The 100K Rule[1] states that employees cannot receive more than $100K worth of exercisable incentive stock options (ISOs) in a calendar year. Any additional ISOs over the $100K threshold are treated as non-qualified stock options (NQOs) in the eyes of the IRS. In situations where this is applicable, the division between ISOs and NQOs is more commonly referred to as the ISO/NQO split. (It should be noted that this rule applies to options that become exercisable for the first time during the year, so vesting schedules for grants become crucially important in maintaining compliance with this regulation. Similarly, early exercise can often trigger this limitation since all options are considered to be available.)
If you’ve ever granted or been granted Incentive Stock Options, you may already know about the difference in treatment by the IRS for ISOs and NQOs. (If these acronyms mean nothing to you, read our post about equity alphabet soup!) Essentially, ISOs are taxed when the employee sells their shares, not at grant or exercise. If the employee hangs onto the shares for one full year after vesting and at least two years after the grant date, any gains classify as capital gains, which have a lower tax rate, and are not considered income. (The Alternative Minimum Tax or AMT may apply, and that’s beyond the scope of this post.) With NQOs, the spread between fair market value and the exercise price is taxed as income at the point of exercise. In order to prevent individuals from abusing the tax benefit guaranteed by ISOs, the 100K Rule (also known as the 100K ISO Limitation) was enacted.
How Do You Calculate The 100K Rule?
At this point you may be wondering, how do I know if this rule applies to me? You already know that the 100K Rule will affect all exercisable/vested ISOs worth over $100K in a given calendar year. To give you an idea of how the 100K rule applies, let’s look at a simple grant example:
On January 1, Julia is granted 400,000 shares with a vesting schedule that vests monthly for four years and has a one-year cliff without early exercise. The fair market value for these shares is $0.90. During the second year of the vesting period, Julia will need to undergo an ISO/NQO split.
Year One: No shares vested due to the cliff.
Year Two: 100,000 shares will vest on the first day of the second year, due to the vesting cliff. During this same year, 11 months of vested shares will also become available for exercise. Doing the math, this adds up to an additional 91,666 shares vested. The total value of the shares for year two would be $172,499.40 (191,666 shares multiplied by $0.90). She will need to undergo an ISO/NQO split this year. For this year, the company’s grant to Julia will be considered both ISO (111,111 shares) and NQO (80,555 shares).
Year Three: 104,167 shares vested with a value of $93,750.30.
Year Four: 104,167 shares vested with a value of $93,750.30.
Total: 400,000 shares valued at $360,000.
Things would change if Julia’s grant has no cliff. Without a cliff, Julia’s grant does not trigger the 100K limitation.
Things To Keep In Mind
Many equity grants are not as simple as the above example. For instance, many companies issue grants that are subject to early exercise. This means that the entirety of the grant is considered applicable to the 100K limit, since all shares are exercisable immediately. Another complication can arise if grants include an acceleration clause. These clauses can sometimes unintentionally cause shareholders to surpass the 100K threshold, since a large portion of shares become exercisable at the same time.
In addition to the aforementioned complexities, the IRS applies this limitation to all ISO grants in a given tax year. For this reason, if you have multiple ISOs, abiding by the 100K Rule can be more complicated than previously stated. You should always speak with your tax advisor if you have questions or concerns about your grant(s) and their tax implications.
[1] 26 U.S. Code § 422 - Incentive stock options | U.S. Code | US Law | LII / Legal Information Institute (cornell.edu)
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Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation. Third party mentioned and Fidelity are not affiliated.
