Although incentive stock options (ISOs) were created under the Economic Recovery Tax Act of 1981, many of the ISO characteristics and limitations as we know them now were a part of the Tax Reform Act of 1986. This includes the $100,000 limitation. However, we do still see questions about the application of the $100,000 limit come up periodically in our Discussion Forum. So, I’d like to take this opportunity to elaborate a bit on the ISO $100,000 limitation.

The $100,000 Limitation

Under Section 422(d) of the Internal Revenue Code, the total aggregate fair value of ISOs that become exercisable for an individual employee for the first time within a calendar year under all plans may not exceed $100,000. The fair value of the shares for the purposes of determining the aggregate value of shares within a calendar year is the value as of the grant date. Any shares that become exercisable within a calendar year that cause the value of the aggregate number of shares vesting to exceed $100,000 will no longer qualify for preferential tax treatment as ISO shares.

For more information on ISO grants, visit our Incentive Stock Options portal. You may also want to take our Incentive Stock Options Compliance-O-Meter quiz to see how your company’s ISO grant practices measure up.

Exercisable for the First Time

The $100,000 limitation applies to the shares as the first become exercisable. This distinction in the language makes the most sense when considering an ISO grant with an early exercise provision. You calculate the value of the shares as they first become exercisable, regardless of when they vest or are actually exercised. If the entire grant is eligible for early exercise, then the full value of the grant is applied against the $100,000 limitation for the year in which it was granted.

However, it is not a common practice for companies to include early exercise in an ISO grant. So, in most cases, the shares “become exercisable for the first time” per the vesting schedule. For these grants, only the shares that are vesting (becoming exercisable) in any given year are included in the calculation. The full value of the grant, or the number of shares in the grant, is not directly relevant.

For example, an ISO grant of 40,000 shares granted on a day when the FMV is $10 would have a total value of $400,000, regardless of whether or not the shares are exercised or how much income is realized from any transaction(s). Although the full value of this grant exceeds $100,000, this entire grant could be an ISO if only 10,000 shares vest and become exercisable each year and the employee holds no other ISOs that become exercisable in the same years.

Keep in mind that the ISO grants under all plans of your company, parent company, and subsidiaries should be aggregated together to determine the value of the shares that become exercisable. If you are using a stock plan administration software that does not aggregate between plans, or if you track grants from a plan or subsidiary outside of your stock plan administration software, then you will need to pay special attention to the $100,000 limitation.

When the ISO Grant Exceeds $100,000

Portions of ISOs that exceed the $100,000 limitation are taxed as if they are non-qualified stock options. You will need to withhold taxes and report the gain on any exercise of shares that exceeds the limit. This includes your company’s matching FICA and FUTA payments (if applicable). Penalties for not withholding the appropriate taxes can be up to 100% of the amounts that should have been withheld, can include interest and other administrative fees, and, in extreme cases, can involve criminal penalties. Additionally, by not properly reporting the income realized by employees upon exercise, your company won’t be able to claim the tax deduction on that income.

This does not mean that you need to have two separate grants approved and awarded to your employee. Even if you know that an ISO will exceed the $100,000 limitation, it should be approved as one ISO grant. Most stock plan administration softwares will bifurcate the grant for you, but this should be for tracking purposes only.

What to Include in Grant Agreements

All ISO grant agreements should include language indicating that an exercise of any portion of the grant exceeding the $100,000 limitation will be subject to income reporting and withholding. This allows employees to make informed decisions about their exercise strategies for their ISOs and avoids unpleasant surprises when they do engage in option exercises. Additionally, including this language even if you don’t believe any portion of the grant exceeds the limitation will help to protect the company if the initial calculation turns out to be incorrect.

Cancellations

The Final ISO Regulations address the cancellation of incentive stock options. If an ISO grant is cancelled prior to the calendar year in which it first becomes exercisable, then the value of the shares no longer needs to be counted against the $100,000 limitation.

This means that if there is a more recent ISO grant held by the employee that exceeded the $100,000 limitation prior to the cancelation, then a larger portion of that grant may now be treated as an ISO. Or, if a new ISO is granted to the employee, then the cancelled grant should not impact the $100,000 limitation as it is applied to that new grant. You may not, however, go back in time and change a non-qualified stock option to an ISO because of the cancellation.

The trickiest part of this rule is the case of a grant that is cancelled prior to vesting, but within the calendar year of the vest date. The value of the shares that would have vested still counts toward the $100,000 limitation for that calendar year. For example, if a grant should vest in October, but is cancelled in the preceding June, the value of that vest must still be included in the calculation for that year. This is especially important if your company is executing an options exchange program that includes unvested incentive stock options.

Accelerations

If the vesting/exercisability of an ISO is accelerated, then the application of the $100,000 limit must be reviewed for the new vesting schedule. Grants should be considered in the order in which they were granted. Therefore, if multiple grants are accelerated simultaneously (in the case of an acquisition, for example), you should review the new vesting schedules beginning with the oldest grant first.

-Rachel