Stock Options in M&A: What Happens to Your Equity?

Executive Summary

When your company undergoes a merger or acquisition, your stock options face one of three fates: assumption, substitution, or cash-out. The tax consequences vary dramatically depending on whether you hold Incentive Stock Options (ISOs) or Nonqualified Stock Options (NSOs), and how the transaction is structured under IRC Section 368 reorganizations.

The bottom line: IRC Section 424 provides a critical exception allowing ISOs to preserve qualified status during M&A if specific tests are met. Cash-outs trigger immediate ordinary income taxation and cause ISOs to lose their favorable treatment. Understanding these rules can save tens of thousands in taxes.¹

Critical Warning: If your ISO options are cashed out in an M&A transaction, they lose qualified status and are treated as NSOs, triggering ordinary income tax (up to 37%) plus FICA taxes (7.65%) on the spread. This can result in $45,000+ in taxes on a $100,000 cash-out that could have been deferred as capital gains.²

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Introduction to Stock Options in M&A

What Happens to Options in M&A?

When a company is acquired, stock options are typically handled in one of three ways:

Source: IRC Section 424(a)

Key Regulatory Framework

The primary authority governing stock options in M&A is IRC Section 424, which permits substitution or assumption of options in corporate transactions without triggering "modification" that would disqualify ISOs. The regulations define a "corporate transaction" broadly to include:³

• Mergers and consolidations
• Stock acquisitions
• Spinoffs, split-ups, and split-offs
• Reorganizations (Type A, B, C under Section 368)
• Partial or complete liquidations
• Stock splits and stock dividends (proportional adjustments)

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IRC Section 424: Core Rules for Change of Control

Substitution and Assumption Defined

Under IRC Section 424(a), a substitution of a new option for an old option, or an assumption of an old option by an employer corporation (or parent/subsidiary), can occur "by reason of a corporate merger, consolidation, acquisition of property or stock, spinoff, split-up or split-off, reorganization or partial or complete liquidation" without being considered a modification.⁴

This exception is critical because, under IRC Section 424(h)(1), any modification, extension, or renewal of an option is treated as the granting of a new option, which could cause an ISO to lose its qualified status.⁵

The Ratio Test and Spread Test

For a substitution or assumption to qualify under Section 424, two conditions must be satisfied:⁶

1. The Ratio Test:

New Option Price / New FMV ≤ Old Option Price / Old FMV

2. The Spread Test: The spread (difference between option price and FMV) cannot be more favorable to the optionee after substitution than before.

Example Calculation:

In this example, both tests pass because the ratio remains constant (50% discount) and the spread increases proportionally with the stock value.

Source: Treasury Regulation §1.424-1

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Treatment of Options by M&A Structure

Tax Treatment by Reorganization Type (IRC Section 368)

The tax treatment of options in M&A depends heavily on the transaction structure:

Source: IRC Section 368

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Cash-Out Treatment

When options are cashed out (canceled in exchange for cash), the tax consequences are immediate:

For NSOs:

• Ordinary income on the spread (up to 37% federal)
• FICA taxes (1.45% + 0.9% Medicare surtax)
• FUTA taxes
• Immediate withholding required

For ISOs:

• Lose qualified status (treated as NSOs)
• Same tax treatment as NSOs above
• No AMT benefit
• No capital gains deferral

Example: $100,000 ISO cash-out (spread value)

• As ISO (if preserved): Deferred to capital gains (~15-23% when sold)
• As NSO (cash-out): $37,000 ordinary tax + $7,650 FICA = $44,650 total

The difference: $20,000+ in additional taxes from cash-out vs. preserving ISO status.

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Tax Consequences for ISOs vs. NSOs

ISOs in M&A

ISOs receive favorable tax treatment under IRC Section 422. For a complete comparison of ISO vs NSO tax treatment, see our ISO vs NSO guide:

Key Considerations:

• No tax at exercise if holding periods met (2 years from grant, 1 year from exercise)
• AMT applies to spread at exercise (28% rate)
• Post-M&A sale: Form 1099-B, Schedule D for long-term capital gains (0-20% + 3.8% NIIT)
• Net exercise or cash-out = NSO treatment, full payroll taxes

Source: IRS Publication 525

NSOs in M&A

NSOs are taxed as ordinary income at exercise:

Strategies:

• Cashless exercise post-M&A to minimize upfront tax
• Coordinate with high-income years to optimize tax brackets
• Consider timing of exercises relative to deal closing

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Accelerated Vesting: Single-Trigger vs. Double-Trigger

Single-Trigger Vesting

Options vest automatically upon a change of control, regardless of continued employment.

Tax Impact: If acceleration occurs as part of a Section 424-compliant assumption or substitution, it does not trigger modification treatment.

Double-Trigger Vesting

Options vest only if both conditions are met:

1. Change of control occurs
2. Employment is terminated (typically without cause or for good reason)

Tax Impact: Same as single-trigger—no modification if Section 424 compliant.

Key Point: Accelerated vesting itself doesn't trigger adverse tax consequences if the underlying transaction qualifies under Section 424. The tax treatment depends on whether you exercise, hold, or sell the shares after vesting. For more on restricted stock and vesting strategies, see our Section 83(b) election guide.

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Reporting and Compliance

Required IRS Forms

Source: IRS Form 3921 Instructions

Withholding Requirements

• NSO cash-outs: Mandatory withholding (22% federal + state)
• ISO exercises: No withholding required
• State taxes: Most states follow federal treatment (PA has exceptions)

Documentation Best Practices

• Document Section 424 compliance (Ratio Test, Spread Test calculations)
• Maintain valuation reports for FMV determinations
• Keep records of transaction structure and timing
• Preserve option agreements and amendment documents

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Planning Strategies and Pitfalls

Strategies to Preserve ISO Status

1. Ensure Substitution Meets Tests

   • Verify Ratio Test and Spread Test calculations
   • Document compliance in transaction documents
   • Work with tax advisor to confirm Section 424 qualification

2. Favor Stock-for-Stock Deals

   • Type B reorganizations offer best ISO preservation
   • Avoid cash consideration (boot) that could disqualify
   • Negotiate for stock consideration when possible

3. Avoid Net Exercise

   • Net exercise (using shares to pay exercise price) causes ISO to lose status
   • Use cash to exercise if preserving ISO status is priority

Common Pitfalls

QSBS Considerations

Qualified Small Business Stock (QSBS) under IRC Section 1202 offers up to 100% exclusion on gains, but:

• ✅ Preserved in stock purchases and reverse triangular mergers
• ❌ Lost with cash consideration or service-tied earnouts
• ⚠️ Timing matters: Must meet 5-year holding period

Source: IRC Section 1202

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Frequently Asked Questions

Does cash-out always trigger taxes?

Answer: Yes, for NSOs cash-out triggers ordinary income tax immediately. For ISOs, cash-out causes loss of qualified status and triggers the same ordinary income treatment. The only way to defer taxes is through assumption or substitution that preserves ISO status.

Source: IRC Section 424(h)(1)

Can I exercise my options before the M&A closes?

Answer: Yes, you can exercise pre-M&A to start the capital gains holding period clock. However, this creates liquidity risk if the deal falls through or if you can't sell immediately due to lockup periods. Consider your cash flow and risk tolerance.

What if the acquirer's stock tanks after the deal?

Answer: If you received acquirer stock in substitution and the value declines, you can realize capital losses when you sell. For options that were underwater (exercise price > FMV), they're typically canceled for no consideration in cash-outs.

How does AMT affect ISO exercises in M&A?

Answer: AMT applies to the bargain element (spread) when you exercise ISOs, regardless of M&A context. If you exercise ISOs before a cash-out, you'll pay AMT on paper gains. Consider a disqualifying disposition (exercise and sell same year) to avoid AMT, though this triggers ordinary income tax instead. For comprehensive AMT planning strategies, see our AMT planning guide.

Source: IRS Form 6251 Instructions

Are there special rules for S-Corporations?

Answer: Yes. S-Corporations can use a 338(h)(10) election to treat a stock sale as an asset sale, providing step-up basis for the buyer. This affects how options are treated—consult a tax advisor for S-Corp specific planning.

What happens to underwater options?

Answer: Underwater options (where exercise price exceeds FMV) are typically canceled for no consideration in cash-outs. In substitutions, they may be adjusted proportionally, but the economic value remains zero or negative.

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Footnotes

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Primary Sources

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Disclaimer: This guide discusses legal tax optimization strategies only. Tax evasion is illegal and is never recommended. This content is for educational purposes and does not constitute tax, legal, or financial advice. Tax laws vary by jurisdiction and change frequently. Always consult a qualified tax professional (CPA, tax attorney, enrolled agent) before making decisions based on this information. The authors accept no liability for actions taken based on this content.

Footnotes

1. IRC Section 424 provides the framework for preserving ISO qualified status during corporate transactions. Treasury Regulation §1.424-1 provides detailed guidance on the Ratio Test and Spread Test requirements. ↩

2. Cash-out of ISOs triggers modification treatment under IRC Section 424(h)(1), causing loss of qualified status and immediate ordinary income taxation. ↩

3. Treasury Regulation §1.424-1 defines "corporate transaction" broadly to include various types of reorganizations and corporate changes. ↩

4. IRC Section 424(a) permits substitution or assumption "by reason of" qualifying corporate transactions without triggering modification. ↩

5. IRC Section 424(h)(1) provides that modifications, extensions, or renewals are treated as new option grants, which could disqualify ISOs. ↩

6. Treasury Regulation §1.424-1 requires both the Ratio Test and Spread Test to be satisfied for substitution to qualify under Section 424. ↩