The ISO 110% Rule is a specific requirement for Incentive Stock Options (ISOs) that applies to individuals considered "10% shareholders," ensuring that options granted to them meet specific criteria to retain their favorable tax treatment.
Understanding the ISO 110% Rule
The ISO 110% Rule dictates that if, immediately before an Incentive Stock Option (ISO) is granted, an individual owns (or is treated as owning) stock accounting for 10% or more of the total combined voting power of all classes of the company's stock, then the options granted to that individual cannot qualify as ISOs unless their strike price (or exercise price) is at least 110% of the stock's fair market value (FMV) on the grant date.
This rule is a critical aspect of ISO compliance, particularly for founders, early employees, or significant investors who might hold a substantial stake in a company. Without adhering to this rule, options intended as ISOs for these key individuals would instead be reclassified as Non-Qualified Stock Options (NSOs), which have different tax implications.
Key Aspects of the 110% Rule
To fully grasp the implications of this rule, consider the following key components:
- Who it Applies To: The rule specifically targets "10% shareholders." This means anyone who, at the time the option is granted, possesses or is deemed to possess 10% or more of the company's total combined voting power across all stock classes.
- The "10% Shareholder" Definition: An individual is considered a 10% shareholder if they own, or are treated as owning, stock that accounts for 10% or more of the total combined voting power of all classes of stock. This includes direct ownership as well as constructive ownership (e.g., stock owned by family members or through certain partnerships and trusts).
- Strike Price Requirement: For a 10% shareholder's options to qualify as ISOs, the strike price must be set at a premium: at least 110% of the stock's Fair Market Value (FMV) on the grant date. For example, if the FMV is $10 per share, the strike price must be at least $11 per share.
- Grant Date Valuation: The FMV used to determine the 110% threshold is the valuation on the specific date the option is granted.
- Impact on ISO Qualification: Failure to meet the 110% strike price requirement for a 10% shareholder means the granted options will not qualify as ISOs, even if they meet all other ISO requirements. They would then be treated as NSOs.
Why is This Rule Important?
The ISO 110% Rule, along with other ISO requirements, is designed to ensure that the favorable tax treatment of ISOs primarily benefits a broad range of employees rather than primarily offering a significant tax advantage to those who already hold substantial control or ownership in the company. For companies, adherence to this rule is essential for maintaining the tax-qualified status of their stock option plans and providing the intended benefits to their employees.
Practical Considerations:
- Valuation Accuracy: Accurate and defensible valuation (FMV) on the grant date is crucial, as it directly impacts the 110% calculation.
- Shareholder Monitoring: Companies must diligently monitor shareholder ownership percentages, especially before granting options, to identify potential 10% shareholders.
- Documentation: Proper documentation of FMV, ownership percentages, and strike price calculations is vital for compliance and audit purposes.
By understanding and adhering to the ISO 110% Rule, companies can effectively manage their equity compensation plans and ensure that their Incentive Stock Options maintain their intended tax advantages for all eligible recipients, including significant shareholders.
