Incentive Stock Options, or ISOs, are subject to specific rules that dictate whether they meet the standards to be treated as a qualifying disposition or a disqualifying disposition. Stated simply, there are rules regarding how and when ISOs are exercised as well as how and when ISOs are sold.
Why does this matter, you ask?
Qualifying dispositions are taxed at preferential long-term capital gains rates. Disqualifying dispositions are taxed at ordinary income rates. The difference between the two tax rates may be the difference between hundreds of thousands of dollars. This is why it’s important to understand the difference between the two.
What Is a Qualifying Disposition?
A qualifying disposition meets the following standards:
- The sale of stock occurs at least two years after the grant date, AND
- The sale of the stock occurs at least one year after the option was exercised.
A Hypothetical Example
Dan receives 1,000 stock options from his employer on January 1, 2016, with a grant price of $20 per share. Thirteen months later, Dan exercises his options when the shares price is $80 per share. He continues to hold the shares after exercise. Thirteen months after exercising the shares, he sells them when the price per share is $100.
In this example, Dan meets the requirements for standard one, as he held the shares for twenty-six months from grant date to final sale date. He then satisfies standard two as he held the shares for at least twelve months (in this example thirteen months) AFTER the initial exercise.
In this example, Dan has a qualified disposition that is eligible for long-term capital gains treatment.
The amount subject to long-term capital gains is the difference between the grant price of twenty dollars per share and the final sale price of $100 per share multiplied by the amount of shares exercised and sold.
- $100 – $20 = $80 gain
- $80 * 1,000 shares = $80,000
A Quick Note on Alternative Minimum Tax (AMT)
AMT is a second tax calculation that occurs every year. You may have never heard of AMT. The reason for this is that most people are not subject to it.
Incentive stock options, however, may change how you look at AMT.
When incentive stock options are exercised, the spread between the grant price and the exercise price is known as the bargain element. In the example above, the bargain element is calculated as the exercise price minus the grant price multiplied by the number of shares.
- $80 – $20 = $60
- $60 * 1,000 = $60,000 (the bargain element)
The bargain element is a preference item that must be included in the calculation for AMT purposes. In short, AMT is essentially forcing you to pre-pay your potential tax liability.
If you do complete a qualifying disposition, it is possible you will get a portion of these prepaid taxes back (aka, an AMT credit).
A Disqualifying Disposition
A disqualifying disposition is anything that doesn’t meet the standards prescribed above for a qualified disposition.
If shares are exercised and sold as a disqualifying disposition, the gain will be subject to ordinary income tax rates.
A hypothetical example:
Dan receives 1,000 stock options from his employer on January 1, 2016, with a grant price of $20 per share. Fifteen months later Dan exercises his options when the price is $80 per share and holds the shares. Another ten months later he sells the shares when the price per share is $100.
In this example, the shares were held for a total of twenty-five months. Therefore, to meet the first standard in that regard, the shares are held for greater than two years from the grant date.
However, the shares were subsequently sold less than one year from the date of exercise. For this reason, they do not meet the second standard and are classified as a disqualified disposition.
As a disqualified disposition, the entire gain, $80,000, is subject to ordinary income tax rates.
What Else You Should Know
From a tax standpoint, long-term capital gains treatment is better than ordinarily income tax treatment. This tax planning opportunity is one reason many will attempt to meet the qualifying disposition standard.
However, it must be noted that in an effort to meet the qualifying standard, a longer holding requirement must be met. This means someone looking to achieve a qualifying disposition will be forced into holding company stock for longer than what they desire. In fact, a longer holding requirement may not be desirable for someone who is seeking to diversify away from company stock or who already holds too much company stock.
For those who value diversification over concentration risk or tax opportunity, a disqualifying disposition may be the best answer.
The above hypothetical figures are for illustrative purposes only and do not attempt to predict actual results of any particular investment.
Diversification does not guarantee a profit or protect against a loss.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.