What Is a Disposition?
Let me explain what a disposition really means in the world of finance. It's the act of selling or otherwise transferring ownership of an asset or security. You might think of it most commonly as selling a stock on the open market, like through a stock exchange.
But dispositions aren't limited to that. They can include donating to charities or trusts, selling real estate like land or buildings, or handling any other financial asset. Other forms involve transfers and assignments. At the end of the day, you're giving up possession of that asset.
Key Takeaways
- A disposition generally means selling securities or assets on the open market.
- It can also be transfers or donations to charities, endowments, or trusts.
- For business dispositions, the SEC requires specific reporting based on the disposition's nature.
- Donations, assignments, or transfers often allow for beneficial tax treatment.
Understanding a Disposition
You've probably heard the phrase 'disposition of shares'—that's one of the most common ways this term comes up. Imagine you're a long-time shareholder in a company, but things aren't going well lately. If you decide to exit that investment, that's a disposition of shares.
You'd likely sell those shares through a broker on a stock exchange. Essentially, you're disposing of the investment. If the sale leads to a capital gain, you'll need to pay capital gains tax on the profits, as long as you meet the IRS requirements.
Dispositions also cover transfers and assignments, where you legally pass assets to family, a charity, or another organization. This is often for tax and accounting reasons, relieving you of taxes or liabilities.
For instance, if you bought stock for $5,000 and it grew to $15,000, you could donate it to a charity to avoid capital gains tax on the profit and deduct the full $15,000 on your taxes.
Business Disposition
Businesses dispose of assets too, and often entire segments or units—this is called divestiture, done through spinoffs, split-ups, or split-offs.
The SEC has strict guidelines on reporting these. If a disposition isn't in the company's financial statements, pro forma statements are needed if it passes a significance test.
Significance comes from an investment test or an income test. The investment test checks if the unit's value is more than 10% of total assets from the last fiscal year-end.
The income test looks at whether the equity in income from continuing operations before taxes and other items is 10% or more of such income from the recent fiscal year-end. Sometimes, this threshold goes up to 20%.
The Disposition Effect
Behavioral economics weighs in on dispositions with the 'disposition effect,' tied to loss aversion. This describes how investors tend to sell winning investments too soon, missing out on full gains, while holding losing ones too long, hoping for a turnaround.
Hersh Shefrin and Meir Statman introduced this in their 1985 paper, 'The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence.' Studies suggest you should do the opposite for better results.
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