Limit of Incentive Stock Options (ISO 100K)
In this article, you would understand one such rule that falls under Incentive Stock Options (ISOs) which is called the ISO 100K rule.
Have you ever had your tax return done, and you’re in shock over the amount of taxes you owe to the IRS over what you expected? Well, it may be because you are not aware of what tax laws affect you and your income. To avoid such a situation again, it may be important to know about the ISO 100K law, especially if you are awarded or are about to purchase incentive stock options soon.
In this article, you would understand one such rule that falls under Incentive Stock Options (ISOs) which is called the ISO 100K rule. But before we can go directly to what ISOs are and what the ISO 100K rule is about, let us first understand what equity compensation is all about.
Equity compensation has long been used as a form of non-cash payments to both motivate current staff, and also to attract potential new employees. This type of compensation is the best for the startup companies as they may lack cash, or usually they wish to invest their cash flow into growth initiatives.
In short, employees are provided with shares of the company giving them rights towards the ownership, and profits of the company. This kind of equity compensation can take many forms such as performance shares, restricted stocks, incentive Stock Options(ISOs), and many others. This article will focus on ISO and the limit of these.
What are ISOs (incentive stock options)?
ISOs, known as incentive stock options, are one of the types of employee stock options companies can use for their staff and enjoy some tax benefits. One of the main tax benefit here is that, when the shares are exercised, the employees don’t have to pay the standard income tax rates on the total value of the sale. Instead, these incentive stock options are taxed at the capital gains tax rate, being much lower, and ultimately saving them money.
These incentive stock options are usually given to employees as an encouragement to stay with the company longer and to add to the development of the overall business. This kind of benefit is also used to entice new hires, mostly when a company is in the startup stage, and there aren’t enough funds in the company to pay high salaries.
Even though incentive stock options have a more favorable tax rate as compared to other plans, like non-qualified stock options (NSOs), ISOs also need the holder to take up more risks, such as holding the stocks for much longer for it to fall under the capital gains tax rate.
How are Incentive Stock Options used?
ISOs have a price of the exact FMV (Fair Market Value) of the shares on the day when the company grants it to the employees. This day is also called the grant date. Nonetheless, there is also a time period as to when the employees have to wait before they can exercise the options at a strike price.
As soon as the period is over, the employee receives the vesting rights and can then exercise the option. The strike price is the predetermined price of the shares (which was determined as per the FMV on the grant date).
The basic idea behind this plan is that as time goes by, before the options can be exercised, the value of the company may increase. This would allow the employees to purchase the stock at a much lower rate (also called discounted rate), than the current FMV of the stocks. The employees would then buy these shares at the discounted rate, and sell them at the market rate, for a profit.
Further, the tax rate would keep changing from the time when the shares are owned. For instance, in case the shares from the incentive stock options were sold after a 2-year period from the grant date, and one year after they got exercised, the capital gains would come under the long-term capital gains tax treatment. In case the shares are sold before that, the gains would be taxed at the ordinary income rate. The capital gains form the ISOs can even be subjected to the AMT (Alternative Minimum Tax).
Reporting and AMT
Qualified ISOs can be reported as under long-term capital gains rates on the form 1040 given to the IRS for reporting personal income tax returns. Another thing that plays a vital role in the capital gains tax placed on the ISOs is the alternative minimum tax.
The AMT tax is imposed on those who have a large amount of certain types of income, such as municipal bond interest or ISO bargain elements. In short, this tax law is there to ensure that each taxpayer pays at least a minimum amount of tax on their income that would have otherwise have been taxed at a rate of 0%.
The AMT is normally calculated on the form 6251, from the IRS. But for those who have exercised a large amount of incentive stock options, we advised you to consult a financial advisor or a tax advisor beforehand. The advisor can let you know exactly what the tax consequences are over the year. The profit that is earned from the sale of the ISOs has to be reported to the IRS on the form 3921 and then has to be written on the Schedule D as well.
What is ISO 100k?
Now that you are aware about what ISOs are, there is a rule that is placed on this to restrict the amount a person can earn from the plan in a year. As per the Internal Revenue Code 422(d), the overall FMV of the incentive stock options that becomes exercisable for an individual employee for the very first time in a year under any equity based plan is not allowed to exceed $100,000.
The $100,000 per year limitation
Under this rule, if the qualified incentive stock options are exercised by an individual in a calendar year and the total cost of all the options exceeds $100,000, the option would then be treated as a non-statutory option. This means that the employees are not permitted to get more than $100,000 worth of exercisable ISOs in a year, as per federal securities law.
In case the company grants a number of options to the employee working in the company greater than $100,000, the options that fall over the limit would be considered as NSOs (Non-Qualified Stock Options). The value of those options for employees are calculated using the FMV of the stock at grant date, for which the options would be exercised. Another important factor about the ISO 100k limit is that it is only for the options that would become exercisable for the very first time in the year.
For instance, imagine that you have a company named Z, and you are the CEO of the company. You have decided to grant ISOs to your favorite employee, Mike. Let us imagine that at the grant time, the FMV of the common stock (also the strike price) is $0.50 per share. Now, in case you offer Mike 500,000 incentive stock options, are violating the $100,000 limit?
Well, it all depends on the schedule for vesting. In case the options are offered to Mike for just 48 months where the first vesting period falls on February 1st, in the first year, about 114,587 options would be vested (which is 11 months’ worth, with no vesting cliff), or would become exercisable. The total value for the options that are vested in that first year would be about $57,293.50. And since this falls below the limit of 100k, all the options that are vested are taken as incentive stock options.
To understand this from another angle, let us change the scenario a bit. Again, let’s say that you offer Mike 500,000 incentive stock options, that have A strike price of $0.50. But in this example, the schedule for the vesting would be different. Here, instead of four years of vesting on a monthly basis, the plan would be a four year plan that has a 1 year cliff.
Here, 1/4th of the options that Mike has would be vested and exercisable after one year from the vesting commencement date. The remaining 3/4th of the options would be vesting on a monthly basis over the next 3 years. In this example, none of the options are vested in the first year as Mike did not hit the 1 year cliff yet.
On the second year, about 239,583 (125,000 options from the 1 year cliff, and 114,583 over 11 months) stock options are vested. The overall value of the incentive stock options that are vested then would be $119,791, which is 239,583 x $0.50. This means, it exceeds the ISO 100k limit, and due to this the last options that cost $19,791 would be taxed as NSOs and not as the incentive stock options as per the law.
Though it seems simple here, it can be highly complex in cases where shareholder has multiple incentive stock option grants that have vesting periods overlapping each other. The reason it can be complex is the rule applies for each shareholder during the year, and not per ISO option grant.
Reason for the rule
From all the explanations above, you might already know that incentive stock options are subjected to favorable tax treatment by the IRS as compared to the NSOs. One of the primary benefits in terms of taxes is that for the ISOs, you would not have to pay the standard income tax on the spread (exercise price over strike price).
For NQSOs, the spread is taxed with the standard income tax rates when the options are exercised. But even though ISOs have a favorable tax treatment, they are some limitations placed on it. The ISOs are subjected to the AMT (Alternative Minimum Tax). This is so that the people cannot avoid paying any taxes at all. Other than this, the ISO 100K limitation is also another rule so that ISO plans cannot be misused as a tax shelter to be paid to the government.
Different parts of rule
Now, let us understand the various parts of the 100k rule on the incentive stock options. There are few components that have to be understood and have been explained in detail below:
Fair Market Value of the stock
The fair market value (FMV) is the value of a share of the company at a specific time. It is used to get the value of stock that are being purchased as ISOs or as any other equity compensation plan.
The value is determined by an internal or external valuation that is conducted by a third-party following the IRS guidelines. The FMV is normally accessed on the option grant date.
Exercisable for the first time
To be clear, the ISO 100k rule is applied to the first shares that are exercisable in a plan. This formulation has many parts to it, as mentioned below:
- When the ISOs are exercised does not matter. The determination of the rule is based on the grant date.
- The rule begins to play on the grant day of the incentive stock options.
For instance, in case the complete grant has the eligibility to be exercised on an earlier date, this is when the entire value of the grant would be placed against the ISO 100K limitation in that year when the options were granted. The number of shares that were granted or the complete value of the granted incentive stock options, are not of and in themselves, directly relevant.
Obviously there are different cases, and to determine when the options would be exercisable would be figured out based on the vesting schedule. The shares that are only about to vest and are exercisable in a year are the ones that are included in the limit rule. For instance, in case Wilson gets the ISOs granted from his company, where the value of the grant he received was $400,000, and the stocks are worth $40,000 vests each year for the next ten years, this would not break the limitation of the ISO 100k rule.
By any individual
The ISO 100k limit is applied to any grant that is given to any individual under any of the plans in the parent company, the company and all/any subsidiaries. This means that any of the ISO grants or any changes in these grants have to be gathered and linked for determining the value of the shares exercisable in that year.
What happens when the ISO 100K limitation is exceeded?
As mentioned previously, the part of the incentive stock options that exceed the 100k limit are taken as NSOs. This means that the extra options taken as NSOs have the standard income tax rates placed on the spread. This means that a single grant becomes “bifurcated” for the tax treatments. In short, a part of it would be treated as the ISOs and the extra part would be treated as the NSOs.
Let us talk about how the amount of the incentive stock options is calculated. At first, the FMV is determined at the time of the grant, which is then multiplied to the number of shares that have been granted. In case the grant has a vesting schedule around 4 years, then the total number of the shares are first divided by 4 to get the amount of shares that would be vested in a month. With this, the total value of the shares vested in one year would then be considered if it violates the ISO 100K limitation.
In case the shares that are granted has the eligibility to be exercised early, then you cannot divide the total number of shares by 4. This is because the total number of the shares would be based entirely on the total number that are eligible for being exercised in that year. If there are any extra shares that fall above the 100k limit, they are considered as NSOs. At the time of the exercise, the NSOs are subjected to the immediate withholding tax.
Cliff Vesting Pitfall
It is normal for incentive stock options to have a 1-year cliff, where about 25% of the total shares granted are vested at once to ensure that you remain with the corporation for at least one year. In case the ISO grant that is offered to the employee was maximized by granting 100k in a year, then the corporation offering it might have unwittingly activated the NSO re-characterization on a few of the incentive stock options that come as extra as per the rule.
For instance, let’s say that Mike has the choice to buy only 400,000 shares with the value (exercise price) of a share at just $1. And there is a one-year cliff where 25% of the total shares have to be vested in the first year while the rest are vested would be based on 1/48 per month over the remaining 3 years. Let us keep the grant date anniversary as 20th January of the year.
On the 20th Jan of the year, Mike would vest 25% of the shares which would be 100,000 shares in total, but Mike would also have to vest 11 more months of the shares in the same year. This means that, the approximate number of shares that would be vested would be 91,666 additional to the 100,000 shares.
This gives a total of 191,666 shares that are vested in the same year. And with the price of a share at $1, the 100k rule would be exceeded by 91,666 shares that would eventually be converted to NSOs and taxed accordingly. The rest of the 100,000 would be considered as incentive stock options. And this is what the cliff pitfall is all about, where there is usually no way to avoid it.
M&A Acceleration Pitfall
It is normal for the incentive stock option grants to have an acceleration clause when the corporation awarding it is procured. The meaning of acceleration here is that a few or all of the shares that are unvested become vested all of a sudden. As a matter of fact, the clause works as a double trigger. This means that the acceleration takes place on in a second event like being demoted or laid off. For such cases, in addition to the standard time-based vesting, the additional vesting of shares is also subjected to the ISO limit of $100,000.
And since we know from the examples above that the time-based vesting usually maxes out the 100k limit, the accelerated shares would eventually also exceed the total amount. This makes the stocks into NSO (non-qualified stock options). In case the Mergers and Acquisitions (M&A) includes the cashing out of all the granted options that are vested, that is when the consequences of the $100,000 limitation is highly reduced. Usually the little differences that are there are from Medicare taxes.
For the incentive stock options that are completely exercised for cash, the ending price of the sale less than the exercise price is a disqualifying disposition. These are basically taxed based on the standard income tax, not including the Medicare tax. Nonetheless, the Medicare tax (about 0.9%) is still applied to the employees who have a higher income or in case the gain from the M&A is large.
How to avoid ISO 100k violations?
A lot of capital is needed for exercising the incentive stock options earlier than normal and the time for the liquidity of the corporation is usually long. And the moment the shares are vested, the owner might be tempted to sell off a few of the shares to get back the initial investment or even just for other financial requirements. It should be noted that the sale of anything is a taxable event and if the shares are not held for at least a year, the tax rates placed on the number of shares sold is high.
And by selling the shares immediately, they are vested truncates the possibilities for any positive aspect of the shares that would be sold in the future. Well, there is a solution for the partial liquidity, and it is to obtain an advance from the Employee Stock Option Fund.
It is a better alternative solution where you get funds needed and also do not get taxed higher as you would not be transferring the title of the stock to anyone. This would let you still have the ability to achieve unlimited favors in terms of the tax treatment. Further, in case the stock turns out to be a worthless, an ESO would take in the loss and it would not be placed on you.
In short, avoid selling the shares immediately after they are vested to avoid any added tax consequences. Also, ensure that the options you are getting and the vesting period does not force you to violate the ISO 100k limit. For this, you can choose to purchase a lesser amount of shares (if you are offered a lot of shares), so that you do not exceed the 100k limit in the end.
How to keep track of ISOs?
One of the best ways to keep a track of all the shares you have, including the incentive stock options, is to use a cap table to note all the movement of the shares. Eqvista is a great application that helps you keep track of the shares, update the incoming and outgoing shares easily without any difficult table constructions or management needed.
At Eqvista, we understand that the ISO 100k rule violation can cost you a lot. With the help of the application, you would be able to ensure that you do not violate it. You would also be able to ensure that you do not sell many shares in a year or before holding the shares for at least a year. This would eventually help you to avoid unnecessary taxes placed on the sale.
Now that you are aware of what incentive stock options are and know all about the way the ISO 100k limit rule work, you can be careful in the number of ISOs you offer to your employees. This would help them avoid any additional taxes that they might have to pay for the options. Moreover, you can also help them understand all about the ISO 100K rule, so that they too know everything that they are getting into.
Let them know about applications, where they too can keep a track of the shares they get and avoid falling prey to high taxes by violating this rule. To keep track of the shares that you are awarding to the employees or the investors (or the shares you are granted by your company), you would need a cap table. And the cap table application on Eqvista is the right one for you. Check it out and use it today to make your life as a shareholder or founder much easier!