Incentive stock options (ISOs) have long been a favored form of equity compensation for companies, particularly startups, to attract, incentivize and retain employees. When properly structured, ISOs offer two key federal tax benefits: (i) ISOs are not taxed as income when granted by the company or exercised by the employee, and (ii) subject to applicable holding periods, any gain on stock acquired from the exercise of an ISO is taxed at a more favorable capital gains rate (however, the spread at exercise may be subject to the alternative minimum tax (AMT)).
But the regulatory framework that gives ISOs potentially advantageous tax treatment comes at the price of their flexibility once granted. What companies may view as a “minor” change to the terms of an ISO may be treated as a “modification” under the tax regulations, which can have significant, unanticipated consequences and, in some cases, cause the ISO to lose its preferential tax treatment altogether, and in the worst-case scenario, become subject to Section 409A and the 20% additional tax thereunder. In such instances, the option no longer qualifies as an ISO and is thereafter treated as a nonqualified stock option (NSO) for tax purposes, meaning that it is taxable upon exercise and any resulting stock is not eligible for favorable capital gains treatment.
Loss of ISO treatment may be frustrating to both companies and their employees, and therefore it is important to understand the implications of an option amendment before implementation.
Summary of ISO Requirements
In order for an option to qualify as an ISO under Internal Revenue Code §422, it must satisfy all statutory requirements, including the following on the date of its original grant:
- Granted to an employee of the company (or its parent or subsidiary)
- Granted under the company’s written equity plan
- Exercise price must be at least equal to the fair market value of the underlying shares (and for employees who are >10% stockholders of the company, the exercise price must be at least 110% of fair market value)
- The term of the option is no longer than 10 years (or no longer than 5 years for >10% stockholders)
- No more than $100,000 of shares (based on the fair market value as of the date of grant) may first become exercisable in any calendar year
To the extent an option fails to meet the statutory requirements, or is in excess of the $100,000 annual limitation, it is treated as an NSO for tax purposes.
Modifications of ISOs
Under applicable tax rules, a “modification” of an outstanding option is generally treated like a newly granted option as of the modification date. “Modification” is broadly defined to include any change that provides additional benefit to the optionholder, regardless of whether the optionholder actually benefits from such changes.
When an option is “modified,” it must re-satisfy all ISO requirements based on and as of the modification date to continue to be treated as an ISO. To the extent that ISO requirements are not met as of the modification date, the option is thereafter an NSO for tax purposes. In most cases, ISO status that is lost due to a modification cannot be restored.
Common Modifications and Their Impact
Companies may contemplate any number of changes to their outstanding options. Most often, companies propose amendments to (i) grant early exercise rights, (ii) accelerate vesting, (iii) extend exercise periods, or (iv) change exercise price.
Grants of Early Exercise Rights
To make option awards more competitive or attractive for its employees, a company may consider granting early exercise rights, which allows employees to exercise outstanding but unvested options, subject to a right of repurchase. Early exercise allows employees to own shares earlier and accordingly start their capital gains holding periods earlier.
While early exercise rights that are added to an option after its original grant date would seem to be a modification because they appear to provide an additional benefit to the optionholder, the ISO regulations specifically provide that this is not a modification of an ISO and can be added without jeopardizing this ISO status.
Acceleration of Vesting
In connection with acquisitions, layoffs, changes in control or other special scenarios, companies may consider adding single-trigger or double-trigger acceleration terms to outstanding options to allow employees to vest in unvested options upon the occurrence of such events.
As a general matter, accelerating vesting does not itself constitute a modification for ISO purposes. However, acceleration might cause more shares to “first become exercisable” in a single calendar year, potentially causing all or a portion of the option to exceed the $100,000 ISO limit for that year. Any excess over the limit is treated as an NSO.
Extensions of Exercise Periods
Most employee options are originally granted with a three-month post-termination exercise period (with certain extended periods provided for death or disability and shorter periods for a termination for cause). When an employee departs, a company may consider extending the exercise periods of the employee’s options to allow them additional time to decide whether to exercise them for shares.
Two separate ISO issues arise with respect to extensions: (i) extending the post‑termination exercise window is generally treated as a modification, causing re‑testing of ISO status as of the extension date, and (ii) regardless of any extension, an exercise that occurs more than three months after employment ends (excluding disability or death) cannot receive ISO tax treatment. In other words, if the ISO is in-the-money when the exercise period is extended, it will become an NSO, and even if the option remains an ISO, if it remains outstanding and exercisable after the three-month post‑employment period, it becomes an NSO at the end of such three-month post-employment period.
Adding Exercise Method (such as Promissory Note)
Adding an additional method of exercising an option, such as allowing exercise with a full-recourse promissory note, is typically expected to be treated as a modification, even though this may have been permissible to include when the ISO was granted. If the ISO is in-the-money or otherwise cannot requalify as an ISO at the date of this modification, it would be expected to become an NSO.
Changes to Exercise Price
If the price of a company’s stock decreases over time, a company may consider repricing any underwater options to restore their retentive purpose. Options are “underwater” if the exercise price per share is greater than the current fair market value of the share, meaning that an employee would inherently lose value by exercising their option. To fix this, a company may want to amend underwater options to reduce their exercise price to the current fair market value.
A reduction in exercise price is among the clearest examples of a modification and results in a deemed new grant of the option. Because ISOs must have an exercise price at least equal to the fair market value on the grant date, a repricing to lower that value will generally cause the option to fail the ISO test; however, repriced ISOs generally should be able to re-satisfy all ISO requirements based on and as of the modification date and typically will continue to be treated as an ISO (although if there are changes that make requalification not possible, such as no longer being an employee, the ISO will lose its ISO status in the repricing). Note that repricing can effectively double count prior ISOs, as the repriced grant is treated as a new ISO, such that the award could exceed the $100,000 limitation when including the prior ISOs as new awards.
Consider the AMT
As a final thought, if the ISO holder would otherwise be subject to the AMT, the loss of ISO status may not be as impactful as expected, because rather than paying a 26% or 28% AMT tax (based on 2026 rates), the individual would be subject to ordinary income tax rates, which may not be as dramatically different than it would be for someone not subject to AMT. Additionally, the vast majority of ISOs are not exercised and held for the required ISO holding periods, and they will become NSOs in the majority of cases in any event, so the loss of ISO status may be less impactful than expected, although the tax benefits of an ISO when utilized to get long-term capital gain are measurably better where possible.
