Business Vantage Point Blog

In the dynamic landscape of employee compensation, companies may reevaluate and adjust the vesting schedules of stock options for various reasons, such as recognizing employee commitment and adapting to shifts in the market or employee performance. For example, changes to a vesting schedule might include changes to time-based or performance-based vesting conditions. However, making changes to a vesting schedule of a stock option involves legal and tax issues that employers should consider.

A “modification” under the U.S. Internal Revenue Code of 1986, as amended (Tax Code), is any change in the terms of the option, plan or governing agreement that provides the option holder with additional benefits, regardless of whether they benefit from the change. A modification of a stock option is treated as a grant of a new option. This means that if an incentive stock option (ISO) is “in the money,” it becomes a non-qualified stock option (NSO) or must be repriced at the fair market value at the time of the modification to maintain ISO status. When an ISO becomes an NSO, it loses potential favorable tax treatment — generally, deferral of any income tax on exercise until the ISO shares are sold and long-term capital gain treatment on the sale proceeds if the ISO holding periods are met. (Note that while ISOs are not subject to ordinary income tax on exercise, the spread between the exercise price and the fair market value of the stock at exercise is subject to the alternative minimum tax on exercise.)

Unlike ISOs, when an optionee exercises an NSO, the optionee recognizes ordinary income at the time of exercise in an amount equal to the spread between the exercise price and fair market value on the date of exercise. In general, changes to vesting schedules are not considered modifications under the Tax Code. However, changes to the vesting schedule of an ISO may be considered a modification if the option is exercisable before fully vesting (so called “early-exercise options”).

A key tax implication for ISOs is that an optionee can only hold up to $100,000 worth of ISOs that first become exercisable in a given calendar year. Any options in excess of this limit are treated as NSOs. If ISOs are not immediately exercisable, the option first becomes exercisable when it vests. Thus, changes to the vesting schedule could impact the $100,000 limit. Board approval may be required to change the vesting schedule of an ISO. Optionee consent is necessary if the change negatively affects the optionee (such as by changing an ISO to an NSO).

As long as an NSO is exempt from Tax Code Section 409A, a company can change the vesting of the option. Options that are granted with an exercise price below fair market value are subject to Section 409A, meaning that they can only be exercised on the occurrence of certain permissible payment events. Because the chief purpose of a stock option is to give an optionee the ability to exercise the option whenever the optionee chooses (and when the option is in the money), it is extremely uncommon to subject a stock option to Section 409A. As with modifications to ISOs, board approval may be required to change the vesting schedule of an NSO, and optionee consent is necessary if the change negatively affects the optionee.