Pro-Rata Rule for Equity Comp: How Moving States Affects Taxes on ISO/NSO/RSU Equity

If you've built wealth through stock options or RSUs at a pre-IPO company, there's a state tax rule that surprises some folks come tax time. It's called the pro-rata rule, and most people either misunderstand it or don't know it exists. Here's how it works and what most people get wrong.

What Is the Pro-Rata Rule?

The pro-rata rule determines if/how multiple states tax your equity compensation when you've moved between states during your vesting period. It applies to ISOs, NSOs, and double-trigger RSUs – basically any equity that vests over time but doesn't trigger taxable income until a future date.

Here's the key insight: For which state(s) may tax you on equity compensation income — where you worked while you were vesting is predominately what matters. But even then it's a bit more nuanced…

The First Mistake: Assuming Current Location Determines Tax Liability

Many people assume their state taxes will be based on where they live when the income tax triggering event actually occurs. This is mostly incorrect.

Nearly every state with an income tax uses pro-rata rules that allocate the income by where you worked while the equity was vesting.

Example: If you vested 100% of your stock options in California, moved to Texas, and then exercised them — you still owe income tax to California (in this case on 100% of the income the option generated).

The Second Mistake: Misinterpreting How Pro-Rata Is Administered

Even if you know about the pro-rata rule, the exact mechanics are often misunderstood. Let me show you with a real example. Imagine you vested your NSOs like this:

• 25% while working in Texas

• 50% while working in California

• 25% while working in New York (where you live now)

Most people think this means 25% gets taxed by Texas, 50% by California, and 25% by New York. That seems logical, right? But it would also be wrong…

How Pro-Rata Really Works

Pro-rata rules for income tax from equity comp have two key rules:

1. The percentages for calculations apply based on where you lived while you vested

2. The state you live in when the income triggering event occurs will claim 100% of the income as state-sourced, but credit you if you owe other states a pro-rata

Let’s use our prior example of 25% TX; 50% CA; 25% NY; and income realized in NY:

• New York (where you live now) claims 100% of your NSO income when the taxable event occurs (in this case, when you exercise your NSOs).

• California claims tax on 50% since you vested half your shares while living there.

• New York gives you a credit on your taxes for what you pay California, so you don't get double-taxed.

• The result: You end up paying 50% to California and 50% to New York. And NOT the 25%/50%/25% split you expected.

YES — this can/does seem unfair if you vested in a 0% tax state (or low tax state) but then moved to a higher tax state. In the above example, you read it correct — you do not get any tax benefit for living in a 0% tax state (Texas). With NY as your “tax realizing” state, it taxes 100% of the income, and then credits back to avoid double taxation.

What This Means for You

Understanding the pro-rata rule is crucial for tax planning, especially if you're considering a move between states. Here are the key takeaways:

• Know the rules + plan your relocation strategically (if you can). The timing of when you change states can significantly impact your tax bill. For example, if you vested 100% of your NSOs in Texas but moved to New York before exercising, you'll pay New York taxes on 100% of the income instead of paying $0.

• Keep detailed records of where you worked and when your equity vested. You'll need this for accurate tax calculations.

• Don't assume you'll avoid state taxes by moving to a no-tax state before the income tax triggering event occurs. Per above, this is not true and you still owe a pro-rata tax to them.

• If you’re uncertain —> consult a professional who understands these rules. The pro-rata calculations can get complex, especially with multiple moves and different types of equity compensation that have different income tax triggering events.