What Is a Qualifying Disposition?
Let me explain what a qualifying disposition is—it's essentially a sale, transfer, or exchange of stock that gets you favorable tax treatment. You typically get this stock through an incentive stock option, or ISO, or via a qualified employee stock purchase plan, known as an ESPP. Remember, a qualified ESPP needs shareholder approval before implementation, and every plan member must have equal rights.
Key Takeaways
- A qualifying disposition is the sale or transfer of stock that qualifies for favorable tax treatment.
- Shares in these dispositions are usually acquired through an ESPP or an ISO.
- Non-statutory stock options, or NSOs, don't qualify for capital gains tax treatment and are taxed at ordinary income rates.
- Companies use ESPPs and ISOs to attract and retain talented personnel.
How Qualifying Disposition Works
For a disposition to qualify, you must sell your position at least one year after exercising the stock and two years after the ISO was granted, or two years after the ESPP offering period began. Take this example: if Cathy's ISO options were granted on September 20, 2018, and she exercises them on September 20, 2019, she has to wait until September 20, 2020, to report a long-term capital gain.
The capital gains treatment applies to the difference between the exercise price and the market price at sale. So, if Tim exercises 1,000 ISO options at $10 per share and sells them at $30 per share, he reports a capital gain of $20,000—that's $20 times 1,000 shares.
NSOs don't get capital gains treatment; they're taxed at ordinary income rates. Offering ISOs and a qualified ESPP helps companies pull in and keep top talent, aligning management and key employees with shareholders since everyone wants the company to succeed and boost its share price. Some companies skip ISOs because, unlike non-statutory plans, there's no tax deduction for the company when options are exercised.
Special Considerations
The 'bargain element' is when an option can be exercised below the current market price, giving you an immediate profit. If you exercise a non-statutory option, you report that bargain element as earned income, subject to income tax. With ISOs, you don't have to report it until you sell the shares.
In a disqualifying disposition—selling immediately after exercise—the bargain element is ordinary income. But in a qualifying disposition, sold one year after exercise and two years after grant, it's a long-term capital gain. Note that for NSOs, the bargain element adds to your alternative minimum taxable income, which ensures a flat tax so everyone pays fairly despite tax strategies.
Qualifying Disposition vs. Disqualifying Disposition
A disqualifying disposition happens when you sell or exchange shares from an ISO or ESPP before the holding period is up—one year from exercise and two years from grant for ISOs, or two years from the ESPP offering date. Gains or losses here get taxed at a higher rate.
In a qualifying disposition, the bargain amount is taxed at the capital gains rate. Disqualifying ones are taxed at the income tax rate, which is usually higher than capital gains.
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