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An explanation of the limit on the amount of ISOs that can become exercisable in a year.
There's a rule for incentive stock options that causes a lot of confusion. How does the $100,000 limit work? Some people get the idea that you have ordinary income if your gain is greater than $100,000. That's not true: you can have millions dollars of gain without hitting the $100,000 limit. Then again, you can hit the limit without getting near $100,000 in gain.
The limit doesn't apply to the amount of gain. It applies to the options that vest in any given year. In other words, it applies to the amount of options that become exercisable in any year.
You determine the amount by looking at the fair market value of the stock at the time the option was granted — not at the time the option vests. Normally the option price is set at the fair market value, and if that's the case you can apply the rule by looking at the option price itself.
The rule is a little strange, so it's helpful to see it in operation. Let's suppose you receive an option to buy 30,000 shares of your company's stock at a time when it's trading at $10. The fair market value of the stock, determined at the time the option was granted, is $300,000.
Does that mean you exceeded the $100,000 limit? We can't tell from these facts. It depends on the vesting schedule. Suppose the option becomes exercisable over a period of four years, 7,500 shares per year. Then you have $75,000 worth of options vesting each year. That's within the $100,000 limit (assuming no other options), so you're OK — even if the stock zooms to $100 before the options vest. You can get the full benefit of incentive stock option treatment for all your gain because the option was within the limit at the time it was issued.
Now suppose you receive another option in the second year. This one is for 4,000 shares, and the entire option is exercisable in the second year. The stock is now trading at $12.50, so that's the value we use in applying the $100,000 limit to this option. This puts you over the limit! You already had $75,000 of options vesting in the second year. Now you have another $50,000 of options vesting in that year. In the second option grant, $25,000 worth can be ISOs, but the other $25,000 worth will be treated as nonqualified options.
Most companies try to keep track of this limit. If they're going to grant options that exceed the limit, they'll figure out how many of the options qualify as ISOs and split the option into two grants, one for the ISO portion and one for nonqualified options. That isn't true of all companies, however. If you think you may be near or over the limit, it's wise to check carefully to see if all your ISOs qualify.
If your options put you over the limit, it's important to keep track of which options are ISOs and which ones are nonqualified. And you have to be very careful to specify which ones you're exercising, if you don't exercise all your options at once. The tax consequences of the two types of options can be very different. You could be in for a nasty surprise if you exercise an option you believe is an ISO, and it turns out to be a nonqualified option.
The $100,000 limit appears to be causing quite a bit of confusion in connection with early exercise stock option plans. That situation is discussed on the following page.
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