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ISO 100K Limit: Maximize Your Profits Thumbnail

ISO 100K Limit: Maximize Your Profits

The ISO 100k limit ensures employees who receive equity compensation don't abuse the tax benefits offered. By limiting the number of options excluded from taxation, employees can't take advantage of the rule and avoid taxation.

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What Is an ISO 100K Limit?

The ISO 100k limit is a rule that limits employees from treating more than $100,000 of their stock options as incentive stock options. This is because ISOs have favorable tax treatment; employees don't pay taxes when exercising their stock options, only when selling the stock.

What Is This Limit Used For?

The ISO 100k limit is to help avoid tax abuse on stock options. The limit applies to exercisable incentive stock options provided as employee compensation. Any stock options exercised with a value over the $100k limit are taxed as non-qualified stock options and have different tax treatments.

An Exercisable Incentive Stock Option (ISO)

You might wonder what an exercisable incentive stock option is and how it affects your taxes.

When you start a job, you may be issued stock compensation in addition to your salary. Some companies issue stock options or the right to exercise the right to buy shares at a strike price. This price is often less than the grant fair market value, giving employees an immediate profit. Typically, this triggers a taxable event, but the first $100k may be protected.

Not owing taxes on the profit until you sell the stock is a benefit in and of itself, and up to the first $100k, each year is eligible.

Difference Between NSO and ISO

When you receive equity compensation, some might be incentive stock options, and others might be non-qualified stock options or NSOs.

The main difference between incentive stock options and NSOs is the tax treatment. When you exercise NSOs, you pay taxes on the difference between the stock's fair market value and the exercise strike price. The difference is taxed at your ordinary income tax rate.

This is different than ISOs which you only incur taxes on the profits when you sell them. If you hold onto the stocks long, you defer the tax liability.

Related Article | Wash Sale Rule Related to Equity Compensation (RSUs, ESPP, ISOs)

Vital Clauses of the ISO 100K Limit

The ISO 100k limit has fine print, as does any regulations. Here's what you should consider.

Fair Market Value

The fair market value (FMV) is the stock's current value as it trades on the stock market. Stock options have a strike price that might be more or less than the fair market value. If you exercise the option to buy a stock at a lower exercise price than the fair market value, you instantly profit. However, if the strike price exceeds the fair market value, the option isn't worth anything.

How to Determine Fair Value

Startup (private) companies can't rely on the market to determine their fair value. Instead, they must have an independent appraisal completed. The 409A valuation must be completed annually to determine the company's stock value.

Exercise of First Share 

The 100k limit applies to the first shares exercised, not the total offered on the grant date. However, you may not exceed the limit if not all shares are exercisable in a year.

For example, if you are granted $300,000 in stock options but exercise $50,000 each year according to your vesting schedule, you wouldn't exceed the 100k limit. This is because most companies have a vesting schedule that starts on the grant date but doesn't allow you to exercise options until a specific date, usually at least one year.

Vesting Calculations

To determine the stock options vested each year, you must know the fair market value and the vesting schedule.

For example, you are given 80 shares, and the fair market value is $100 with a 4-year vesting period. You could exercise 20 shares per year at $100 each or $2,000. You wouldn't exceed the 100k limit.

On the other hand, if you are given 5,000 shares with a $100 fair market value and a 4-year vesting period, you'd get 1,250 shares per year. If you exercised all the shares, only the first $100,000 out of the $125,000 would be treated as ISOs.

Cliff Vesting 

Most employee stock option programs have a 1-year cliff to encourage longevity. Many programs award 25% of the stock options on the first anniversary; however, you may get awarded additional stock options monthly after the cliff vesting.

If the value of the options exceeds $100k in the year, only the first $100k would be treated as incentive stock options.

For example, you can purchase 5,000 shares at $50 a share with a 1-year 25% cliff vesting period. On your first anniversary, which is January 1, you exercise the option to buy 250 shares at $62,500. However, you continue vesting monthly, exercising more options each month. Once you hit the $100k limit, your tax benefits end, and the stocks become NSOs.

M&A Acceleration 

A company can force immediate vesting if it has an M&A acceleration provision. This usually happens only when another event, such as being laid off, occurs. However, the immediate vesting may put you over the $100k limit, triggering a tax event.

Related Article | 8 Tips If You're Being Compensated With Incentive Stock Options (ISOs)

Why Companies Should Keep the 100K Limit

Companies should adhere to the 100k limit to avoid violations and stop employees from exercising their options early.

Here are a few reasons to consider it:

  • Promotes equitable ownership in the company rather than one employee monopolizing it
  • Avoids abuse of the tax law
  • Ensures IRS compliance
  • It may help a company survive

How to Calculate an ISO 100K Limit

To calculate the ISO 100k limit, you'll need the stock's fair market value and the number of exercisable shares. With these numbers, you can determine if you've violated or are at risk of violating the 100,000 limitations.

ISO 100K Calculation Examples

Here is an example to help you understand the ISO 100k limit rule.

You are granted 150,000 shares as options. The grant date is 2/1/2021, with a five-year vesting period with a 1-year cliff period. After the cliff period, your shares vest monthly, and the fair market value is $3.00 per share.

On 2/1/2022, you can exercise 30,000 shares; then, for the following 48 months, you can exercise 2,500 shares. This means in 2022, you'd exercise 55,000 shares in total. With a fair market value of $3.00, you could exercise up to $165,000 in stock options, which exceeds the $100,000 limitation. This means an ISO/NSO split would occur.

In the remaining years, though, you could exercise 30,000 annually (2,500 per month) at a $3 fair market value, which has a total value of $90,000 below the $100,000 limitation.

Related Article | Your Guide to Microsoft RSUs, ISOs and ESPP

ISO 100K Limit FAQs

What Will Happen if You Violate the ISO Limit of 100K?

If you violate the ISO limit of 100k, you'll lose the tax benefit of ISOs. Any options you receive in excess of the $100k limit will be taxed at your ordinary income tax rate.

How Are Incentive Stocks Used?

Incentive stock options help companies attract more talented employees and help reduce turnover. In addition, a longer vesting schedule helps employees stay employed longer to receive their stock options and full compensation.

How Do You Keep Track of Incentive Stock Options?

Consider using a program to track your investments, including your stock options. This way, you'll know how many options you've exercised for the year so you don't exceed the $100,000 limitation.

ISO 100K Limit - The Bottom Line

The ISO 100k limit is important for companies and employees. It may seem complicated or unfair, but it keeps everyone on the same page. In addition, you'll pay your required taxes and limit the number of options you exercise to keep a company stable.