The $100,000 per year ISO limitation rule

The $100,000 per year ISO limitation rule

Defining the rule

Under IRC Section 422(d), the total fair market value of stock related to ISOs that become exercisable for an individual employee for the first time within a calendar year under all plans may not exceed $100,000.

(1)General rule. An option that otherwise qualifies as an incentive stock option nevertheless fails to be an incentive stock option to the extent that the $100,00 limitation described in paragraph (a)(2) of this section is exceeded.

(2)$100,000 per year limitation. To the extent that the aggregate fair market value of stock with respect to which an incentive stock option (determined without regard to this section) is exercisable for the first time by any individual during any calendar year (under all plans of the employer corporation and related corporations) exceeds $100,000, such option is treated as a non-statutory option.

Breaking this down into its component parts:

  • Fair Market Value of the stock

This is the value, for tax purposes, of the stock to which the ISO is attached (most typically common stock). For private companies, the fair market value is typically determined through an external or internal valuation that is conducted in accordance with IRS guidelines. The fair market value is assessed as of the grant date of the ISO(s) in question.

  • Exercisable for the first time

The limitation applies to the shares as they first become exercisable. This special formulation of the language has several aspects to it:

  • It is considered as of the grant date of the option(s)
  • It doesn’t matter when the options are exercised or not – the determination is as of the grant date
  • For example, 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
  • The full value of the grant, or the number of shares granted, are not in and of themselves, directly relevant

 

In most cases, the determination of “exercisable” will be determined by the vesting schedule. Only the shares that are vesting, and therefore are exercisable, in any given year are included in the calculation.

For example, if Fred received a grant of ISOs, where the value of the underlying common stock at the time of grant was $500,000, but only $50,000 worth of stock vests each year for the next ten years, this would not fall afoul of the limitation.

  • By any individual

The ISO limitation applies to all grants received by an individual under any plans of the company, parent company, and any/all subsidiaries. Thus, any ISO grants, or changes to such grants, need to be aggregated to determine the value of the shares that become exercisable in a calendar year.

What happens when the $100,000 limitation is exceeded?

Portions of ISOs that exceed the $100,000 limitation are treated as if they are non-qualified stock options. This may result in a single grant being “bifurcated” for purposes of treatment as partially ISO and partially NSO.

Nuances – Cancellations and Accelerations

Cancellations

If an ISO grant is canceled 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. For example, 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.

Special consideration should be given in cases 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 must still be included in the calculation for that year.

Accelerations

If the vesting 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 (e.g. in the case of a change of control provision), you should review the new vesting schedules beginning with the oldest grant first (options are always considered in the order in which they were granted).

 

APPENDIX

Key Provisions & Examples

(26 CFR 1.422-4)

  1. “Exercisable”

(4) For purposes of this section, an option is considered to be first exercisable during a calendar year if the option will become exercisable at any time during the year assuming that any condition on the optionee’s ability to exercise the option related to the performance of services is satisfied. If the optionee’s ability to exercise the option in the year is subject to an acceleration provision, then the option is considered first exercisable in the calendar year in which the acceleration provision is triggered. After an acceleration provision is triggered, the options subject to such provision are then taken into account in accordance with paragraph (b)(3) of this section for purposes of applying the limitation described in paragraph(a)(2) of this section to all options first exercisable during a calendar year.   However, because an acceleration provision is not taken into account prior to its triggering, an incentive stock option that becomes exercisable for the first time during a calendar year by operation of such a provision does not affect the application of the $100,000 limitation with respect to any option (or portion thereof) exercised prior to such acceleration. For purposes of this paragraph (b)(4), an acceleration provision includes, for example, a provision that accelerates the exercisability of an option on a change in ownership or control or a provision that conditions exercisability on the attainment of a performance goal. See paragraph (d), Example 4 of this section.

  1. b) Cancellation

(ii) 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.

  1. c) Bifucation

(1)Options. The application of the rules described in paragraph (b) of this section may result in an option being treated, in part, as an incentive stock option and, in part, as a non-statutory option.

(2)Stock. A corporation may issue a separate certificate for incentive option stock or designate such stock as incentive stock option stock in the corporation’s transfer records or plan records. In such a case, the issuance of separate certificates or designation in the corporation’s transfer records or plan records is not a modification under § 1.424-1(e).  In the absence of such an issuance or designation, shares are treated as first purchased under an incentive stock option to the extent of the $100,000 limitation, and the excess shares are treated as purchased under a non-statutory option.

(d)Examples

The following examples illustrate the principles of this section. In each of the following examples E is an employee of X Corporation. The examples  are as follows:

Example 1. General rule.

Effective January 1, 2004, X Corporation adopts a plan under which incentive stock options may be granted to its employees. On January 1, 2004, and each succeeding January 1 through January 1, 2013, E is granted immediately exercisable options for X Corporation stock with a fair market value of $100,000 determined on the date of grant. The options qualify as incentive stock options (determined without regard to this section). On January 1, 2014, E exercises all of the options. Because the $100,000 limitation has not been exceeded during any calendar year, all of the options are treated as incentive stock options.

Example 2. Order of grant.

X Corporation is a parent corporation of Y Corporation, which is a parent corporation of Z Corporation. Each corporation has adopted its own separate plan, under which an employee of any member of the corporate group may be granted options for stock of any member of the group. On January 1, 2004, X Corporation grants E an incentive stock option (determined without regard to this section) for stock of Y Corporation with a fair market value of $100,000 on the date of grant. On December 31, 2004, Y Corporation grants E an incentive stock option (determined without regard to this section) for stock of Z Corporation with a fair market value of $75,000 as of the date of grant. Both of the options are immediately exercisable. For purposes of this section, options are taken into account in the order in which granted using the fair market value of stock as of the date on the option is granted. During calendar year 2004, the aggregate fair market value of stock with respect to which E’s options are exercisable for the first time exceeds $100,000. Therefore, the option for Y Corporation stock is treated as an incentive stock option, and the option for Z Corporation stock is treated as a non-statutory option.

Example 3. Acceleration provision.

(i) In 2004, X Corporation grants E three incentive stock options (determined without regard to this section) to acquire stock with an aggregate fair market value of $150,000 on the date of grant. The dates of grant, the fair market value of the stock (as of the applicable date of grant) with respect to which the options are exercisable, and the years in which the options are first exercisable (without regard to acceleration provisions) are as follows:

 

Date of grant Fair market value of stock Firstexercisable
Option 1 April 1, 2004 $60,000 2004
Option 2 May 1, 2004 50,000 2006
Option 3 June 1, 2004 40,000 2004

 

(ii) In July of 2004, a change in control of X Corporation occurs, and, under the terms of its option plan, all outstanding options become immediately exercisable. Under the rules of this section, Option 1 is treated as an incentive stock option in its entirety; Option 2 exceeds the $100,000 aggregate fair market value limitation for calendar year 2004 by $10,000 (Option 1’s $60,000 Option 2’s $50,000 = $110,000) and is, therefore, bifurcated into an incentive stock option for stock with a fair market value of $40,000 as of the date of grant and a non-statutory option for stock with a fair market value of $10,000 as of the date of grant. Option 3 is treated as a non-statutory option in its entirety.

Example 4. Exercise of option and acceleration provision.

  • In 2004, X Corporation grants E three incentive stock options (determined without regard to this section) to acquire stock with an aggregate fair market value of $120,000 on the date of grant. The dates of grant, the fair market value of the stock (as of the applicable date of grant) with respect to which the options are exercisable, and the years in which the options are first exercisable (without regard to acceleration provisions) are as follows:

 

Date of grant Fair market value of stock Firstexercisable
Option 1 April 1, 2004 $60,000 2005
Option 2 May 1, 2004 40,000 2006
Option 3 June 1, 2004 20,000 2005

 

(ii) On June 1, 2005, E exercises Option 3. At the time of exercise of Option 3, the fair market value of X stock (at the time of grant) with respect to which options held by E are first exercisable in 2005 does not exceed $100,000. On September 1, 2005, a change of control of X Corporation occurs, and, under the terms of its option plan, Option 2 becomes immediately exercisable. Under the rules of this section, because E’s exercise of Option 3 occurs before the change of control and the effects of an acceleration provision are not taken into account until it is triggered, Option 3 is treated as an incentive stock option in its entirety. Option 1 is treated as an incentive stock option in its entirety. Option 2 is bifurcated into an incentive stock option for stock with a fair market value of $20,000 on the date of grant and a nonstatutory option for stock with a fair market value of $20,000 on the date of grant because it exceeds the $100,000 limitation for 2003 by $20,000 (Option 1 for $60,000 Option 3 for $20,000 Option 2 for $40,000 = $120,000).

(iii) Assume the same facts as in paragraph (ii) of this Example 4, except that the change of control occurs on May 1, 2005. Because options are taken into account in the order in which they are granted, Option 1 and Option 2 are treated as incentive stock options in their entirety. Because the exercise of Option 3 (on June 1, 2005) takes place after the acceleration provision is triggered, Option 3 is treated as a non-statutory option in its entirety.

Example 5. Cancellation of option.

(i) In 2004, X Corporation grants E three incentive stock options (determined without regard to this section) to acquire stock with an aggregate fair market value of $140,000 as of the date of grant. The dates of grant, the fair market value of the stock (as of the applicable date of grant) with respect to which the options are exercisable, and the years in which the options are first exercisable (without regard to acceleration provisions) are as follows:

 

Date of grant Fair market value of stock Firstexercisable
Option 1 April 1, 2004 $60,000 2005
Option 2 May 1, 2004 40,000 2005
Option 3 June 1, 2004 40,000 2005

 

(ii) On December 31, 2004, Option 2 is canceled. Because Option 2 is canceled before the calendar year during which it would have become exercisable for the first time, it is disregarded. As a result, Option 1 and Option 3 are treated as incentive stock options in their entirety.

(iii) Assume the same facts as in paragraph (ii) of this Example 5, except that Option 2 is canceled on January 1, 2005. Because Option 2 is not canceled prior to the calendar year during which it would have become exercisable for the first time (2005), it is treated as an outstanding option for purposes of determining whether the $100,000 limitation for 2005 has been exceeded. Because options are taken into account in the order in which granted, Option 1 is treated as an incentive stock option in its entirety. Because Option 3 exceeds the $100,000 limitation by $40,000 (Option 1 for $60,000 Option 2 for $40,000 Option 3 for $40,000 = $140,000), it is treated as a non-statutory option in its entirety.

(iv) Assume the same facts as in paragraph (i) of this Example 5, except that on January 1, 2005, E exercises Option 2 and immediately sells the stock in a disqualifying disposition. A disqualifying disposition has no effect on the determination of whether the underlying option is considered outstanding during the calendar year during which it is first exercisable. Because options are taken into account in the order in which granted, Option 1 is treated as an incentive stock option in its entirety. BecauseOption 3 exceeds the $100,000 limitation by $40,000 (Option 1 for $60,000Option 2 for $40,000Option 3 for $40,000 = $140,000), it is treated as a non-statutory option  in its entirety.

Example 6. Designation of stock.

On January 1, 2004, X grants E an immediately exercisable incentive stock option (determined without regard to this section) to acquire X stock with a fair market value of $150,000 on that date. Under the rules of this section, the option is bifurcated and treated as an incentive stock option for X stock with a fair market value of $100,000 and a non-statutory option for X stock with a fair market value of $50,000. In these circumstances, X may designate the stock that is treated as stock acquired pursuant to the exercise of an incentive stock option by issuing a separate certificate (or certificates) for $100,000 of stock and identifying such certificates as Incentive Stock Option Stock in its transfer records. In the absence of such a designation (or a designation in the corporation’s transfer records or the plan records) shares with a fair market value of $100,000 are deemed purchased first under an incentive stock option, and shares with a fair market value of $50,000 are deemed purchased under a non-statutory option.