Startup clients grant stock options to employees and expect them to be incentive stock options (ISOs). Whether they are depends on a list of statutory tests, and one of them, the $100,000 limit, is applied at exercise time using values from grant time. Option grants that exceed it are split automatically, and the employee finds out when the tax return is prepared. The CPA firm that advises the company should check the grants before the employees exercise. The grant-date price itself is the subject of 409A valuations.
What makes an option an ISO
Under section 422(b), an incentive stock option is an option granted to an individual in connection with employment, by the employer corporation or its parent or subsidiary, to purchase stock of any of those corporations, but only if:
- the option is granted under a plan that states the aggregate number of shares and the eligible employees, approved by stockholders within 12 months before or after the plan is adopted;
- it is granted within 10 years from the plan's adoption or stockholder approval, whichever is earlier;
- by its terms it is not exercisable after 10 years from grant;
- the option price is not less than the fair market value of the stock at grant;
- it is not transferable other than by will or the laws of descent and distribution and is exercisable only by the employee during life; and
- at grant, the employee does not own stock possessing more than 10 percent of the total combined voting power of all classes of stock of the employer or its parent or subsidiary.
The 10 percent owner test has an alternative under section 422(c)(5): the option qualifies if the exercise price is at least 110 percent of fair market value and the option is not exercisable after 5 years. An option does not qualify if its terms provide that it will not be treated as an ISO.
The $100,000 limit
Under section 422(d)(1), to the extent that the aggregate fair market value of stock with respect to which ISOs are exercisable for the first time by an individual during any calendar year, under all plans of the employer and its parent and subsidiaries, exceeds $100,000, the options are treated as options that are not ISOs. The limit is applied by taking options into account in the order in which they were granted. The fair market value of stock is determined as of the time the option is granted.
Holding periods and employment
Section 422(a) gives ISO treatment on exercise only if the holder makes no disposition of the share within 2 years from the date of grant nor within 1 year after the transfer of the share, and is an employee of the granting corporation, its parent or subsidiary, or a corporation that issued or assumed the option, at all times from grant until 3 months before exercise. A sale before both periods have run is a disqualifying disposition.
Tax treatment and AMT
For an ISO, section 421(a) provides that no income results at exercise and the employer gets no deduction for the share. For an NSO, the spread at exercise is compensation under section 83, and the employer deducts the amount included under section 83(h).
For the alternative minimum tax, section 56(b)(3) provides that section 421 does not apply to stock acquired by exercising an ISO. Publication 525 explains the adjustment: when the stock becomes transferable or is no longer subject to a substantial risk of forfeiture, the adjustment is its fair market value minus the option price. The adjustment goes on Form 6251, line 2i, and increases the AMT basis in the stock. No adjustment is needed if the stock is sold in the year of exercise. Regular basis and AMT basis differ, so the preparer keeps both.
Worked example: the $100,000 split
An employee holds options on 12,000 shares granted at an exercise price of $10, which was also fair market value at grant. All of them become exercisable for the first time in 2027. She exercises them all in 2027 when the stock is worth $25.
- Value at grant of the shares first exercisable in 2027: 12,000 times $10, or $120,000.
- Limit: $100,000, so 10,000 shares (10,000 times $10) qualify as ISOs and the remaining 2,000 shares are treated as NSOs.
- NSO compensation income: 2,000 times ($25 minus $10), or $30,000.
- ISO AMT adjustment: 10,000 times ($25 minus $10), or $150,000, assuming the stock is vested at exercise and she holds the shares past year end.
If the options came from two grants, the earlier grant is counted first under section 422(d)(2). The company reports the NSO portion as wages and the ISO exercise on Form 3921.
Worked example: a disqualifying disposition
Publication 525 gives the pattern. An ISO for 100 shares is granted March 12, 2023 at $10. It is exercised January 7, 2024 when the stock is worth $12, and the shares are sold January 27, 2025 at $15. The sale is within 2 years of grant, so the holding period fails.
- Total gain: ($15 minus $10) times 100, or $500.
- Ordinary income, the lesser of the gain or the spread at exercise: ($12 minus $10) times 100, or $200.
- Capital gain: $500 minus $200, or $300.
- Basis: the amount paid plus the $200 reported as wages.
If the sale price had been below the exercise price, the loss is a capital loss and there is no ordinary income. Under section 421(b), the income and the employer's deduction fall in the year of the sale, and no income tax withholding is required on it.
Common errors
- Measuring the $100,000 limit at exercise value instead of grant value.
- Counting by grant year instead of by the calendar year the options first become exercisable.
- Applying the AMT adjustment to a same-year sale, where none is needed.
- Missing the 3-month employment rule for a former employee who exercises late.
- Using the exercise date, not the vesting date, as the AMT measurement date for unvested stock.
Do ISOs need a Form 3921?
Yes. Every corporation that transfers stock on an ISO exercise in a calendar year files Form 3921 for each transfer. The form reports the grant date, the exercise date, the exercise price per share, the fair market value per share at exercise and the number of shares. Publication 525 states the employee copy is due by January 31 of the following year.
Company checklist
- Plan document and stockholder approval, with dates.
- Grant agreements stating the ISO designation, price and term.
- Fair market value support at each grant date. See 409A valuation.
- A schedule of first-exercisable values by employee by calendar year to apply the $100,000 limit.
- Tracking of employee status and disqualifying dispositions.
- Accounting for option expense under ASC 718 for private companies and modifications and graded vesting.
- Year-end estimates for employees with large exercises, see estimated tax safe harbors.
Sources
- Legal Information Institute, 26 U.S.C. 422, Incentive stock options: https://www.law.cornell.edu/uscode/text/26/422
- Legal Information Institute, 26 U.S.C. 421, general rules and disqualifying dispositions: https://www.law.cornell.edu/uscode/text/26/421
- Internal Revenue Service, Publication 525, Taxable and Nontaxable Income (ISO rules, Examples 7 and 8): https://www.irs.gov/publications/p525
- Internal Revenue Service, Instructions for Form 3921: https://www.irs.gov/instructions/i3921
- Legal Information Institute, 26 U.S.C. 56, Adjustments in computing alternative minimum taxable income: https://www.law.cornell.edu/uscode/text/26/56
- Legal Information Institute, 26 U.S.C. 83, Property transferred in connection with performance of services: https://www.law.cornell.edu/uscode/text/26/83
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