Repricing Underwater Stock Options: ISO and 409A Rules

Can you reprice underwater stock options after a down round?

Yes. Tax law lets a company lower the exercise price of options that are worth less than their price, but it treats the repriced option as a new option granted on the repricing date (26 U.S.C. 424(h)). For an incentive stock option (ISO), the new grant must pass every ISO test again that day. For a nonqualified stock option (NSO), the new grant stays outside section 409A if its price is at least that day's fair market value (26 CFR 1.409A-1(b)(5)(v)).

What makes a repricing not simple:

• Employees who own more than 10% of the voting power, often founders, face stricter price and term rules on the new date.
• Shares already vested, or vesting this year, can push an employee over the annual ISO limit.
• An offer left open 30 days or more modifies the option even for employees who say no.
• A valuation dated before the down round may not support the new price.
• Exchanging options for restricted stock units changes the tax rules entirely.

Gather: the option ledger (grant dates, prices, vesting, ISO or NSO), the plan and its stockholder approval date, the new 409A report, the board consent, and each employee's election and offer dates. Whether employees must consent and whether an exchange offer is subject to securities tender-offer rules are questions for the company's counsel.

Why does repricing an ISO count as a new grant?

Section 424(h) treats any change to an option that gives the holder an additional benefit as the grant of a new option. A lower exercise price is an additional benefit, so the old ISO ends and a new one starts on the date of the change (26 CFR 1.424-1(e)). The new option may or may not qualify as an ISO; that is tested on its own grant date.

The regulation counts a change as a modification "regardless of whether the optionee in fact benefits." Some common changes and how the regulation treats them:

A share recapitalization that changes the stock itself is covered in down round and recapitalization tax.

Does repricing restart the ISO holding period?

Yes. Every ISO rule measured from the grant date restarts on the repricing date (26 U.S.C. 422; 26 CFR 1.424-1(e)). The one-year holding period from exercise is unaffected because it never ran from grant.

Two traps follow. A founder over the 10% line whose repriced option keeps a term longer than 5 years from the repricing date, or whose new price is below 110% of that day's value, holds an NSO. And a plan adopted, or approved by stockholders, more than 10 years ago cannot grant new ISOs, so options repriced under it become NSOs. Shortening an option's term is not a modification, so the term can be cut to fit.

Vesting is a contract term, not a tax rule: the company may keep the original vesting schedule. Only the tax clocks restart. How the employee is taxed at exercise and sale is covered in exercising startup stock options.

How do repriced ISOs count toward the annual ISO limit?

A repriced ISO counts as a new grant, valued at the repricing date. ISO shares first exercisable by one employee in a calendar year are ISOs only up to $100,000 of value, measured at grant; the excess is treated as an NSO (26 CFR 1.422-4). Options are counted in the order granted, so the repriced option queues behind everything granted before it.

The lower price usually helps, because each share is valued at the new, lower grant-date value. Two rules can squeeze the repricing year:

• Vested shares. Shares already vested under the old option are exercisable on the new grant's first day, so on a plain reading they are first exercisable again in the repricing year.
• The old option still counts. An option modified before the year it would first become exercisable drops out only if it then stops being an ISO or is cancelled; an option modified at any other time stays counted under its original terms until the end of that year (26 CFR 1.422-4(b)(5)). The regulation does not say which rule covers an option repriced before that year that stays an ISO.

The regulation has no repricing example, so the double count in the repricing year follows from its general rules and is worth testing employee by employee. One option can end up part ISO and part NSO; the company may mark which shares are ISO shares in its records, and that designation is not a modification.

When does a repricing offer count as a modification? The 30-day rule

An offer to change an option that stays open 30 days or more is a modification on the date the offer is made, even if the employee never accepts (26 CFR 1.424-1(e)(4)(iii)). An offer open less than 30 days is not, so an employee who declines it keeps the original option unchanged.

For an employee who declines a long offer, the ISO keeps its old price but gets a new grant date on the offer date. Its price is still above that day's value, so it can remain an ISO, but the two-year holding period and the annual-limit count restart. Keeping an exchange window under 30 days avoids this for those who decline.

Discretion also counts: giving the board the right to add a benefit later is a modification when that right is added. Using discretion the option already reserves over a cash bonus or a loan at exercise, paying with existing shares, or employment and withholding taxes is not a modification.

Is repricing an NSO safe under section 409A?

Yes, when the new exercise price is at least the fair market value on the repricing date. Under section 409A, a change that may reduce the exercise price is a modification and is treated as a new stock right, tested on that new date (26 CFR 1.409A-1(b)(5)(v)). An NSO avoids 409A if its price can never be below the grant-date value, the share count is fixed at grant, and it has no other deferral feature (26 CFR 1.409A-1(b)(5)(i)).

An NSO repriced below that day's value is deferred compensation. If it then fails section 409A, the holder includes the amount in income and owes an additional 20% tax plus interest. For an employee, the company reports that amount on Form W-2 in box 1 and in box 12 with code Z (W-2 instructions).

Two related points:

• ISOs that become NSOs. An ISO that the repricing turns into an NSO is treated for 409A as an NSO from its original grant, with the repricing tested as a new grant (26 CFR 1.409A-1(b)(5)(ii)). Pricing at that day's value keeps it outside 409A.
• Extending the term at the same time. Extending an option's exercise period while its price is at or above the stock's value is treated as a modification, a new grant, rather than a 409A extension (26 CFR 1.409A-1(b)(5)(v)(C)).

Do you need a new 409A valuation before repricing?

Usually yes. The new price must be at least the fair market value on the repricing date, and a valuation made before the down round may no longer be reasonable. For private stock, an independent appraisal dated no more than 12 months before the grant is presumed reasonable, but a value stops being reasonable when it misses later information that may materially affect it (26 CFR 1.409A-1(b)(5)(iv)(B)). A down round is the kind of new information the company should weigh.

For ISOs, a price that turns out too low is forgiven only if it came from a good-faith attempt to set fair market value; for private stock the regulation points to valuations from independent, well-qualified experts (26 CFR 1.422-2(e)(2)). The company engages a valuation provider for a current 409A report, then the board sets the repricing date on or after the report's valuation date. How long a valuation holds for later grants is covered in stock options after a 409A.

Repricing, option exchange or RSUs: what differs?

All three replace an underwater award, but only the first two keep an option.

A cancelled ISO still counts toward the annual limit through the end of the year it would first have become exercisable, unless it is cancelled before that year (26 CFR 1.422-4(b)(5)).

RSUs work differently. The IRS audit guide, which is not binding guidance, describes RSUs as unfunded promises to deliver stock or cash later; no section 83(b) election is possible, and the stock's value is generally income when it is delivered (Publication 5992). For an employee that is wages, so payroll withholds; if delivery comes after vesting, social security and Medicare tax may be due at vesting instead. RSUs give up the ISO capital-gain path entirely.

What changes on Form 3921 when a repriced ISO is exercised?

The company files Form 3921 only when an ISO is exercised, not when it is repriced. For a repriced ISO, box 1, the date the option was granted, is the repricing date, because the law treats that as the grant; box 3 is the new exercise price (Form 3921 instructions). Box 4 is still the value on the exercise date.

The instructions do not mention modifications, so keep both dates in the ledger. Shares exercised before the repricing keep the original grant date and price; the regulation's own example treats an exercise before the change as an exercise of the original statutory option (26 CFR 1.424-1(e)). An employee reading box 1 uses it to time the two-year holding period, so a wrong date there misleads the employee about a disqualifying disposition. Filing deadlines and Form 3921 basics are in stock options after a 409A.

How does an option repricing show in the books?

Under the US accounting standard for stock compensation, a repricing is a modification: the company adds expense equal to the fair value of the repriced option minus the fair value of the original option just before the change, on top of the original grant-date cost still being recognized. A cancellation paired with a replacement grant is measured the same way (ASU 2017-09, Topic 718). The tax deduction does not follow this expense; it still arises only on an NSO exercise or an ISO disqualifying disposition. See stock options after a 409A for the deduction and catching up on stock compensation expense for the auditor's schedule.

Example

These examples are illustrative, in US dollars.

Underwater ISOs

An employee holds 10,000 ISOs at $3.00 a share, granted three years ago. After the down round, the new 409A values common stock at $1.00. In May the board reprices the options to $1.00, the value that day.

• ISO status: the options are a new ISO grant dated May.
• Holding period: if the employee exercises next February, a sale before the second anniversary of the May repricing is a disqualifying disposition, even though the original grant is three years old.
• Form 3921: box 1 shows the May date and box 3 shows $1.00.

Offer left open 45 days

On September 1 the company offers to reprice every employee's $3.00 ISOs to $1.00, and the offer stays open 45 days. One employee declines and keeps the $3.00 price. Because the offer was open 30 days or more, that employee's option was still modified on September 1: it becomes a new grant that day, and its two-year holding period now runs from September 1. A 25-day window would have left the declined option untouched.

Limit squeeze

An employee's repriced ISOs include 50,000 unvested shares that vest next year, valued at $1.00 on the May repricing date: $50,000. In June the company also grants 60,000 new ISOs at $1.00 that vest next year: $60,000. Next year $110,000 first becomes exercisable. Assuming the old option's unvested shares drop out, and counting in grant order, the repriced option is fully ISO, and $10,000 of the new grant, 10,000 shares, is treated as NSOs. Payroll must withhold when those shares are exercised. If instead the old option still counts on its original terms next year, its 50,000 shares at the original $3.00 grant-date value, $150,000, fill the limit first, and all 110,000 shares from the repriced option and the new grant that vest next year are treated as NSOs.

Different for you?

• The down round also converts preferred stock, adds a reverse split or re-issues founder shares: see down round and recapitalization tax.
• You are granting new options, not repricing old ones: see stock options after a 409A.
• You hold repriced options and are deciding when to exercise or sell: see exercising startup stock options and AMT on incentive stock options.
• You already exercised and the shares fell: see taxed on stock options that lost value.
• Some option holders live and work in Canada: see stock options for employees in Canada.
• Founders over the ownership line, ISOs near the annual limit, an exchange for RSUs, or an offer already open 30 days: these turn on dates and plan terms; get startup tax help before the board acts.