of dollars of taxable income. The total tax bill could exceed $700,000 more than with the election. Tax analysis
The 83(b) election also starts the clock for long term capital gains holding period and for the qualified small business stock five year holding period. That is important for founders who plan to sell their shares later and claim the Section 1202 exclusion.
How are restricted stock units (RSUs) taxed?
An RSU is a promise to give you shares when vesting conditions are met. Because an RSU is not actual stock until the shares are delivered, the Section 83(b) election is not available. Tax alert When the RSUs vest, the company delivers shares. You then have ordinary income equal to the fair market value of those shares. The company withholds income and payroll taxes.
This can create a problem for private company employees. They owe tax on shares they cannot sell because the stock is not publicly traded. Many AI startups avoid RSUs for this reason and use stock options instead.
How are nonqualified stock options (NSOs) taxed?
An NSO gives you the right to buy company shares at a fixed exercise price. At grant, you generally have no tax because a private company option has no readily ascertainable value. You are taxed later, when you exercise. At exercise, the spread (fair market value of the stock minus the exercise price) is ordinary compensation income. Treas. Reg. § 1.83-7 The company must withhold income tax, Social Security tax, and Medicare tax.
If you exercise an NSO early, before the shares vest, you receive restricted stock. At that point you can file an 83(b) election for the restricted stock you received. This can limit future tax if the stock value rises. Because NSOs are taxed at exercise, many employees exercise only when they can sell some shares to cover the tax.
How are incentive stock options (ISOs) different?
ISOs get special tax treatment if they meet strict rules under Section 422. The option must be granted under a written plan approved by shareholders. The exercise price cannot be less than the fair market value of the common stock on the grant date (110 percent for a 10 percent owner). The option term cannot exceed 10 years (5 years for a 10 percent owner). The total value of ISOs first exercisable in any calendar year cannot exceed $100,000, measured at grant. Any options over that limit are treated as NSOs. 26 U.S.C. § 422
When you exercise an ISO, you do not owe regular income tax at that time. The company does not withhold. However, the spread at exercise is an adjustment item for the alternative minimum tax, which I explain below.
If you hold the shares for more than two years from the grant date and more than one year from the exercise date, the entire gain above your exercise price when you sell is taxed as long term capital gain. That is a qualifying disposition. If you sell before meeting those holding periods, it is a disqualifying disposition. The spread up to the sale price is ordinary income, and any extra gain is capital gain. Treas. Reg. § 1.421-2(b)(1), Treas. Reg. § 1.422-1(b)
If you leave the company, you generally have only three months after termination to exercise your ISOs and keep ISO treatment. The window is one year for disability and unlimited for death. 26 U.S.C. § 422(c)(6), 26 U.S.C. § 421(c)(1) Missing this window turns any remaining ISOs into NSOs, taxed at exercise.
Some AI startups allow early exercise of unvested ISOs. This can start the holding periods early. For AMT, however, the tax event normally happens when the stock vests, not at exercise, under Section 56(b)(3). You can file an 83(b) election for AMT purposes at early exercise to lock in the current spread as your AMT income. That can reduce AMT if the stock price rises before vesting. 26 U.S.C. § 56(b)(3), 26 U.S.C. § 83(b)
What about the alternative minimum tax (AMT) and ISOs?
The AMT is a parallel tax system. When you exercise an ISO, the bargain element (the spread) is added to your alternative minimum taxable income, even though you have not sold the shares and have no cash from them. 26 U.S.C. § 56(b)(3) Many employees are surprised to owe a large AMT bill.
Here is a real example. Sarah, a single founder, earns a salary of $160,000 in 2026. She exercises 50,000 ISOs with a $2 strike price when the fair market value is $10 per share, producing a $400,000 spread. Her regular taxable income is low. But for AMT, her income becomes $560,000. The 2026 AMT exemption is $90,100 for single filers, but it phases out starting at $500,000 of AMT income. The phaseout rate is 50 percent. Sarah’s AMT income exceeds the threshold by $60,000, so her exemption falls by $30,000, leaving an exemption of $60,100. Her tentative AMT is about $135,000. After subtracting her regular tax of roughly $29,400, she owes about $105,600 in AMT. Her total federal tax bill is approximately $135,000 on a $160,000 salary, and she has no proceeds from selling the stock to pay it. Tax analysis
The 2026 changes under the One Big Beautiful Bill Act make this worse. While the AMT exemption is slightly higher than in 2025, the phaseout thresholds are lower ($500,000 single, $1,000,000 married) and the phaseout rate doubled from 25 percent to 50 percent. In the phaseout zone, each extra dollar of AMT income is taxed at an effective rate of 42 percent. That is higher than the top regular ordinary rate of 37 percent. Tax analysis, Tax analysis
You do not lose the AMT you pay forever. The AMT creates a minimum tax credit that you can use in future years when your regular tax exceeds your tentative AMT. In a later year when you sell the shares, you may recover some of that AMT credit. But the timing is uncertain. AMT credit analysis
Another example shows the credit recovery. A married employee with $300,000 of W-2 income exercises 10,000 ISOs with a $10 strike and $50 fair market value, creating a $400,000 bargain element. Regular tax is about $48,000. AMT tentative tax is about $150,725. They owe an additional $102,725 in AMT. The following year, their regular tax exceeds their tentative AMT by $8,000, and they recover that much of the prior AMT credit. Full recovery may take many years. Financial analysis
Before exercising ISOs, you should model your AMT exposure, especially with the new 2026 phaseout rules. The tax on paper gains can be severe.
Why does Section 409A matter for option pricing?
Every stock option, ISO or NSO, must have an exercise price at or above the fair market value of the common stock on the grant date. If the exercise price is too low, the option becomes deferred compensation subject to a harsh tax penalty under Section 409A. The employee, not the company, pays a 20 percent additional tax plus interest on the undervalued amount. 26 U.S.C. § 409A, Treas. Reg. § 1.409A-1(b)(5)
To protect yourself, AI startups hire an independent appraiser to perform a 409A valuation. The valuation sets the fair market value of the common stock. If the valuation is done correctly by a qualified appraiser, the IRS presumes it is reasonable. The safe harbor valuation is valid for 12 months unless a material event happens, such as the resolution of material litigation or the issuance of a patent. Treas. Reg. § 1.409A-1(b)(5)(iv)(B), IRC § 409A(a)(1)(B)
These valuations typically cost between $2,000 and $9,000 for an early stage startup and take two to four weeks. Valuation provider Many startups use cap table platforms that bundle valuations.
Can you defer tax on private company equity under Section 83(i)?
There is a little used provision that allows employees of certain private companies to defer income tax on options or RSUs for up to five years. To qualify, the company must grant options or RSUs to at least 80 percent of its U.S. employees (excluding part-time and certain excluded employees) in the same calendar year. Tax alert Current and former CEOs, CFOs, one percent owners, and the four highest paid officers cannot use it. Even if an employee qualifies, the deferral ends early if the stock becomes transferable or the company goes public. The employee still owes employment taxes at vesting. Because the 80 percent participation rule is hard to meet and the benefits are narrow, very few startups implement 83(i) plans.
How does the qualified small business stock (QSBS) exclusion work?
Section 1202 offers one of the biggest tax breaks for early equity holders in C corporations. If you hold qualified small business stock for more than five years, you can exclude a portion of your capital gain from federal tax. The One Big Beautiful Bill Act, signed on July 4, 2025, expanded this benefit. 26 U.S.C. § 1202
For stock issued before July 4, 2025, the old rules apply. The exclusion is 100 percent after five years, with a per issuer cap of $10 million or 10 times your basis, whichever is larger, and a $50 million aggregate asset test for the corporation.
For stock issued on or after July 4, 2025, the new rules apply. The exclusion is now tiered. You can exclude 50 percent of the gain after a three year holding period, 75 percent after four years, and 100 percent after five years. The per issuer cap rises to $15 million (indexed for inflation after 2026). The aggregate asset test rises to $75 million. 26 U.S.C. § 1202
To qualify, the stock must be in a domestic C corporation that uses at least 80 percent of its assets in an active trade or business. Certain service businesses do not qualify, but most technology companies do. The stock must be acquired directly from the company for money, property, or services. So founder stock, early employee option exercises, and RSUs can all be QSBS if the other tests are met.
The QSBS five year clock starts on the date you acquire the stock. For founders who file an 83(b) election on restricted stock, the holding period starts at the grant date, not the later vesting dates. That can shave years off the required holding period. Without the election, each vesting tranche starts its own five year clock, delaying eligibility.
Here is the practical upshot for an AI founder. If you incorporate as a Delaware C corporation, buy your shares early at a low price, file an 83(b) election, and hold them for five years, you may pay zero federal tax on the first $15 million of gain when you sell. If you form an LLC taxed as a partnership, your LLC interest is not QSBS, because Section 1202(c)(1) requires QSBS to be stock in a C corporation, and Section 1202(g) does not define whether a profits interest constitutes an interest for the pass-through exclusion. 26 U.S.C. § 1202 That structural choice alone can mean a tax difference of millions.
What is the net investment income tax (NIIT)?
The 3.8 percent net investment income tax is an extra surtax on investment income when your modified adjusted gross income exceeds certain thresholds. 26 U.S.C. § 1411 When you sell stock from an equity grant, your capital gain is net investment income. If your income is above $200,000 (single) or $250,000 (married filing jointly), the 3.8 percent tax applies on top of the capital gains rate. So a qualifying ISO sale could be taxed at 20 percent for capital gains plus 3.8 percent for NIIT, for a 23.8 percent total rate. The NIIT does not apply to ordinary income from NSO exercise or RSU vesting. IRS Form 8960 instructions The NIIT thresholds are not adjusted for inflation, so more families become subject to it over time.
How are profits interests in LLCs taxed?
Many AI startups are organized as limited liability companies (LLCs) and grant profits interests to founders and key employees. A profits interest gives you a share of future equity value, not current capital. Under IRS guidance in Revenue Procedures 93-27 and 2001-43, receiving a properly structured profits interest is generally not a taxable event at grant, provided it has a liquidation value close to zero at the time of grant. Rev. Proc. 93-27, Rev. Proc. 2001-43
Even though an 83(b) election is not required, nearly every tax professional recommends filing a protective 83(b) election within 30 days. The election locks in a zero or low fair market value at grant and offers the potential for long-term capital gains on all future appreciation. The Tax Adviser
Consider a chief technology officer who receives a 5 percent profits interest when the company is worth near zero. She files an 83(b) election immediately. Five years later the company sells for $20 million. Her $1 million share is taxed entirely at long term capital gains rates. Without the 83(b) election, each year as the interest vests, part of the value could be treated as ordinary income when the company is already valuable.
LLC profits interests do not qualify for the QSBS exclusion under Section 1202 because the issuer is not a C corporation. 26 U.S.C. § 1202 This is a significant structural disadvantage compared with C corporation equity.
Key takeaways
- File an 83(b) election within 30 days when you receive restricted stock or early exercise options, unless the cost of paying tax early outweighs the potential savings.
- ISO exercises can trigger surprising AMT bills, especially under the 2026 phaseout rules. Model the exposure before you exercise.
- Get a 409A valuation at least every 12 months so your option exercise prices are safe from the 20 percent penalty tax.
- If you plan to hold for five years, structure as a C corporation to qualify for QSBS. The expanded Section 1202 after July 2025 makes this even more valuable.
- RSUs and NSOs produce ordinary income you cannot defer, so plan for the tax withholding.
- For LLCs, a protective 83(b) election on a profits interest is almost always a good idea, but remember you give up QSBS.
- NIIT adds 3.8 percent to capital gains from equity sales above the income thresholds. Factor it into your sale planning.
Frequently asked questions
Q:What is the 83(b) election and do I need it?
A:The 83(b) election lets you pay tax on the value of your restricted stock or early exercised options on the grant date instead of when the shares vest. You need it if the value at grant is low and you expect the stock value to rise. You must file it within 30 calendar days. 26 U.S.C. § 83(b)
Q:Can I file an 83(b) election late?
A:No. The 30 day deadline is absolute. Late elections are not accepted. IRS Form 15620 instructions
Q:Do ISOs trigger tax when I exercise them?
A:They do not trigger regular income tax, but the spread is added to your income for alternative minimum tax. That can cause a large AMT bill even if you do not sell the shares. 26 U.S.C. § 56(b)(3)
Q:What is the AMT trap with ISOs?
A:If you exercise ISOs in a year when the stock price is high, you may face an AMT bill that far exceeds your regular tax. That bill is based on paper gains, not cash you received. This is known as the AMT trap. The 2026 tax changes widened the trap by lowering the phaseout thresholds and raising the phaseout rate. Tax analysis
Q:Do I need a 409A valuation for my startup?
A:Yes, if you grant stock options. The valuation sets the exercise price. Without a valid valuation, the option may be treated as deferred compensation and the employee can be hit with a 20 percent penalty tax. Treas. Reg. § 1.409A-1(b)(5)(iv)(B)
Q:What is QSBS and how do I qualify?
A:QSBS stands for qualified small business stock. You can exclude up to 100 percent of your capital gain from federal tax if you hold the stock for more than five years. The company must be a U.S. C corporation with gross assets not exceeding $75 million (or $50 million for shares issued before July 4, 2025) when you get the shares, and you must acquire the stock at its original issue (directly or through an underwriter) for money, other property (not including stock), or as compensation for services. 26 U.S.C. § 1202
Q:Can LLC members get QSBS?
A:No. Only stock in a C corporation can be QSBS. If your AI startup is an LLC taxed as a partnership, it cannot issue QSBS while taxed as a partnership, but converting to a C corporation can start QSBS eligibility for post-conversion appreciation, with the holding period beginning at conversion. 26 U.S.C. § 1202(c), 26 U.S.C. § 1202(i)(1)(A), Treas. Reg. § 301.7701-3
Q:How are RSUs taxed differently from stock options?
A:RSUs are taxed at vesting as ordinary income, and you cannot use an 83(b) election to accelerate tax. Options can defer tax (ISOs) or trigger tax at exercise (NSOs), and you can sometimes use an 83(b) election after early exercise. RSUs are simpler but can create phantom income on illiquid stock.
Q:What is the net investment income tax and does it apply to my equity?
A:The 3.8 percent NIIT applies to investment income, including capital gains from selling shares, when your income exceeds $200,000 (single) or $250,000 (married). It does not apply to ordinary income from NSO exercise or RSU vesting. 26 U.S.C. § 1411
Q:Is Section 83(i) a good option for deferring tax?
A:Not usually. It requires the company to grant equity to at least 80 percent of U.S. employees annually and excludes many key staff. The five year deferral sounds useful, but the restrictions make it impractical for most AI startups. IRS Notice 2018-97, Law firm analysis, Tax alert
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Junde Liu, JD, LL.M. (Taxation) candidate at UF Law. Originally published on Compute Law Blog. This article is general information and does not constitute legal advice. Reading it does not create an attorney client relationship. The reader should not act on the basis of any content here without first consulting a licensed attorney in the relevant state. Last reviewed for accuracy May 23, 2026.