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ISOs have tax benefits that NSOs don't. Is there a limit that I should be aware of?
The $100K ISO limit is a tax rule put in place to prevent people from abusing the tax benefits of ISOs and using them as a tax shelter.
All exercised ISOs exceeding $100k in value will undergo an ISO/NSO split.
What is the mandatory ISO/NSO split?
The IRS treats anything over $100K worth of stock options that are exercisable in one calendar year as NSOs. It's important to note that the rule covers exercisable options and not exercised options, and the rule covers option grants and vesting. Any excess options and subsequent grants above the $100K limit are considered NSOs. This affects the amount of taxes we'll owe and when we'll owe them.
A consequence of receiving ISOs with early exercise clauses is that all of the shares promised over the vesting period are exercisable right away and can trigger the $100k rule. Let's step through a quick example.
Remember, ISOs and NSOs are taxed differently - we usually owe taxes on NSOs when we exercise our options in addition to when we sell the shares. With ISOs, we usually only pay taxes when we sell.
Splitting the difference
To figure out if the grant will split, we can follow the following algorithm below.
If we can early exercise our options, then go directly to step 3.
If the grant is subject to vesting (such as monthly for 4 years with a 1-year cliff), add up the number of shares that are exercisable each calendar year.
Multiply the number of shares (total grant if early exercisable, or each calendar year if vesting) by the FMV of the shares at the time of the grant.
It's helpful to note that the FMV on the grant date is usually the same as the strike price. Let's walk through a more detailed example of an ISO/NSO split with early exercise.
Here's an example of the ISO/NSO split with shares with no early exercise.
We need to know the details of our option grant to figure out if it will trigger the $100K rule. Here is a lesson about understanding an option grant that we can use for reference.
If we find ourselves over the limit, we should be ready to pay taxes in addition to the exercise costs when we exercise the converted options.
We should always reach out to a tax advisor if we have any questions or concerns about our grants and their tax implications.