A candidate sees a $55,000 gain on stock sold just 8 months after exercise. They correctly identify it as a short-term capital gain and move on. They fail the question. The examiner's trap wasn't the holding period for capital gains; it was the disqualifying disposition of an incentive stock option, which recharacterized $30,000 of that gain into ordinary W-2 income, completely changing the tax outcome.
The "Wages, salaries, and tips" topic on EA SEE Part 1 tests all forms of employee compensation, including cash, fringe benefits, and stock options. Success requires distinguishing between taxable and non-taxable income, understanding income recognition timing, and correctly calculating the impact on Adjusted Gross Income (AGI).
Key facts
- Exam Section: Special Enrollment Examination (SEE) Part 1: Individuals
- Topic Weighting: "Income" constitutes 17% of SEE Part 1
- Official Body: Internal Revenue Service (IRS)
- Passing Score: 105 (on a scaled score of 40-130)
- Question Format: 100 multiple-choice questions (MCQs)
- Time Allotment: 3.5 hours per part
What Are Wages, Salaries, and Tips on the EA Exam?
This topic covers all remuneration for services an employee performs for an employer. It's the starting point for the Form 1040 and includes base salary, bonuses, tips, and non-cash compensation like fringe benefits and stock options.
On the SEE Part 1 exam, this content appears in two ways. First, you'll face direct questions asking you to identify taxable income. These test your knowledge of specific rules, like the exclusion for employer-provided health insurance or the reporting requirements for cash tips.
Studying for EA SEE1? Benchmark your score in 5 minutes.
Get an instant weak-spot assessment and a custom 12-week study plan PDF generated for your exam window.
Second, these concepts are embedded in larger scenario questions. You might need to calculate a taxpayer's AGI. If you misclassify a taxable fringe benefit as non-taxable, your starting income is wrong, your AGI is wrong, and every subsequent calculation based on AGI will also be wrong. This is how a single mistake on a fundamental topic cascades into multiple lost points. Examiners love to test the gray areas: stock options, reimbursed expenses, and the valuation of taxable benefits. Try VoraPrep's free EA practice questions to see how these concepts are tested.
What Key Compensation Rules Must I Know for 2026?
Success on this topic requires understanding the specific tax treatment for different compensation types. Memorizing a list isn't enough; you need to apply the rules to exam-day scenarios.
Employee Stock Options: The ISO vs. NSO Trap
This is one of the most tested and difficult areas. The tax treatment depends entirely on the type of option.
| Feature | Incentive Stock Options (ISO) | Non-Statutory Stock Options (NSO) |
|---|---|---|
| Tax at Grant | No tax event. | No tax event (if exercise price is FMV). |
| Tax at Exercise | No regular tax event. AMT adjustment applies. | Ordinary income on bargain element (FMV - exercise price). |
| Tax at Sale | Long-term capital gain if holding periods are met. | Capital gain (long or short) on sale price minus basis. |
| Employer Deduction | No deduction if employee meets holding periods. | Deduction for amount of employee's ordinary income. |
| Holding Periods | Must hold stock >2 years from grant AND >1 year from exercise. | No special holding periods apply for tax characterization. |
The single most important concept here is the disqualifying disposition. If an employee with an ISO sells their stock without meeting both holding period requirements, the bargain element at exercise becomes taxable as ordinary W-2 income in the year of sale. This is a favorite exam trick.
Employee Stock Purchase Plans (ESPPs)
Covered under IRC §423, these plans let employees buy company stock at a discount. The tax treatment is similar to ISOs. If holding periods are met (more than two years from the offer date and one year from the exercise date), the ordinary income component is limited. If not, a disqualifying disposition occurs, and the bargain element at the exercise date is treated as ordinary income.
Taxable vs. Non-Taxable Fringe Benefits (IRC §132)
The general rule under IRC §61 is that all fringe benefits are taxable unless a specific law excludes them. You must know the key exclusions under IRC §132:
- No-additional-cost services
- Qualified employee discounts
- Working condition fringes
- De minimis fringes
- Qualified transportation fringes: For 2024, this was up to $315/month for transit passes and parking. The 2026 limit will be adjusted for inflation; always verify the current year's amount.
- Qualified retirement planning services
- Employer-provided health insurance coverage
For taxable benefits, you must also know the valuation rules. A common example is employer-paid group-term life insurance: the cost of coverage over $50,000 is taxable income to the employee, calculated using an IRS premium table.
The 2026 Reversal of Moving Expense Rules
This is a critical update for the 2026 exam. The Tax Cuts and Jobs Act (TCJA) made employer-paid moving expense reimbursements taxable income for non-military personnel from 2018 through 2025.
That provision expires after December 31, 2025.
For tax year 2026, the pre-TCJA rules are scheduled to return. This means reimbursements for qualified moving expenses will once again be excludable from an employee's income if paid under an accountable plan. Examiners will likely test this change to catch candidates relying on outdated information.
Accountable vs. Nonaccountable Plans
This distinction determines whether employee expense reimbursements are included in W-2 wages.
- Accountable Plan: Reimbursements are NOT reported as wages. To qualify, the plan must require employees to (1) have incurred expenses with a business connection, (2) adequately account for these expenses to the employer, and (3) return any excess reimbursement in a reasonable time.
- Nonaccountable Plan: Reimbursements ARE reported as wages on Form W-2 and are subject to income and employment taxes. Any plan that fails one of the three accountable plan tests is a nonaccountable plan.
Other Key Distinctions: Statutory Employees & NQDC
Be aware of two other classifications:
- Statutory Employee: This is a specific category of independent contractor treated as an employee for employment tax purposes (FICA/FUTA). Their income is reported on Schedule C, but they don't pay self-employment tax. Look for Box 13 on Form W-2 to be checked.
- Non-Qualified Deferred Compensation (NQDC): Under IRC §409A, NQDC is generally included in income when it is no longer subject to a substantial risk of forfeiture. This is a complex area, but for the exam, focus on the timing of income recognition.
Worked Example: Unpacking a Disqualifying ISO Disposition
Let's walk through a scenario that highlights the most common stock option trap.
Scenario: On February 1, 2024, ACME Corp grants its employee, David, an incentive stock option (ISO) to purchase 100 shares of ACME stock at $20 per share. On that date, the fair market value (FMV) of the stock is also $20.On March 1, 2025, when the stock's FMV is $50 per share, David exercises his option and buys all 100 shares for $2,000 (100 shares x $20).
On October 15, 2025, David sells all 100 shares for $75 per share, receiving $7,500.
What is the tax impact for David in 2025?
Step 1: Identify the Event and Check Holding PeriodsThis is an ISO. The key is to check the holding periods for a qualifying disposition:
- Hold for >2 years from grant date? No. The grant was Feb 1, 2024, and the sale was Oct 15, 2025 (less than 2 years).
- Hold for >1 year from exercise date? No. The exercise was Mar 1, 2025, and the sale was Oct 15, 2025 (less than 1 year).
David failed both tests. This is a disqualifying disposition.
Calculate Your Required EA Study Hours
See exactly how many hours you need across SEE 1, 2, and 3 based on your experience and target test window.
Because it's a disqualifying disposition, David must recognize ordinary income equal to the bargain element at the date of exercise.
- FMV at exercise: $50/share
- Exercise price: $20/share
- Bargain element per share: $50 - $20 = $30
- Total ordinary income: $30/share x 100 shares = $3,000
This $3,000 will be reported as wages on David's Form W-2.
Step 3: Calculate the Capital Gain ComponentDavid's basis in the stock is his original cost plus the ordinary income he recognized.
- Original cost: $2,000 (100 shares x $20)
- Ordinary income recognized: +$3,000
- David's adjusted basis: $5,000
Now, calculate the capital gain:
- Sale proceeds: $7,500 (100 shares x $75)
- Adjusted basis: -$5,000
- Capital gain: $2,500
Since he held the stock from March 1 to October 15, this is a short-term capital gain.
The Tempting Wrong AnswerThe common mistake is to ignore the disqualifying disposition. A candidate might calculate the total gain of $5,500 ($7,500 proceeds - $2,000 cost) and classify it all as a short-term capital gain. This is incorrect because it fails to recognize the $3,000 of ordinary wage income, which is taxed at a different rate and impacts the AGI calculation differently.
How to Test Your Knowledge with Practice Questions
Seeing how these concepts are framed in exam-style questions is critical. The VoraPrep question bank has over 3,000 questions, including dozens specifically on employee compensation, to help you build this skill.
Question 1 Emily received her Form W-2 from her employer, GreenTech Solutions. Which box on Form W-2 shows the total amount of federal income tax withheld from her pay for the year?> Correct Answer: A > Explanation: Box 2 of Form W-2 specifically reports the total federal income tax withheld from an employee's wages for the year. Box 1 reports total wages, tips, and other compensation. Box 3 shows Social Security wages (up to the annual limit).
Question 2 Sarah served on a jury for one week and received $300 in jury duty pay. Her employer continued to pay her full salary but required her to turn over the jury duty pay. Sarah gave the $300 to her employer. How should Sarah report this?> Correct Answer: A > Explanation: Jury duty pay is taxable income. When an employee must give this pay to their employer, they must first include the jury pay in income. They can then deduct the amount given to the employer as an adjustment to income (an "above-the-line" deduction). Answer B is a common error.
Question 3 Jane works as a server. In March, she received $25 in cash tips. By what date must Jane report these tips to her employer?> Correct Answer: B > Explanation: An employee must report cash tips to their employer by the 10th of the month after the month the tips are received. This rule applies if the employee receives $20 or more in tips in a calendar month. The deadline for March tips is April 10.
To truly test your readiness, work through dozens of questions like these. Our adaptive learning engine at VoraPrep will identify your weak spots in this topic and serve you questions to strengthen them. You can also review our full EA exam format and details breakdown.
What Is the Best Study Strategy for This Topic?
- Connect Wages to AGI: Wages are the starting point for the entire Form 1040. As you study, constantly ask, "How does this affect AGI?" Understanding that link is crucial for topics like calculating key above-the-line deductions.
- Focus on the Exceptions: The general rule is "everything is income." Spend your time on the specific statutory exclusions. Create flashcards for non-taxable fringe benefits and the holding period rules for ISOs and ESPPs.
- Review the Forms: Pull up a blank Form W-2 and Form 1040. Trace where the numbers go. Look at Box 1, Box 12 codes, and Box 13 for statutory employees. This grounds the abstract rules in practical documents.
- Drill the Changes: For the 2026 exam, the moving expense rule change is a prime target. Make sure you understand both the 2018-2025 rule and the post-2025 rule to avoid being caught by a question set in a specific year.