Incentive Stock Options (ISOs), as opposed to Non-qualified Stock Options (NSOs aka NQSOs), are subject to favorable IRS treatment. The main benefit being not having to pay ordinary income tax on the spread between the fair market value (FMV) and the original exercise strike price when exercised. For NSOs, ordinary income tax on the spread is withheld at the point of exercise. However, ISOs are still subject to Alternative Minimum Tax (AMT) to prevent wealthy individuals from sheltering all of their income this way. The $100K Limit (100K ISO limitation) is another IRS rule to prevent the ISO program from being abused as a tax shelter. See this article link for a more complete list of the differences between an ISO and an NSO.
The $100K Limit means that the maximum amount of ISOs that an employee can receive (vest) per year is $100K. The amount is computed by taking the per share FMV at the time of the grant and multiplying by the number of shares granted. If the grant is subject to vesting such as a 4 year schedule, then the previous product is divided by 4 to determine whether the grant is under the $100K ISO limitation. If the grant is eligible for early exercise, then you do not divide by 4 since the number of shares is based on the number eligible for exercise that year. Any excess options and subsequent grants above the $100K limit are deemed NSOs and subject to immediate withholding tax at the time of exercise.
It is very common for employee stock option grants to have a one year cliff when 25% of your grant vests all at once to encourage you to stay with the company at least one year. If your ISO grant was maximized by granting $100K per year, then your company may have inadvertently triggered NSO re-characterization on some of your options. The 100K maximum is based on the tax year in which they options first became exercisable as opposed to the time along the way. For example, let's say you have option to purchase 400,000 shares at a $1 exercise price. These vest over a 4 year period with 25% vesting at the 1 year anniversary and the rest vesting 1/48 per month over the remaining 3 years. Let's say that your option grant date anniversary is Jan 15th each year. On Jan 15 of the year of your first anniversary, you'll vest 25% (100,000 shares) but you'll proceed to vest 11 more months of shares during the same tax year. That would be approximately 91,666 more shares which brings your total to 191,666 shares vested during the same tax year. At $1 per share exercise price, you exceed the 100K rule by 91,666 shares which would become NSOs while the other 100,000 shares remain ISOs.
It is very common for employee stock option grants to have an acceleration clause when the company issuing the grant is acquired. Acceleration means that some or all of the unvested shares will suddenly vest. Those clauses are usually double trigger which means that acceleration only occurs if a second event such as being laid off or demoted also occurs. In any case, the additional vesting in addition to regular time-based vesting of shares is also subject to the 100K Limit. Since time-based vesting is often already maxed out to reach the 100K Limit, the accelerated shares will exceed that amount and become non-qualified stock options (NSOs). If the M&A involves cashing out all of the vested option grants then the consequence of the 100K ISO limitation is greatly reduced. The small differences are the Medicare taxes. For ISOs that are net-exercised for cash, the final sale price less the exercise price is a disqualifying disposition and taxed at the ordinary income tax rate but without the Medicare surcharge. However, the Medicare additional tax of 0.9% still applies for high income employees or when the gain from the M&A is large. For NSOs that are net-exercised for cash, the entire gain will be taxed as compensation income subject to ordinary income tax including the Medicare surcharges.
Exercising stock options early can require a lot of capital and yet the time to liquidity for your company can be quite long. As your shares vest, you may be tempted to sell some shares to recover your original investment or perhaps fund other financial needs. Be aware that a sale is likely a taxable event and most likely at high tax rates when held for less than a year. A sale also truncates any possibility of future upside on the shares being sold. An alternative solution for partial liquidity is to get an advance from the Employee Stock Option Fund. This is an attractive solution since you are not transferring title to the stock and still retain the ability to achieve unlimited upside. Furthermore, if the stock becomes worthless, ESO absorbs the loss, not you. For more information on stock option advances or tax matters, please contact Scott Chou at the Employee Stock Option Fund.