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Incentive Stock Options and the $100,000 Limit – How Does It Work?

Under the Tax Cuts and Jobs Act of 2017, fewer taxpayers will be subject to the alternative minimum tax (“AMT”) due to the increase of the AMT exemption and threshold amounts for tax years after 2017 and before 2026, as well as the elimination or scaling back of certain itemized deductions.  Accordingly, incentive stock options (“ISO” or “ISOs”), on which the spread (stock fair market value (“FMV”) less the exercise price) on exercise is treated as an adjustment for purposes of the AMT, are now more valuable and attractive to employees.

Background

ISOs provide a way to avoid two tax disadvantages associated with nonqualified stock options (“NSO” or “NSOs”): 

  1. the reporting of taxable income at the time of the option exercise and
  2. having income treated as ordinary income rather than capitals gains.

With an ISO, there is no income taxation upon either grant or exercise, although the spread on exercise is treated as an adjustment for alternative minimum tax purposes as noted above. If the shares of stock acquired on exercise are held for at least two years from the date the option was granted and one year after the option was exercised (the “ISO holding period”), then any gain upon sale of the stock will be considered capital gains and taxed at capital gains rates.

One of several requirements (the others not being the subject of this article) that must be met in order for an option to be treated as an ISO is the so-called $100,000 limitation.  This limitation, while relatively simple on its face, seems to be a source of confusion for many companies and holders of stock option grants.  Thus, we will attempt to clarify the operation of this rule in simple terms below.

The $100,000 Limitation – in General

The first thing to understand is that if an ISO fails to meet the $100,000 limitation, for whatever reason, it is simply taxed as if it were a NSO; meaning rather than capital gains tax treatment (assuming the AMT did not apply), the gain at exercise will treated as ordinary income to the option holder. 

The Limitation

The limitation applies on a calendar year basis and simply states that if the FMV (determined at the date the option was granted) of the shares of stock subject to the option that first become exercisable (generally meaning they vest in that year) during the calendar year, exceeds $100,000, the option or portion of the option (see discussion below) in excess of $100,000 will be treated as an NSO.

Example 1

On January 1, 2013, Jane Smith, an employee of ABC Corp., is granted ISOs for ABC Corp. stock with a FMV of $500,000.  The options vest ratably over five years; i.e. 20% or $100,000 each year, beginning January 1, 2014 and ending January 1, 2018.  On January 30, 2020 Jane exercises all $500,000 of options.  Because the $100,000 limitation was not exceeded in any calendar year during the vesting period, all the options are treated as incentive stock options.

Application of the Limitation

In order to determine if the $100,000 limitation described above has been exceeded, the following rules need to be applied:

  1. Only options or the portion thereof that otherwise meet the requirements to be treated as an ISO are considered for purposes of the limitation.  For this purpose, an ISO that is modified, cancelled, or transferred before the year it becomes first exercisable (thus losing ISO status) is disregarded in calculating the limit.  If an ISO is modified, cancelled, or transferred during the year it first becomes exercisable, it is included for purposes of calculating the limit for that calendar year.
  2. Except as noted in 5), below, ISOs are taken into account in the order in which they were granted.  See example 2.
  3. For purposes of determining when an ISO is first exercisable during a calendar year, the option is considered as first exercisable in a calendar year if it will become exercisable at any time in that calendar year assuming that any time-based service requirement (vesting service) is met during the year.
  4. If the ISO contains an acceleration provision (for example on a change of control or achievement of a performance goal), the ISO is then considered first exercisable in the calendar year in which the acceleration provision is triggered.  See example 3.
  5. Because an acceleration provision is not taken into account before the event triggering it, an ISO that becomes first exercisable during a calendar year as a result of an acceleration event does not affect the application of the limitation with respect to any ISO or portion thereof that was exercised prior to the acceleration event.  In other words, an ISO that is exercised prior to an acceleration event will be treated as an ISO for purposes of the $100,00 limit for that calendar year, even if it had a later grant date than other ISOs that have accelerated vesting triggered in the same calendar year. See example 4.

Example 2 – Ordering Rule

ABC Corp. is the parent corporation of XYZ, Inc.  Jane Smith is an employee of ABC Corp.  Both companies have adopted their own stock option plan under which an employee of any member of the corporate group may be granted stock options for either of the companies.  On January 1, 2018, ABC Corp. grants Jane an ISO for stock of ABC with a FMV of $100,000.  On January 31, 2018, XYZ, Inc. grants Jane an ISO for stock of XYZ with a FMV of $75,000.  Both ISO grants are immediately exercisable by Jane.  For purposes of determining the limitation, the ISOs are taken in the order they are granted.  During calendar year 2018, the total FMV of stock subject to Jane’s ISOs that are exercisable for the first time exceeds $100,000 ($175,000 became exercisable during the calendar year).  Accordingly, under this ordering rule, the ISO for ABC Corp. stock with a value of $100,000 at the grant date will be treated as an ISO and the ISO for stock of XYZ, Inc. with a value of $75,000 will be treated as an NSO in its entirety.

Example 3 – Acceleration of Vesting

In 2018, ABC Corp. grants Jane Smith three separate ISOs for its stock with a total FMV at the grant dates of $150,000.  The details for each ISO grant are as follows:

  Date of Grant  FMV of Stock 

Calendar
Year First Exercisable

Option 1 January 2, 2018 $60,000 2018
Option 2 May 1, 2018 $50,000 2020
Option 3 June 1, 2018 $40,000 2018


In July of 2018, there is a change in control of ABC Corp. and under the terms of the ISO grants, all outstanding options become immediately exercisable.  Under the ordering rule, Option 1 is treated as an ISO in its entirety.  Option 2 results in the $100,000 limit being exceeded for 2018 by $10,000 ($60,000 + $50,000 = $110,000).  Thus, Option 2 must be bifurcated for tax purposes into an ISO with a FMV at the grant date of $40,000 and an NSO with a FMV of $10,000 at the grant date.  Option 3 is treated entirely as an NSO.

Example 4 – Exercise of ISO and Acceleration of Vesting

In 2018, ABC Corporation grants Jane Smith three separate ISOs for its stock with a total FMV of $120,000.  The details for each ISO grant are as follows:

  Date of Grant  FMV of Stock 

Calendar
Year First Exercisable

Option 1 April 1, 2018 $60,000 2019
Option 2 May 1, 2018 $40,000 2020
Option 3 June 1, 2018 $20,000 2019


On June 1, 2019, Jane exercises Option 3 and at the time of exercise the FMV of ABC Corp. stock on which ISOs held by Jane that are first exercisable in 2019 does not exceed $100,000 (Option 1 for $60,000 + Option 3 for $20,000 = $80,000).  On September 1, 2019, there is a change of control of ABC. Corp. and under the terms of the ISO grants, all outstanding options become immediately exercisable.  Under the ordering rules, because Jane exercised Option 3 before the change of control and the effect of the acceleration of the options is not taken into account until the date it is triggered, Option 3 will be treated as an ISO in its entirety despite the fact that it has a later grant date than Option 2.  Option 1 will also be treated as an ISO in its entirety.  Consequently, Option 2 will be bifurcated into an ISO with a FMV of $20,000 to account for the balance of the $100,000 limit for 2019 and a NSO with a FMV of $20,000 to account for the amount in excess of the $100,000 limit (Option 1 for $60,000 + Option 3 for $20,000 + Option 2 for $40,000= $120,000).

Assume the same facts as above except that the change of control of ABC Corp. occurs on May 1, 2019.  Thus, Jane’s exercise of Option 3 occurs after the change of control and acceleration of vesting.  Because the options are taken in the order of grant to determine the $100,000 limit for 2019, Option 1 and Option 2 will be treated as ISOs in their entirety (Option 1 for $60,000 + Option 2 for $40,000 = $100,000).  Since the exercise of Option 3 takes place after the acceleration of its vesting, it is treated as an NSO in its entirety.

Conclusion

While the $100,000 ISO limitation is relatively easy to understand in concept, it could become complicated to apply to multiple grants.  Companies will want to pay close attention to the ordering rules as described above in particular with respect to grants which had their vesting accelerated and years on which ISOs were exercised.

Peter Alwardt is a Tax Partner specializing in employee benefits, tax and ERISA issues for domestic and international clients. He is a member of the American Institute of Certified Public Accountants and NY State Society of CPAs.

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