The $100,000 Limit on Incentive Stock Options: IRS Rules, Exceptions, and Real-World Scenarios Explained
What does the annual limitations of $100,000 for incentive stock options mean?
According to the IRS website, “there is a $100,000 annual limitation on the value of an employee's ISO that may become exercisable for the first time during any calendar year. See IRC § 422(d). This limit is determined based on the FMV of the stock at the time the option is granted and not at the time the option vests. To the extent in which an ISO is exercisable for the first time (first day the FMV exceeds $100,000), the excess amount over $100,000 is treated as a Non-Statutory Option, subject to all employment tax rules governing those options. At the time of exercise, this results in ordinary income to the employee and a wage deduction to the employer. See Treas. Reg. § 1.422-4 for rules related to the $100,000 rule. See IRC § 422(c)(5) for the special rules for a 10% owner.”
https://www.irs.gov/pub/irs-pdf/p5992.pdf
Background Concepts:
• ISO (Incentive Stock Option): A type of stock option that has specific tax advantages if certain conditions are met. One key rule is the $100,000 limit: no more than $100,000 worth of ISOs (based on their value at the time they were granted) can become exercisable in a single calendar year.
• Exercisable: When you are allowed to purchase the stock at the option's set price (the "exercise" price).
• NQSO (Non-Qualified Stock Option): A type of stock option without the special tax benefits of ISOs. If an ISO loses its status, it becomes an NQSO.
• Cancellation of ISOs: If an ISO grant is canceled, its treatment under the $100,000 rule depends on its vesting status at the time of cancellation.
• Underwater ISOs are stock options where the exercise price (the price at which the holder can buy the stock) is higher than the current market price of the company's stock. Underwater ISOs are generally a result of declining stock performance and can create challenges for both employees and companies trying to maintain motivation and alignment.
We learn by doing so let's look at some examples.
Example 1:
• Granted 40,000 shares
• Exercise Price is $10
• The fair market value of the stock at the time the option is granted is $10
• 25% of the option vests each year on the grant date
Calculation:
• 40,000 shares / 4 years (vest 25% annually) = 10,000 shares vest per year
• 10,000 shares X $10 "fair market value of the stock at the time the option is granted," not exercise price = $100,000
Year 1 | 10,000 X $10 = $100,000 | Remain ISO status
Year 2 | 10,000 X $10 = $100,000 | Remain ISO status
Year 3 | 10,000 X $10 = $100,000 | Remain ISO status
Year 4 | 10,000 X $10 = $100,000 | Remain ISO status
Example 2:
• Granted 40,000 shares
• Exercise Price is $12
• The fair market value of the stock at the time the option is granted is $10
• 25% of the option vests each year on the grant date
Calculation:
• 40,000 shares / 4 years (vest 25% annually) = 10,000 shares vest per year
• 10,000 shares X $10 "fair market value of the stock at the time the option is granted," not exercise price = $100,000 per year
Year 1 | 10,000 X $10 = $100,000 | Remain ISO status
Year 2 | 10,000 X $10 = $100,000 | Remain ISO status
Year 3 | 10,000 X $10 = $100,000 | Remain ISO status
Year 4 | 10,000 X $10 = $100,000 | Remain ISO status
Example 3:
The $100,000 limit applies to the total value of ISOs that vest in a single year. For multiple ISO grants, the annual limit is calculated by adding them up in the order they were granted, and any amount over this limit is automatically treated as NQSOs. See IRS Section 1.422 for more details.
https://www.irs.gov/irb/2004-36_IRB
• Granted 40,000 shares
• Exercise Price is $12
• The fair market value of the stock at the time the option is granted is $10
• 25% of the option vests each year on the grant date
• Granted an additional 1,000 shares in Year 2 with:
•• Exercise Price: $12
•• Fair market value: $10
•• 25% of the additional shares vest each year on the grant date
Calculation:
• Original Grant (40,000 shares):
40,000 shares / 4 years (vest 25% annually) = 10,000 shares vest per year
10,000 shares X $10 = $100,000 per year
• Additional Grant (1,000 shares in Year 2):
1,000 shares / 4 years (vest 25% annually) = 250 shares vest per year
250 shares X $10 = $2,500 per year
Year 1 | original grant of 10,000 X $10 = $100,000 | $100,000 remain ISO status
Year 2 | (original grant of 10,000 X $10 = $100,000) + (additional grant of 250 X $10 = $2,500) = $100,000 remain ISO status and $2,500 become NQSOs
Year 3 | (original grant of 10,000 X $10 = $100,000) + (additional grant of 250 X $10 = $2,500) = $100,000 remain ISO status and $2,500 become NQSOs
Year 4 | (original grant of 10,000 X $10 = $100,000) + (additional grant of 250 X $10 = $2,500) = $100,000 remain ISO status and $2,500 become NQSOs
Year 5 | additional grant of 250 X $10 = $2,500 remain ISO status
Our companies should differentiate between ISOs and NQSOs when grants exceed the $100,000 limitation. If no designation is made, it is assumed that we exercise the ISOs before the NQSOs.
Example 4
Focus on the year the options vest because they become exercisable, rather than the year they are exercised.
Continuing from Example 2, we exercised all of our 40,000 ISOs in Year 4. All 40,000 ISOs are ISOs because only $100,000 worth of ISOs are vested in Year 4. The remaining ISOs are vested in Year 1, Year 2, and Year 3.
Year 1 | 10,000 X $10 = $100,000 | remain ISO status, ISOs not exercise
Year 2 | 10,000 X $10 = $100,000 | remain ISO status, ISOs not exercise
Year 3 | 10,000 X $10 = $100,000 | remain ISO status, ISOs not exercise
Year 4 | 10,000 X $10 = $100,000 | remain ISO status, exercised all 40,000 ISOs and all 40,000 ISOs will still be ISOs
Treatment of Modifications, Cancellations, and Dispositions:
Section 1.422-4(b)(5)(ii) of the 2003 proposed regulations provides that if the option is not canceled, modified, or transferred prior to the year in which it would first become exercisable, it is treated as outstanding until the end of the year in which it first becomes exercisable.
https://www.irs.gov/irb/2004-36_IRB
Let’s breakdown this regulation into four parts:
1. Disqualification Before Vesting Year: If ISOs are modified, transferred, or canceled (which disqualifies them from ISO status) before the year they vest and can first be exercised, they are excluded from the $100,000 limit calculation. Essentially, they don’t count toward the limit since they were disqualified before becoming exercisable.
2. Disqualification After Vesting Year: If disqualification happens after the options vest and are first exercisable, the ISOs are considered “outstanding” and will count toward the $100,000 limit for the year they became exercisable. This rule applies even if they are canceled later in the same year.
3. Prior IRS Rules: Before the final regulations were issued, exercisable ISOs that were canceled during the year didn’t count against the $100,000 limit for the full year. This is no longer the case.
4. Disqualifying Dispositions: Selling the shares in a way that disqualifies the ISOs (e.g., cashless exercises) doesn’t affect how they count toward the $100,000 limit. They are still included in the calculation for the year they vest and become exercisable. In short, the timing of disqualification (before or after the year of vesting) determines whether ISOs are included in the $100,000 limit. Disqualifying dispositions don't remove them from the calculation.
For more details on this regulation, check out the IRS website and the Code of Federal Regulations. Below is the direct quote from the Code of Federal Regulations.
- “An option (or portion thereof) is disregarded if, prior to the calendar year during which it would otherwise have become exercisable for the first time, the option (or portion thereof) is modified and thereafter ceases to be an incentive stock option described in § 1.422-2, is canceled, or is transferred in violation of § 1.421-1(b)(2).
- If an option (or portion thereof) is modified, canceled, or transferred at any other time, such option (or portion thereof) is treated as outstanding according to its original terms until the end of the calendar year during which it would otherwise have become exercisable for the first time.
- A disqualifying disposition has no effect on the determination of whether an option exceeds the $100,000 limitation.”
Grant Order and Acceleration Rules:
The Electronic Code of Federal Regulations also teaches us that “options are taken into account in the order in which they are granted.” When multiple incentive stock options (ISOs) become exercisable in the same year due to acceleration, the most recently granted options are evaluated first, working backward, to determine which exceed the $100,000 limit. If the most recently granted options have already been exercised, they retain their ISO status but still count toward the $100,000 limit for that year.
https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/subject-group-ECFR2b7577e2af5412b/section-1.422-4
Example 5:
It seems that some awards, often at private companies, might include a provision allowing employees to exercise ISOs immediately upon grant. These are sometimes referred to as early-exercise stock options. From what I understand, they could be considered exercisable right away, even if the resulting shares are unvested. It’s possible that the $100,000 limit applies to the full value of the award at the time of the grant. If there are other outstanding ISO grants, exceeding the limit might lead to some of these options being treated as NQSOs. However, it’s always a good idea to consult a tax professional for clarification on these matters. We can read this document to learn more.
https://www.irs.gov/pub/irs-regs/td9144.pdf
Let’s use Example 2 and we will add on the ability to exercise the ISOs immediately upon grant.
• Granted 40,000 shares
• Exercise Price is $12
• The fair market value of the stock at the time the option is granted is $10
• 25% of the option vests each year on the grant date
• We have the ability to exercise ISOs immediately upon grant
Scenario Breakdown
1. Granted 40,000 shares:
• The total potential value of the ISO grant is 40,000 shares × $10 (FMV at grant) = $400,000.
2. Exercise Price is $12:
• The exercise price is above the fair market value (FMV) at the time of the grant. There’s no immediate bargain element because the exercise price is higher than the FMV.
3. 25% vesting per year:
• Normally, 10,000 shares vest each year, and the $100,000 limit would apply to those shares exercisable in each year. However, with the early-exercise provision, the entire grant (40,000 shares) could be treated as exercisable immediately upon grant.
$100,000 ISO Limit Calculation
• The $100,000 limit is based on the FMV at grant ($10/share), not the exercise price ($12/share).
• The maximum number of shares that can qualify as ISOs is calculated as follows:
Maximum ISO Shares = $100,000 / FMV at grant of $10 per share = 10,000 shares
• 10,000 shares qualify as ISOs under the $100,000 limit for the year the options are exercisable.
• The remaining 30,000 shares (40,000 total ISOs - 10,000 ISOs) would convert to non-qualified stock options (NQSOs).
Tax Implications
1. ISO Shares (10,000 shares):
• These retain ISO status and may qualify for favorable tax treatment if the required holding periods are met (2 years from grant and 1 year from exercise).
2. NQSO Shares (30,000 shares):
• These are treated as non-qualified stock options (NQSOs). The bargain element (difference between FMV at exercise and exercise price) would be taxable as ordinary income at the time of exercise.
3. Early-Exercise Consideration:
• With the early-exercise provision, unvested shares would likely be subject to a substantial risk of forfeiture. Depending on the terms, a Section 83(b) election may allow the taxpayer to report income at the time of exercise (based on the FMV at $10/share).
Summary of Impact
• ISO Treatment: 10,000 shares qualify as ISOs under the $100,000 limit.
• NQSO Treatment: 30,000 shares are treated as NQSOs and may trigger ordinary income tax on exercise.
• Vesting and Risk of Forfeiture: Early-exercised shares involve tax considerations based on vesting schedules.
Now we’re diving deep into the $100,000 annual limit for incentive stock options—fascinating, isn’t it?
Example 6:
Acceleration of vesting could trigger the annual limitations of $100,000 for incentive stock options. Normally, ISOs vest (become exercisable) over time, spreading out their value across multiple years. If an event (like a merger, acquisition, or job termination agreement) accelerates the vesting, more of the ISO's value might become exercisable in a single calendar year. If this exceeds the $100,000 limit, any excess value of those ISOs loses its tax-advantaged status and converts to NQSOs, but the options themselves aren’t forfeited. The $100,000 limit is calculated based on the value of the options at the time they were granted, not their value at the time of acceleration.
• We receive ISOs with a grant value of $200,000, vesting evenly over 4 years ($50,000 per year).
• If an event accelerates vesting so that $200,000 becomes exercisable in one year, this exceeds the $100,000 limit. The $100,000 remains eligible for ISO status and the excess $100,000 loses ISO status and becomes NQSOs.
Example 7:
When a company cancels Incentive Stock Options (ISOs), their treatment under the $100,000 annual limit depends on whether they’ve vested:
• Unvested ISOs: If canceled before the calendar year they become exercisable, they no longer count against the $100,000 limit. This allows the company to issue new ISOs or adjust grants without exceeding the limit.
• Vested ISOs: If already vested and exercisable when canceled, they still count against the $100,000 limit for the year. Replacement ISOs are limited by this cap.
• Tax Implications: Replacement ISOs are treated as new grants with a fresh timeline for favorable tax treatment (2 years from grant and 1 year from exercise).
• In 2020, we were granted ISOs with an aggregate exercise price of $70,000, vesting on January 1, 2024.
• In 2021, we were granted another set of ISOs with an aggregate exercise price of $70,000, also vesting on January 1, 2024.
• The 2021 ISOs are underwater (stock price is below the exercise price), so the company cancels them in 2023.
Result:
• The $30,000 from 2021 no longer counts against the $100,000 limit because they were canceled before 2024, the year they would have first become exercisable.
• This allows the company to re-grant $30,000 worth of ISOs without exceeding the cap for the year.
• If these options had already vested (e.g., canceled in 2024), they would still count against the $100,000 limit for that year.
Example 8:
The 10% Ownership Rule for Incentive Stock Options (ISOs) stipulates that if an employee owns more than 10% of the total combined voting power of all classes of stock of their employer corporation, certain conditions must be met for the stock options to qualify as ISOs:
• Exercise Price: The option price must be at least 110% of the fair market value of the stock at the time the option is granted.
• Option Term: The option must be exercisable within five years from the date of grant.
• Exercise Price: The exercise price must be at least 110% of the fair market value (FMV) of the stock on the grant date. If the FMV is $100/share on the date of grant, your exercise price must be $110/share or higher. If the exercise price had been set below $110/share, the options would fail the 10% ownership rule and lose ISO tax treatment, becoming Non-Qualified Stock Options (NQSOs) instead.
• Exercise Term: The option must be exercisable within 5 years of the grant date, instead of the standard 10 years. If we miss this deadline, the options expire.
Limit to the number or value of ISOs granted to employees.
• While there's no explicit limit on the number or value of ISOs that can be granted, the $100,000 rule stipulates that the aggregate fair market value of stock options that become exercisable for the first time in any calendar year cannot exceed $100,000. Any amount exceeding this is treated as a Non-Qualified Stock Option (NQSO) for tax purposes.
• Normally, the plan is approved by the company's board of directors and shareholders.
• ISOs can only be granted to employees, not to consultants or outside directors.
Please note that this material is for educational use only and is subject to change. Tax laws are complex, there are exceptions to the rules, and it’s constantly changing. Be sure to talk to a qualified professional before making an informed decision. Thank you for watching. Until next time, this is Tan, your Trusted Advisor.
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