ABOUT THE AUTHOR: Amelia Ungureanu is an EA with more than 7 years of experience in small business accounting. She completed her bachelor’s degree in 2012 and her master’s degree in 2016. Amelia enjoys working with technology and staying up to date with taxes. She embraces the demands to expand her tax knowledge through research and continuing education. She is passionate about helping her clients understand and take control of their unique tax situations.
Incentive stock options (ISOs) are an attractive form of compensation because of their favorable tax treatment. There is generally no tax consequence upon exercise (with careful tax planning to avoid AMT). If the holding period is satisfied, the gain on sale of ISOs is subject to lower long-term capital gains rates. But are you aware of the $100,000 ISO rule.
What Is the $100,000 ISO Rule?
Like most things in the tax world, there can be too much of a good thing, which is why Section 422 of the Internal Revenue Code places a $100,000 yearly limit on exercisable ISOs. This means only up to $100,000 of ISOs can be first exercisable (generally at vesting) in a year. Any ISOs that become exercisable beyond this $100,000 in the same year automatically become non-qualified stock options (NQSOs). NQSOs do not enjoy the same favorable tax treatment as ISOs. When exercised, NQSOs trigger income tax at ordinary tax rates on the bargain element, which is the difference between the fair market value on the date of exercise and the exercise price. Additional tax will be owed once the NQSOs are sold: ordinary rates if held less than a year and long-term rates if held greater than a year.
The $100,000 limit on ISOs is calculated using the fair market value of the stock on the date of the grant. This amount typically becomes the exercise price. Any subsequent changes in the price of the stock leading up to and including the date of exercise are irrelevant in the $100,000 limit calculation.
Jim was granted 20,000 ISOs when the stock was worth $20/share. The exercise price was set at $20/share. A year later, 25% of the shares vest, and Jim exercises 5,000 ISOs when the stock is worth $25/share. All 5,000 shares retain their character as ISOs, since only $100,000 worth of ISOs vested that year.
It is important to note that the $100,000 limit does not mean you can only exercise $100,000 of ISOs in a calendar year. The limit applies only to the vesting, not the actual exercise. For instance, $100,000 could vest in Year 1, then another $100,000 could vest in Year 2. In Year 2, you could then exercise $200,000 of ISOs.
Certain Situations Can Make You Exceed the $100,000 Limit
Most companies carefully structure their grants to avoid going over the $100,000 limit. However, certain situations could put you at risk of going over the $100,000 limit, some of which can be unexpected and unavoidable.
For example, Bob has 120,000 shares worth $2/share that are subject to 4-year vesting with a 1-year cliff. The cliff vesting occurs in January, so $60,000 of ISOs become available (25% x 120,000 x $2 per share). Following this, an additional 2,500 shares would continue to vest each month between February and December, totaling $55,000 (2,500 * 11 months * $2 per share). This means $15,000 of ISOs will become NQSOs.
Overlapping Grants with Graded Vesting
For example, Sue has $70,000 of ISOs from grants that will vest in Year 1. Also during Year 1, Sue is given another grant of ISOs, of which $40,000 will vest in Year 1. A combined total of $110,000 of ISOs will vest in Year 1, which means $10,000 of ISOs will become NQSOs.
Certain Canceled ISOs
If ISOs are canceled prior to the year they are first exercisable, they do not count toward the $100,000 limit. If ISOs are already exercisable or are canceled in the year they become exercisable, they will count toward the $100,000 limit until the end of the calendar year.
Early Exercise Opportunities
Early exercises allow you to exercise stock options before they vest. Because the limitation is based on when shares become first exercisable, this means the entire grant is subject to the $100,000 limit when granted.
Accelerated vesting can occur as a result of a company merger or job termination. More exercisable shares that become available sooner could put you above the $100,000 limit.
Navigating the $100,000 ISO Rule
Finally, it should also be noted that the $100,000 limit cannot be circumvented through a disqualifying disposition, i.e. exercising and immediately selling or gifting the ISOs. Your employer can help clarify any questions you have regarding your proximity to the $100,000 limit. Moreover, your financial and tax advisors can help you navigate the implications of staying under or surpassing the $100,000 limit.