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The $100K rule for ISOs

Lesson in Course: Finance at work (advanced, 4min)

ISOs have tax benefits that NSOs don't. Is there a limit that I should be aware of?

Eureka!

What it's about: A tax law that sets a limitation to the amount of ISO shares that can be vested in a year.

Why it's important: Any ISOs granted or vested above the limit will be converted to NSOs with different tax treatments.

Key takeaway: The maximum amount of exercisable ISOs received for a year has to be less than $100K in value before they are split into NSOs.

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. 

The $100K ISO limit (also known as the $100K ruleprevents employees from treating more than $100K worth of exercisable options as incentive stock options (ISOs) in a year

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. 

Large grants with early exercise clauses can cause an unplanned ISO/NSO split

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.

$100k rule on early exercise

 If our company grants us $120K worth of ISOs that can be early exercised, the grant will automatically split into $100k worth of ISOs and $20k worth of NSOs since we can exercise them immediately.

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.

  1. If we can early exercise our options, then go directly to step 3. 
  2. 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.
  3. 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.
The $100k limit is calculated with the FMV

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.

Example of early exercise

Let's say a company grants us 100,000 ISOs with a strike price of $0.85 per share on our start date of Feb. 1st, and the equity plan allows for early exercise. Six months later, the company has raised a new round of financing, and we receive a performance grant of 20,000 ISOs with a new strike price of $1.50 per share.

The total value of our equity grant for the calendar year:

  • Feb grant: 100,000 x $0.85 = $85,000
  • Oct grant: 20,000 x $1.50 = $30,000
  • Total value: $85,000 + $30,000 = $115,000

That's $15,000 over the $100K limit! To figure out how many ISOs convert to NSOs, we divide the $15K by the strike price from the new grant: $15,000 / $1.50 = 10,000

In our second grant, half of the 20,000 ISOs received, or 10,000 shares, will need to be categorized as NSOs.

Here's an example of the ISO/NSO split with shares with no early exercise.

Example without early exercise

Let's say we receive 150,000 ISOs with a strike price of $2 per share on our start date of June 1st, 2021. The options can't be exercised early and vest monthly for 4 years with a 1-year cliff.

First, let's look at how many shares we'll receive each year from the table below:

In the table above, we notice that we receive 56,250 shares in 2022: 18,750 are from 6 months of 2021 and 37,500 from the entire year of 2022. The 1-year cliff unintentionally triggers the $100K rule because of the extra 2021 shares that become exercisable when we reach the cliff.

Since 2022 is $12,500 over the $100K limit, we treat 6,250 shares as NSOs. ($12,500 divided by $2 FMV gives us 6,250 shares).

 

Actionable ideas

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.

Glossary

What is ISO Split ?

The $100K ISO limit (also known as the $100K rule) prevents employees from treating more than $100K worth of exercisable options as incentive stock options (ISOs) in a calendar year. The excess is treated as NSOs.