The $100K Rule for ISOs

The IRS imposes a limit on Incentive Stock Options (ISOs) that prevents an employee from vesting more than $100k of exercise value as ISOs in a calendar year.

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Any ISOs vesting above the $100,000 of cumulative exercise value are converted to Non-Qualified Stock Options (NSOs).

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In practice, the first $100k of stock options that become exercisable in a given year are issued as ISOs, and the remaining options that vest are issued as NSOs. Once issued, the options retain their classification and are treated as such going forward through future exercise and sale events.

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The ISO/NSO split calculation is simple. Map the vesting schedule of all ISOs. Then, starting with the earliest grant, multiply all the options vesting in each calendar year by the exercise price for that grant. Repeat that for each grant to see if any year exceeds $100k. You can even assess whether the next ISO grant will trigger the conversion and set expectations with your client.

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Generally, the employer will identify when the cumulative exercise price of all vesting ISOs exceeds $100k and split the grant into an ISO grant and an NSO grant accordingly. However, there are instances when equity management software has missed the $100K rule, so below is some general guidance for better planning outcomes.

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Planning Considerations around the $100K Rule

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EXAMPLE 1 - Early Exercise Provisions: If a grant can be early exercised, it accelerates the recognition of the grant’s total exercise value to the year of grant rather than the year of vest. This leads to a higher probability of breaching the $100K limit, impacting the initial grant and any following ISO grants.

• Grant 1
  • Grant: 120,000 ISOs on 3/1/2024
  • Exercise Price: $2.50
  • Vesting: 4-year vest period (no cliff)

Without the ability to early exercise, the employee doesn’t trigger any ISO/NSO splits throughout their vesting period. However, with an early exercise provision, the employee must accelerate the recognition of exercisable options to the grant year, which then causes a breach of the threshold. As a result, the first $100k of options will retain ISO status and the remaining will be treated as NSOs that inherit the ISO grant vesting schedule.

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If your client intends to early exercise some or all of their option grant, it can be helpful to negotiate and have the amount of options they want to purchase be issued / granted as NSOs - especially if there is no spread. This limits exposure to the $100k rule for that grant and future grants.

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EXAMPLE 2 - Vesting Cliffs: If an equity grant is subject to a cliff, the employee may inadvertently trigger the $100K limit in the year the cliff occurs. For example, with a 12-month cliff, the employee will be able to exercise the first 25% of their grant. If the cliff occurs early in the year with subsequent vesting or the exercise price is high, the option holder is more likely to trigger the rule.

• Grant: 120,000 ISOs on 3/1/2024
• Exercise Price: $2.50
• Vesting: 4-year vest period with 1-year cliff.

In this example, you can see timing considerations when a vesting cliff is in play. In 2025, the employee can exercise the first 25% of their options that cleared the cliff in addition to an additional 18.75% that vest over the course of the year. Due to the overlap, the employee breaches the $100k limit and an ISO/NSO split occurs.

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The ISOs that vest above the $100k threshold in 2025 will be converted to NSOs. Options vesting up to the threshold in 2025 and in future years will retain ISOs treatment.

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EXAMPLE 3 - Multiple ISO Grants: When an employee has been at a private company for many years, they will have experience multiple equity grant cycles. If early enough, multiple grants could be ISOs, which may also cause complexity with the $100k rule when the 409A continues to go up. 

• Grant 1
  • Grant: 120,000 ISOs on 3/1/2024
  • Exercise Price: $2.50
  • Vesting: 4-year vest period with 1-year cliff
• Grant 2
  • Grant: 20,000 ISOs on 3/1/2026
  • Exercise Price: $5.50
  • Vesting: 4-year vest period with 1-year cliff
• Grant 3
  • Grant: 10,000 ISOs on 3/1/2027
  • Exercise Price: $14.50
  • Vesting: 4-year vest period with 1-year cliff

In this example, you can see the impact of multiple ISO grants vesting over time. The employee triggers the same ISO/NSO split in 2025 as in the example above. Then, triggers it again in 2027 and 2028 due to the overlap in the vesting of the two refresher grants they received while working for the company.

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EXAMPLE 4 - Acceleration Clause: This clause can unintentionally cause employees to surpass the $100K limit since a large portion of their shares become exercisable at the same time. This is important to keep in mind, especially with M&A activity, as there can be a vesting acceleration as a provision in the transaction that the employee will need to be aware of - although it’s difficult to plan for.