As a startup founder, you only have so many tools in your arsenal with which to lure top-quality talent. And perhaps no tool is as powerful as employee stock options, a form of equity compensation that’s particularly popular with employees at startups. But heed this word of warning: There are a couple different types of startup stock options that can be granted to employees, and some key regulations that govern what one employee can receive. One such regulation to keep in mind is the ISO $100K limit.
In this guide, we’ll review the basics of incentive stock options (ISOs) and their unique tax benefits. We’ll also define the ISO $100K limit and explain how it prevents employees from abusing those tax benefits. This is all important stuff for a founder to know, as it helps to determine how much you can grant individual employees in the form of stock options.
- What is the ISO $100K limit?
- Key tax differences between ISOs and NSOs
- What happens if you violate the ISO $100K limit?
- How to calculate the ISO $100K limit
- Pulley helps you make sense of employee equity
What is the ISO $100K limit?
To understand the ISO $100K limit, it helps to know what incentive stock options are.
Incentive stock options (ISOs) are a type of stock option that qualify for preferential tax treatment under the United States Internal Revenue Code if they meet certain criteria. If these criteria are met, the employee does not pay federal income taxes when they exercise their options. (The employee must still pay federal income tax when they sell the stock.)
ISOs can only be granted to employees, so their tax benefits don’t apply to just anyone. If you want to grant stock options to people who aren’t employees of your company, you will need to use another type of stock option called non-qualified stock options (NSOs or NQSOs). NSOs are taxed at the ordinary federal income tax rate when they’re exercised, so they don’t have the same tax benefits as ISOs.
The ISO $100K limit, also known as the “ISO limit” or “$100K rule,” exists to prevent employees from taking too much advantage of the tax benefits associated with ISOs. It states that employees can’t receive more than $100,000 worth of exercisable ISOs in a given calendar year. Any amount beyond that will be taxed as if the ISOs are NSOs.
What do you mean by “exercisable” ISOs?
“Exercise” is a key term in understanding how stock options work. A stock option is essentially a contract that allows an employee to purchase a number of shares of stock at a fixed price, which is sometimes referred to as the exercise price (or strike price). If the employee decides to purchase the stock, she is exercising her right to do so.
This is an important distinction, because not every stock option included in an option grant is exercisable in the first year. Oftentimes, options vest over a prescribed period of time known as a vesting schedule. For example, a vesting schedule of four years may state that 25% of options in the ISO grant vest after the first, second, third, and fourth year following the grant date.
As long as the total value of exercisable options that vest in a given tax year does not exceed $100,000, the employee won’t surpass the ISO $100K limit. This is one reason why it’s important to pay attention to the vesting period outlined in the option grant.
Just note that some equity plans allow the employee to “early exercise” stock options before they vest, so any options that qualify for early exercise must also be accounted for when calculating the $100K limit.
Key tax differences between ISOs and NSOs
We mentioned above that ISOs and NSOs differ primarily in how they’re taxed. The important thing to remember is that ISOs benefit from favorable tax treatment, while NSOs do not.
When you exercise NSOs, you’ll owe ordinary income tax on the difference between the stock’s fair market value (FMV) at the time of exercise and the initial exercise price. This amount is taxed as the ordinary income tax rate because the IRS considers it a form of compensation.
When you exercise ISOs, you won’t owe any ordinary income tax on the difference between the FMV and the initial exercise price. This is a potentially big advantage! One thing to keep in mind, however, is that ISOs are subject to the Alternative Minimum Tax (AMT). The AMT exists to ensure that certain wealthy taxpayers pay at least a minimum tax, limiting their possible tax deductions and exclusions.
If you (or an employee) aren’t sure about the amount of taxes you may owe on options, it’s best to reach out to a tax professional for help.
What happens if you violate the ISO $100K limit?
If an employee receives more than $100,000 in exercisable ISOs in a calendar year, any ISOs that surpass the $100K mark will be considered NSOs for tax purposes.
Technically, companies can’t authorize a grant that gives an employee more than $100,000 in exercisable ISOs in a given year. If a company accidentally offers a number of options that exceeds this limit, the portion of options above the limit will simply be reclassified and taxed as NSOs. This can be confusing (not to mention, a huge bummer) for employees who expect their options to all be taxed in a consistent way upon exercise, so it’s important to avoid screw-ups that may cause ISOs to be reclassified as NSOs.
How to calculate the ISO $100K limit
To calculate the ISO $100K limit, the IRS uses the aggregate fair market value of the stock with which the ISO is associated (this is usually common stock). The calculation itself is straightforward: the FMV per share on the date of grant x the number of shares that first become exercisable in any given year.
What is fair market value (FMV) and how is it determined?
Fair market value can be a confusing concept for first-time employees or those new to the startup scene, so it’s important to understand how it works and how it’s calculated.
Since private companies can’t depend on the open market to set a fair market value for their stock, they must depend on other means. Private companies that want to offer equity must complete an independent, unbiased appraisal of how much their stock is worth. This is known as a 409A valuation. As a general rule, a company must complete a 409A valuation every 12 months, or whenever a material event (e.g. a funding round) changes the valuation of the company’s stock.
Pulley helps you make sense of employee equity
As a startup founder, one of your responsibilities is to keep your employees happy and engaged. And one way to do that is to offer transparent equity plans with all the tools your employees need to make sense of their grant details.
Fortunately, Pulley is here to help your employees see the value of their equity. Our cap table management tools include a full suite of features to help you communicate the important aspects of equity, from delightful offer letters to number-crunching calculators. And with our audit-ready 409A valuations, you can rest assured that you’ll stay compliant and clear-headed even as your cap table increases in complexity.
Schedule a call with us today and see how we can help.
