An explanation of the $100,000 limit for early exercise ISO plans.
I’ve had repeated questions about how the $100,000 limit for incentive stock options applies to early exercise plans, so I decided to post a page in this guide rather than keep answering the question on our message board.
As explained elsewhere, the tax law imposes a $100,000 limit on options that become exercisable in a given year. Here’s an example of how the rule applies:
Example: Your company grants an option to buy $160,000 worth of stock (value measured as of the date the option was granted). The option becomes exercisable over a period of four years. Although you received a single option for more than $100,000 worth of stock, the option doesn’t exceed the limit because the amount that becomes exercisable in any one year is only $40,000. That’s true even if you wait until the fourth year and exercise the entire option at that time.
As you can see from this example, for purposes of this rule it doesn’t matter when you actually exercise the option, and it doesn’t matter when you receive the option. What matters is when the option became exercisable.
Early exercise plans
In recent years, many companies have adopted early exercise plans. In this type of plan, there may be little or no delay between the time you receive the option and the time you can exercise it. Instead, the plan (or the option agreement) provides that you can lose some or all of the option benefit if your employment terminates prior to vesting. The way this normally works is the company has the right to repurchase any unvested shares at the price you paid when you exercised the option.
Early exercise plans are usually set up to be essentially equivalent to the more traditional plans in which options become exercisable over a period of years. Just as in a traditional plan, the worker has to remain employed until a specified date to be able to retain the economic benefit of the option. Yet early exercise plans give greater flexibility to the option holder, who may be able to improve his or her tax results by exercising the option before the stock has increased greatly in value.
Early exercise plans can be a boon to the employee, especially at companies that are planning to go public but have not yet done so. They provide greater opportunity to manage the tax consequences of exercising options, while leaving the basic economic bargain intact. Yet there’s a problem in using this type of plan to issue incentive stock options, and some plan administrators seem to be unaware of the issue.
As mentioned above, the $100,000 limit applies to the options that become exercisable in a given year. There’s nothing in the tax law that says you count only the options that are exercisable for currently vested shares. In fact, according to section 83(e)(1) of the Internal Revenue Code, the vesting rules don’t apply at all when you exercise an incentive stock option.*
The IRS has never issued guidance on how the $100,000 limit applies to early exercise incentive stock options. It seems clear enough from the language of the tax law, however, that delayed vesting doesn’t affect the $100,000 limit. As a result, if you convert a traditional incentive stock option (one that becomes exercisable over a period of time) into an early exercise stock option, you may end up with an option that exceeds the limit.
Example: Suppose the option to buy $160,000 worth of stock described earlier is converted to an early exercise option. The entire option becomes exercisable in the year it is granted, although the stock will vest over the next four years. The option becomes exercisable for more than $100,000 worth of stock in a single year, so the option exceeds the $100,000 limit.
Exceeding the limit doesn’t disqualify the entire option, but it causes the part of the option that exceeds the limit to become a nonqualified stock option. This issue may not be important to people who exercise their options while the value of the stock is equal to the exercise price and file the 83b election, because in that situation the tax treatment of incentive stock options and nonqualified stock options is equivalent. If the value of the stock rises before the option is exercised, however, the tax consequences of converting part of the option into a nonqualified stock option can be detrimental to the option holder.
It appears to me, based on messages posted on our message board, that a number of companies adopting early exercise plans are oblivious to this issue. I suspect that many people are treating nonqualified stock options as incentive stock options because they are unaware of this glitch. This issue affects the company as well as the option holder, because the company has withholding and employment tax obligations for nonqualified stock options that don’t apply to incentive stock options. As far as I can tell, this issue hasn’t appeared on IRS radar screens so far, but if they wake up to this issue there are likely to be quite a few people who are unhappy with the consequences.
* Vesting rules apply to ISOs under the alternative minimum tax because under the AMT, ISOs are generally treated as nonqualified stock options.