What is a qualifying disposition?
A qualifying disposition is the sale, transfer, or exchange of stock that meets specific holding‑period rules and therefore receives favorable tax treatment. These shares are most commonly acquired through incentive stock options (ISOs) or a qualified employee stock purchase plan (ESPP).
Key points
- Qualifying dispositions generally result in long‑term capital gains treatment rather than ordinary income tax.
- Typical sources: incentive stock options (ISOs) and qualified ESPPs.
- Non‑statutory (non‑qualified) stock options (NSOs) do not qualify for capital gains treatment and are taxed as ordinary income when exercised/sold.
- Holding‑period rules align employee incentives with shareholder value by encouraging longer ownership.
Holding‑period requirements
To be a qualifying disposition:
* For ISOs: the shares must be sold more than 1 year after exercise and more than 2 years after the ISO grant date.
* For a qualified ESPP: the shares must be sold more than 1 year after purchase (exercise) and more than 2 years after the beginning of the offering period.
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Example: If options are granted on Sept. 20, 2018, and exercised on Sept. 20, 2019, the employee must wait until Sept. 20, 2020 (one year after exercise and two years after grant) for a qualifying disposition.
Tax treatment
- Qualifying disposition
- Gains are taxed at long‑term capital gains rates. The basic capital gain is the difference between the sale price and the option exercise (or purchase) price.
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Example: Exercising 1,000 ISO options at $10/share and selling at $30/share yields a long‑term capital gain of $20 x 1,000 = $20,000 (if holding‑period tests are met).
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Disqualifying disposition
- Selling before the required holding periods generally results in the “bargain element” (the difference between market price at exercise and the exercise price) being taxed as ordinary income.
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Any additional gain beyond the bargain element may be capital gain or loss depending on the holding period from exercise to sale.
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NSOs
- Non‑statutory options do not receive capital gains treatment; the bargain element is ordinary income when exercised and is subject to payroll and income taxes.
Bargain element and alternative minimum tax (AMT)
- Bargain element: the immediate gain an employee realizes when exercising an option at a price below the market value.
- ISOs: the bargain element is not taxed as ordinary income at exercise for regular tax purposes, but it is an adjustment for the alternative minimum tax (AMT) in the year of exercise and can trigger AMT liability even if the shares are not sold.
- NSOs: the bargain element is ordinary income at exercise and is included in regular taxable income and payroll tax calculations.
Why companies use ISOs and ESPPs
ISOs and qualified ESPPs help attract and retain employees and align employee incentives with shareholder interests by encouraging employees to hold company stock and focus on long‑term value appreciation. Some companies opt not to offer ISOs because the company generally does not receive a tax deduction when ISOs are exercised (unlike NSOs, where the employer typically receives a tax deduction when the employee recognizes ordinary income).
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Summary
A qualifying disposition lets employees convert option or ESPP gains into long‑term capital gains by meeting specific holding‑period tests (more than 1 year after exercise and more than 2 years after grant or offering). Failing to meet those tests produces a disqualifying disposition, where some or all of the gain is taxed as ordinary income. ISOs carry potential AMT consequences at exercise; NSOs are taxed as ordinary income.