Options Repricing: Tax Consequences for Employees

What makes options “underwater” — and why companies reprice

A stock option is underwater when the exercise price exceeds the current fair market value of the underlying stock. If your ISO grant has a $12.00 strike and the company’s latest 409A valuation came in at $4.50, the option has negative intrinsic value — exercising it would mean paying $12.00 for something worth $4.50. Nobody does that.

This happens most often after a down round (the company raises new capital at a lower valuation than the prior round), a broad market correction, or a sector-specific decline. In 2022–2023, roughly 40% of venture-backed startups that raised follow-on funding did so at a flat or lower valuation. Employees at those companies woke up to option grants that were economically worthless despite representing years of vesting.

Companies reprice because underwater options fail at their primary job: retention. If your equity is worth nothing, you have no financial incentive to stay. The company can either issue new options at the lower price (diluting existing shareholders) or reprice the existing ones. Repricing is cheaper on the cap table but carries tax and accounting complexity — and most of that complexity lands on you, the employee.

Three structures for repricing — and they’re not taxed the same

Companies typically use one of three approaches. The tax consequences differ sharply:

The critical point: under IRS guidance and IRC § 424(h), any modification of an outstanding ISO that gives the option holder additional benefits — including reducing the strike price — is treated as the grant of a new option. Whether the company calls it a “repricing,” “amendment,” or “replacement,” the IRS sees a new ISO grant date. This matters enormously for holding periods and the $100K cap.

ISO repricing: the three tax clocks that reset

When your ISOs are repriced, three separate tax timelines restart from the repricing date:

Clock 1: The 2-year grant-date holding period (IRC § 422(a)(1))

For a qualifying disposition of ISO shares (taxed as long-term capital gains rather than ordinary income), you must hold the shares for at least 2 years from the grant date. Repricing creates a new grant date. If you had held the original ISO for 20 months — 4 months from clearing the 2-year threshold — and the company reprices, you go back to zero. You now need 2 full years from the repricing date.

Clock 2: The 1-year exercise-date holding period (IRC § 422(a)(1))

The second qualifying-disposition requirement — holding shares for 1 year after exercise — is unaffected by the repricing itself. But because you likely haven’t exercised the repriced options yet (they were underwater), this clock starts fresh when you eventually exercise.

Clock 3: The $100K annual ISO vesting cap (IRC § 422(d))

This is where repricing creates the most unexpected tax outcomes. Under IRC § 422(d), ISOs are only treated as ISOs to the extent that the aggregate FMV of stock (determined at grant) first becoming exercisable in any calendar year does not exceed $100,000. Any excess is automatically reclassified as an NSO.

The FMV used for this calculation is the FMV at grant. In a repricing, the new “grant” FMV is the current (repriced) value — which may be higher than the original grant-date FMV for employees who joined at an earlier stage.

Worked example: down-round repricing at a Series C startup

Priya is a senior engineer in Seattle. She joined her company at Series A and received 80,000 ISOs at a $1.50 strike price (the 409A FMV at grant). The options vest over 4 years: 20,000 shares per year. Annual vesting value at original grant: 20,000 × $1.50 = $30,000/year — well under the $100K cap.

Two years in, the company raises a down Series C. The 409A valuation drops from $14.00 (pre-round high) to $4.50. The board approves a repricing: all outstanding options get a new strike of $4.50.

Before repricing

• Options vested (year 1–2): 40,000 shares at $1.50 strike — exercisable but underwater ($1.50 strike vs. $4.50 current FMV is actually in the money, but the shares dropped from $14.00 to $4.50)
• Options unvested (year 3–4): 40,000 shares at $1.50 strike — still in the money at $4.50 FMV
• ISO annual vesting value: 20,000 × $1.50 = $30,000 — under $100K cap
• 2-year holding clock: 24 months completed on vested shares

Wait — Priya’s options are actually still in the money at $4.50 (strike is $1.50). Why would the company reprice? Because the board wants to reset the strike for employees who joined later at higher 409A values — $8.00, $12.00 — whose options are truly worthless. A blanket repricing catches all outstanding grants, including Priya’s.

After repricing

• New strike: $4.50 (up from $1.50 for Priya — her options are actually worse economically)
• New grant date: the repricing date (month 24 of employment)
• ISO annual vesting value recalculated: 20,000 × $4.50 = $90,000/year
• 2-year holding clock: resets to zero

Priya’s $100K cap is now $90,000/year — still under the limit, but barely. If the company had repriced at $5.50 instead ($110,000/year), the excess $10,000 would automatically convert to NSOs, taxed as ordinary income at exercise rather than qualifying for ISO treatment.

The tax math if Priya exercises post-repricing

Assume Priya exercises all 80,000 repriced ISOs in year 4 (2 years after repricing). The company’s 409A has recovered to $10.00/share.

• Exercise price: 80,000 × $4.50 = $360,000
• FMV at exercise: 80,000 × $10.00 = $800,000
• Bargain element: $800,000 − $360,000 = $440,000
• Regular income tax at exercise: $0 (ISOs — no ordinary income at exercise for qualifying dispositions)
• AMT preference item: $440,000 (the full bargain element is an AMT adjustment under IRC § 56(b)(3))

If Priya’s other income places her in the 24% regular bracket (taxable income between $103,351 and $197,300 single, 2026), the $440,000 bargain element pushes her well into AMT territory. At the 28% AMT rate, the AMT on the bargain element alone could exceed $100,000. This is the ISO AMT trap — you owe tax on paper gains before you have any cash to pay it.

Without the repricing, Priya would have exercised at $1.50 with a $680,000 bargain element ($10.00 − $1.50 × 80,000) — a larger AMT hit but she would have already cleared the 2-year holding period on her vested shares. The repricing reset that clock, so she needs to wait 2 more years from the repricing date before selling for qualifying-disposition treatment. If she sells before the 2-year mark, the entire gain is a disqualifying disposition taxed as ordinary income — up to 37% federal.

NSO repricing: simpler but still not free

NSOs don’t have the ISO holding-period requirements, the $100K cap, or AMT preference treatment. Repricing an NSO is cleaner from a tax perspective:

• At exercise: ordinary income = FMV at exercise minus the new (repriced) strike price. Subject to federal income tax (up to 37%), plus the employee portion of FICA (Social Security 6.2% up to the $181,800 wage base for 2026, and Medicare 1.45% on all wages plus 0.9% Additional Medicare Tax on wages above $200K single / $250K MFJ).
• No holding-period reset: NSOs have no statutory holding period, so there is no clock to restart.
• No $100K cap: the annual vesting limit applies only to ISOs.

The primary risk with NSO repricing is IRC § 409A. If the repriced NSO’s exercise price is set below FMV on the modification date, the option is treated as nonqualified deferred compensation. The consequences for the employee:

• Income recognized at vesting, not exercise
• 20% penalty tax on top of the regular income tax
• Interest penalty calculated from the vesting date

The employee pays the § 409A penalty. The company may have set the price, but the tax liability falls on you. This is why a contemporaneous 409A valuation on the repricing date is essential — and why you should ask your company to confirm the new strike price is at or above the current 409A FMV before you sign the repricing amendment.

The $100K ISO cap: how repricing turns ISOs into NSOs

Under IRC § 422(d), the test is straightforward: add up the grant-date FMV of all ISO shares that first become exercisable in any calendar year. If the total exceeds $100K, the excess shares are reclassified as NSOs — automatically, with no election or notification.

A repricing resets the grant-date FMV used for this calculation. Here is how that plays out:

The employee with 20,000 shares vesting at a $6.00 repriced FMV has 3,333 shares per year automatically reclassified as NSOs. At exercise, those 3,333 shares generate ordinary income (spread × shares) instead of qualifying for the ISO capital-gains pathway. Most employees never learn this happened until their brokerage reports the disposition type.

Option-for-RSU exchange: the cleanest path (but different tax profile)

Some companies skip the repricing complexity and offer to exchange underwater options for RSUs. This avoids the ISO holding-period reset, the $100K cap recalculation, and the § 409A risk on option pricing. But it changes the tax profile fundamentally:

• RSUs are taxed as ordinary income at vesting — the full FMV, not a spread. If 5,000 RSUs vest when the stock is $10/share, you recognize $50,000 of ordinary income in that year.
• There is no exercise decision, no AMT preference, and no $100K cap — but also no ability to defer income by delaying exercise.
• After vesting, subsequent appreciation is capital gains (long-term if held 12+ months from vesting). The LTCG rate depends on your taxable income: 0% up to $48,350 (single), 15% up to $533,400, 20% above that, plus 3.8% NIIT on net investment income above $200K (single) / $250K (MFJ).

The typical exchange ratio is not 1:1. Because RSUs have value regardless of stock price (unlike options, which need the stock to exceed the strike), companies offer fewer RSUs than the number of options surrendered. A common ratio is 3:1 or 4:1 — 40,000 underwater options exchanged for 10,000–13,000 RSUs.

Shareholder approval and SEC rules: what the employee needs to know

For publicly traded companies, NYSE and Nasdaq listing rules require shareholder approval before repricing options (with limited exceptions). This means the board cannot simply reprice on its own — it goes to a proxy vote, which adds 3–6 months of lead time and creates public disclosure of the repricing terms.

At private companies, the equity plan document governs. Most startup equity plans either (a) allow the board to reprice without shareholder approval, or (b) require consent of a majority of shareholders. Read your equity plan — specifically the section on “amendments” or “modifications” — to understand what the company can do unilaterally.

As an employee, you generally have to opt in to a repricing by signing an amendment to your option agreement. You are not required to accept. If your existing options are actually in the money (as in Priya’s case above, where her $1.50 strike was below the $4.50 post-down-round FMV), declining the repricing and keeping the original terms may be the better move — especially if your 2-year ISO holding period is almost complete.

ASC 718 accounting: why this matters to you

You might think accounting treatment is the company’s problem, not yours. But it affects you indirectly. Under ASC 718 (the accounting standard for stock compensation), a repricing requires the company to recognize incremental compensation expense: the difference between the fair value of the modified award and the fair value of the original award immediately before modification.

This additional expense hits the company’s income statement, reducing reported earnings. For pre-IPO companies, this expense shows up in financial statements shared with future investors and in S-1 filings. Some companies avoid repricing specifically because the accounting cost is too visible — opting instead for new grants at the lower price (which have their own ASC 718 expense but are psychologically easier for the CFO to present). If your company is choosing between repricing and new grants, the tax consequences to you are often the tiebreaker.

What to check before you sign a repricing amendment

If your company offers to reprice your options, review these five items before signing:

1. Confirm the new strike is at or above the current 409A FMV. Ask for the date of the most recent 409A valuation and whether it was updated for the repricing. A stale valuation (more than 12 months old, or predating a material event like a down round) is a § 409A red flag.
2. Check whether your options are ISOs or NSOs. ISO repricing resets holding-period clocks; NSO repricing does not. If your ISOs are close to clearing the 2-year holding period, you may be better off declining the repricing.
3. Run the $100K cap math. Multiply the new grant-date FMV by the number of shares vesting per year. If any year exceeds $100K across all your ISO grants, the excess converts to NSOs.
4. Understand the vesting schedule on the repriced options. Some repricings add a new vesting cliff (e.g., 1 additional year) to the repriced options. This means shares you had already vested may re-vest — you lose immediate exercisability.
5. Evaluate whether you even need the repricing. If your original strike is below the current FMV (your options are in the money), a repricing moves your strike up. Unless the company is offering additional shares or other consideration, accepting a repricing on in-the-money options is economically irrational.

Key takeaways

• Options repricing — reducing the strike price of underwater stock options to match the current FMV — is treated by the IRS as a cancellation and regrant for ISOs under IRC § 424(h). This resets the 2-year holding period, restarts the $100K annual ISO vesting cap calculation using the new (often higher) grant-date FMV, and can automatically reclassify excess ISOs as NSOs.
• NSO repricing is simpler — no holding-period reset, no $100K cap — but the § 409A risk is the same: a repriced strike below FMV triggers a 20% penalty tax plus interest on the employee, not the company.
• Option-for-RSU exchanges avoid repricing tax complexity but change the income character entirely: RSUs are ordinary income at vesting with no exercise decision, no AMT preference, and no ability to defer income recognition.
• Before signing a repricing amendment, verify the 409A valuation date, calculate the $100K cap impact, check whether you are giving up a nearly-completed ISO holding period, and evaluate whether your options are actually underwater — blanket repricings can move an in-the-money strike up.
• The AMT impact of exercising repriced ISOs can be substantial — the full bargain element at exercise is an AMT preference item under IRC § 56(b)(3). Model the AMT bill before exercising and consider staging exercises across tax years to stay below AMT thresholds.