Incentive Stock Options (ISOs) provide employees the ability to receive employer stock without realizing taxable income when granted or exercised. In order to qualify as an ISO, the exercise price of the option may not be less than the fair market value of the stock when granted, the option plan must be approved by shareholders, and the option must be excercisable within 10 years from receipt.
Other requirements, such as the person being a current independent contractor or employee of the employer from the time the option is granted until at least three months before exercise, must also be satisfied. Unless otherwise agreed under a stock option agreement, an employee usually has up to three months after employment termination to exercise an ISO.
The amount of ISOs that can be granted to an employee is limited. The amount of options issued to any employee that are first exercisable in any
calendar year cannot have a market value of more than $100,000 (calculated by multiplying the number of shares first exercisable in that year by the exercise price at grant).
For example, Employee M was granted 500,000 options by his employer. Employee M’s ISO shares are calculated as follows: $100,000 / 4.74 = 21,097 (rounded down). Suppose the vesting schedule has a 25% cliff for the first year. If 21,097 shares may be acquired pursuant to the $100,000 cap, then Employee M’s total ISO options are 84,388 (21,097 X 4).
A stock cliff is the period of time between the grant date of a set of options and the date that the first portion vests. In the example above, the first 25% of the options grant vests after a 12 month period. That first 12 months is known as the cliff. The purpose of the cliff is to entice the employee to stay at a position for at least a year: The employee does not get any equity before the first 12 months is over.
Only ISOs that are vested count towards the $100,000 limit. If options are granted in excess of the $100,000 limit, the excess options are considered non-qualified stock options (NQSOs). NQSOs are not eligible for the favorable tax treatment of ISOs.
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