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Subject:   option article
Date:   Wed, 30 Jan 2008
From:   Joe

I'm confused about how the $100,000 per year limit for ISOs works. (If more than $100,000 of ISOs are first exercisable in a taxable year, any excess of options issued over the limit are reclassified to NQOs.) What's the interplay between the value on the grant date and when the stock becomes exercisable?

Thank you.

Answer

Date:   1 Feb 2008

Hello Joe,

The value of stock in determining the limit is based on the fair market value on the grant date. The option price for most ISOs is the fair market value on the grant date, so that can be a "short hand" way of determining whether the limit applies.

The dollar limit applies based on when the options are exercisable. Most ISOs become exercisable as they vest, but some have an early exercise privilege.

For example, the ISOs for XYZ Company become exercisable as they vest. They vest 25% per year. In year 1, an ISO is granted to Jane Employee for 100,000 shares at 50¢ per share, the fair market value when the ISO is granted. In year 2, another ISO is granted to Jane for 200,000 shares at $1 per share, also fair market value on the grant date. These are the only ISOs granted. In year 3, $62,500 is first exercisable for the $100,000 limit. (100,000 X 50¢ = $50,000 X 25% = $12,500 for ISOs granted in Year 1; 200,000 X $1 = $200,000 X 25% = $50,000 for Year 2.)

You have to look at the terms of the plan and whether vesting has later been accelerated to determine if there is a problem.

Good luck!

Mike Gray

For more information about incentive stock options, request our free report, Incentive Stock Options - Executive Tax and Financial Planning Strategies.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this answer was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.