Learn everything you need to know about section 409A of the internal revenue code. From what is a 409A valuation to 409A methodologies and process.
The $100K ISO limit (also known as the $100K rule) prevents employees from treating more than $100K worth of exercisable options as incentive stock options (ISOs) in a year.
Incentive stock options (ISOs), as opposed to non-qualified stock options (NSOs), qualify for favorable tax treatment by the IRS. The $100K ISO limit is an effort to prevent abuse of this tax benefit. Anything in excess of $100K worth of stock options exercisable in one year is treated by the IRS as NSOs.
To comply with the $100K rule, you can divide option grants that exceed the $100k threshold into ISO and NSO portions. This division is commonly called an ISO/NSO split.
Why you should care about the $100K rule
The $100K rule could affect the amount of taxes that your company needs to withhold (or that your employees will owe). This is because ISOs and NSOs are taxed differently—NSOs are usually taxed both when your employees exercise (i.e. purchase) and when they sell stock, while ISOs are usually only taxed when employees sell. Plus, your company can take a tax deduction when your employees exercise NSOs, but not ISOs.
It’s important to understand when the $100K rule triggers and plan ahead. After you issue an equity grant, it can be difficult to change or amend the grant.
With Carta, you don’t have to manually check that each of your grants follows the $100K rule. With all of your cap table data in Carta, our platform automatically takes care of ISO/NSO splits for you.
Download the $100K limit guide
What the $100K ISO rule says
According to the U.S. Internal Revenue Code, §422(d)(1-3), you need to know the following in order to determine if you exceed the $100K limit:
- The number of shares that first become exercisable in a calendar year;
- The issue date of the grant(s); and
- The fair market value (FMV) of the shares when the grant(s) were issued.
The rule says that if an employee receives more than $100K worth of exercisable ISOs in a year, the oldest $100K in options (according to the grant date) can be issued as ISOs. All options that vest after that amount that year will be treated as NSOs.
Here’s a simple example of the $100K rule. For other scenarios, download our Guide to the $100K Rule.
$100K limit example: A single grant
An employee receives an option grant with the following details:
- Options granted: 120,000 shares
- Grant date: 3/1/2018
- Vesting schedule: Monthly for four years with a one-year cliff
- Fair market value (FMV): $2.50
- Early exercisable: No
According to the $100K rule, this ISO grant should be split in 2019. On 3/1/2019, 30,000 options—a quarter of the grant—become exercisable based on the one-year vesting cliff date. Over the remaining nine months of the calendar year, 22,500 shares become exercisable (because 2,500 grants vest in each additional month). At an FMV of $2.50 per share, the value of the 52,500 exercisable shares is $131,250 in 2019, which exceeds the $100,000 ISO treatment limit.
A portion of the grant should be issued as NSOs in 2019 to help the company and employee comply with the $100K rule. In this example, 40,000 options are issued as ISOs and 12,500 options are issued as NSOs in 2019. The ISO portion of the grant has a value of $100,000 (40,000 shares × $2.50 FMV), which satisfies the $100K rule.
In this situation, the employee still has the same number of options and the same vesting schedule, but the ISO/NSO split clarifies the tax obligations on each portion of the grant for that year.
Many equity grants, like this example, include a one-year cliff as part of the vesting schedule. However, one-year vesting cliffs can unintentionally trigger the $100K rule because a large number of shares become exercisable in a short span of time. Some Carta customers create custom vesting schedules to maximize the number of ISO options in a grant.
Early exercising, multiple grants, cancellation, and more
The $100K rule gets more complicated with other scenarios like early exercisable grants, grants with multiple splits, multiple grants, and canceled or modified grants. To see examples of each of these scenarios (and more), download our guide.
Stay up to date with monthly blog highlights