Incentive Stock Option Modifications – Key Considerations and Traps for the Unwary

Incentive stock options (ISOs) are a form of equity compensation widely used by companies with employees who are subject to US taxes. Emerging and late-stage private companies alike frequently choose to issue ISOs because they are not immediately taxed upon exercise and may receive favorable tax treatment if holding period requirements are met. An ISO allows employees to defer tax until sale of the stock issued upon exercise of the ISO and, if the optionee satisfies certain holding periods, for the tax at sale to be treated as long-term capital gain instead of ordinary income.

Founders and in-house legal and finance teams are sometimes surprised to learn that modifying the terms of ISOs can unintentionally convert ISOs into non-qualified stock options (NSOs), causing them to lose their special tax treatment and resulting in payroll tax withholding obligations for the company upon option exercise.

This article summarizes the tax rules governing ISO modifications and highlights certain common changes that can cause a loss of ISO status. For general background on ISOs and the differences between ISOs and NSOs, see this Cooley GO article.

What is ‘modification’ of an ISO?

Under section 424 of the US Internal Revenue Code, a “modification” is any change to an ISO that gives the option holder additional direct or indirect benefits. As noted above, a “modification” can result in an ISO losing its special tax treatment. The IRS’s definition of “modification” is broad, and the relevant IRS guidance is highly fact-specific and should be consulted carefully before making even minor, well-intentioned tweaks to help employees, to avoid accidentally and unexpectedly converting an ISO into an NSO.

Do changes to vesting and acceleration terms count as ‘modifications’?

Not necessarily. Adjusting vesting, adding double-trigger acceleration or extending vesting upon family leave generally does not constitute a modification in and of itself. However, it’s important to remember that, for a given employee, the aggregate grant-date fair market value of ISOs that become exercisable for the first time in any calendar year may not exceed $100,000. Any excess over this amount is treated as an NSO. Adjustments that would not otherwise be considered “modifications” can therefore trip up this limit if they operate to increase the aggregate grant-date fair market value of options that first become exercisable in a given year. Accelerating vesting, for instance, may cause options that were previously set to vest over several years to become exercisable in a single year and push the ISO over the annual $100,000 limit. The excess over the annual $100,000 limit automatically converts to NSOs even if the option was not otherwise amended.

Does an offer to modify an ISO automatically convert an ISO into an NSO?

No. An offer to modify an ISO does not automatically convert an ISO into an NSO. However, an offer to modify an ISO that is left open for 30 days or more results in an automatic loss of ISO status, even if the offer is never accepted. This sometimes arises in connection with an extension of an ISO’s post-termination exercise period. The extension of the post-termination exercise period is a modification, and if the offer to extend the post-termination exercise period remains open for more than 29 days, the ISO converts to an NSO regardless of whether or not the offer is accepted, even if the option is exercised during the standard three-month period following employment termination (i.e., even if the employee did not take advantage of the extended post-termination exercise period).

Does repricing or exchanging underwater ISOs convert them into NSOs?

Not necessarily, although it can lead to this result. Lowering the exercise price or exchanging underwater options for ISOs is treated as a brand-new grant, and resets the grant date and restarts the ISO holding periods. Note that the entire fair market value of the grant (calculated as of the time of repricing or exchange) counts toward the $100,000 annual limit described above; exceeding the annual $100,000 limit converts excess shares to NSOs.

Implementing option repricing early in the calendar year can help spread vesting value across the first and subsequent years and reduce the likelihood of breaching the annual $100,000 limit, which is measured on a year-by-year basis. However, for larger option grants, if the repricing or exchange does not change the exercisability of the resulting option, it is likely a portion of the repriced or exchanged option will convert to an NSO due to exceeding the $100,000 limit.

Does allowing cashless exercise in a secondary or tender offer convert ISOs to NSOs?

When options are purchased in a secondary sale or tender offer, it is common for the company to allow “cashless exercise” of options. In a cashless exercise, the company (or a buyer) typically funds the exercise price and taxes out of the sale proceeds, so the employee receives shares (or cash if part of an immediate liquidity program) on a net basis, without the option holder having to pay cash to exercise the option.

Permitting cashless exercise tied to an immediate liquidity program is generally viewed as an ISO modification because the employee no longer bears the economic risk of share ownership. As a result, the portion of an ISO participating in the cashless transaction converts to an NSO immediately prior to exercise. Companies can mitigate the impact of modification by limiting cashless exercise to NSO portions.

How can I avoid or solve the issues noted above?

The IRS rules around ISOs are complex, and ISO modifications can be deceptively easy to trigger and extraordinarily costly to fix – if they can even be fixed at all. A brief consult with counsel before changing option terms, extending offer windows or facilitating liquidity events can help preserve favorable tax treatment for employees and avoid unexpected payroll and reporting obligations for the company. Below are a few additional best practices for companies to consider when modifying ISOs.

• Ensure any offers to modify an ISO remain open for no more than 29 days.
• Before adjusting vesting or exercisability schedules, run a $100,000 limit analysis for each impacted employee.
• Model the tax and accounting impact of any repricing or option exchange before board approval.
• When planning secondaries, consult tax counsel to structure liquidity so that ISO portions are either preserved or intentionally disqualified with full disclosure to employees.
• Maintain a centralized equity database to flag potential ISO disqualification events in real time.