The $100K ISO limit (also known as the $100K rule) prevents employees from treating more than $100,000 worth of exercisable options as incentive stock options (ISOs) in a single year.
The first $100,000 of stock options that become exercisable for an employee in a year can be issued as ISOs, and any additional stock options will be taxed as non-qualified stock options (NSOs). ISOs are not taxed when exercised, so the $100K ISO limit aims to prevent abuse of this tax benefit.
To comply with the $100K rule, your company may divide option grants that exceed the $100,000 threshold into ISO and NSO portions. This division is commonly called an ISO/NSO split.
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Why the $100K rule matters
The $100K rule could affect the amount of taxes that you will need to pay when exercising your stock options, because ISOs and NSOs are taxed differently. NSOs are usually taxed both when employees exercise (i.e. purchase) shares and when they sell them, whereas ISOs are only taxed when employees sell them.
When you exercise (i.e. purchase) NSOs, you will owe tax on the “bargain element,” or the difference between the fair market value (FMV) of your shares at exercise and the exercise price. The bargain element is taxed as compensation at your ordinary income tax rate. While you pay taxes as an employee when exercising your NSOs, your company can take a tax deduction.
In contrast, ISOs are not taxed upon exercise, and exercising does not give your company a tax deduction.
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