What is your understanding of the Section 422(d) limitation?

October 2, 1998

From: Frank

What is your understanding of the Section 422(d) limitation?


Hello Frank,

Section 422(d) defines one of the limitations an employer must meet in order for an employee stock option to qualify as an incentive stock option.

In the year the option is granted, the maximum fair market value of stock for which incentive stock options are initially exercisable for an employee is $100,000 per year. Any options exceeding the $100,000 limit are non-qualified options. Options are counted against the limit in the order of the years they were granted. For this test, the fair market value of the shares is determined on the date the options are granted.

Example 1: During 19X1, ABC Corporation awards stock options intended to qualify as incentive stock options to Doug Super. The fair market value of the stock on the date of grant is $1 million. The options are exercisable for $100,000 of stock per year for ten years. No other incentive stock options are granted to Doug.

Since an incentive stock option may be exercisable up to 10 years after the date the option is granted and not more than $100,000 of options are exercisable , the above options should qualify as incentive stock options.

Example 2: Sally Star is granted the following options, intended to qualify as incentive stock options.

Year FMV Year
Granted At Grant Exercisable
19X1 100,000 19X2
19X2 50,000 19X2
19X2 100,000 19X3

Since the fair market value of the options exercisable in 19X2 exceeds $100,000, which is the amount granted in 19X1, the $50,000 of shares granted and exercisable in 19X2 are non-qualified options.

What if an option intended to qualify as an incentive stock option is granted to an employee for $150,000 of shares, exercisable in 19X2? $100,000 of the shares may qualify as ISO shares, and $50,000 of the shares would be non-qualified option shares. The company may issue certificates designating which shares are which, or each share will be considered 1/3 non-qualifying and 2/3 ISO.

What if an event, such as a corporate acquisition, resulted in accelerating the dates the options are exercisable? The shares disqualifying for ISO treatment are redetermined.

Example 3: Same as Example 2, but during 19X2, ABC Corp is acquired by Microbender Corp and all incentive stock options become immediately exercisable. Only the shares granted in 19X1 would qualify for ISO treatment. All of the options granted in 19X2 would be treated as non-qualified options.

Good luck!

Mike Gray

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

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