Even though you may pay a higher tax rate by selling your incentive stock options as a disqualifying disposition, you may not want to completely discount the benefits of an exercise and sell quite yet.
The alternative, of course, is to earn the right to capture your profit at long-term capital gains tax rates — which are lower than ordinary income.
But how do you secure that lower rate? You need a qualifying disposition, which you can secure if you meet both of the following standards:
- The final sale of the stock occurs at least 2 years past the grant date.
- The final sale of the stock occurs at least 1 year past the exercise date.
If you meet these two standards, the total realized profit between the grant price and the final sales price (times the number of shares sold) is subject to long-term capital gains tax.
Think Beyond Taxes Before Deciding on a Strategy for Exercising Incentive Stock Options
The allure of this potentially lower income tax treatment can be a strong motivator in seeking a qualifying disposition. But receiving preferential tax treatment is not the only option nor the only thing to consider when choosing a strategy for exercising ISOs and selling shares.
Anything that is not a qualifying disposition is a disqualifying disposition. With a disqualifying disposition, a portion of the profit may be subject to ordinary income tax rates and a portion may be subject to short- or long-term capital gains tax rates.
A disqualifying disposition will likely leave you with a different tax liability than a qualifying disposition, but that may not be a bad thing.
In fact, in some scenarios, it might make more sense to intentionally do a disqualifying disposition, even while knowing that you won’t secure a long-term capital gains tax rate.
Here are a few reasons why you might intentionally choose a strategy for ISOs that ends in a disqualifying disposition.
A Disqualifying Disposition of Incentive Stock Options Allows to You Immediately Capture Potential Profits
When you exercise and hold incentive stock options with the intention of doing a qualifying disposition, you must hold the stock shares for at least 1 year past the exercise date. During this time, you are subject to the risk-reward tradeoff of owning a single stock position.
During this holding period, you don’t realize any profit as you may not have sold any shares. The value may change as the share price fluctuates, but it’s all unrealized losses or gains.
Only when you sell the shares do you realize a profit. But that’s a big “if,” which is why holding the shares in an attempt to achieve a qualifying disposition comes with risk.
If you do a disqualifying disposition whereby you exercise the incentive stock option and immediately sell the shares, you capture the value right away. You won’t be subject to the daily ups and downs of the stock price, or the risk that the eventual share price drops below the exercise price.
You take the unrealized profit on paper and turned it into cash you can actually use, making a disqualifying disposition an attractive technique if your primary goal is to capture profit immediately without subjecting yourself to the risk of a drop in the share’s value and price.
A Disqualifying Disposition May Help You Manage Cash Flow
When you exercise and hold incentive stock options past the calendar year-end, you may be subject to 2 cash calls:
- The cash required to buy the shares, and
- The cash required to pay the alternative minimum tax (AMT)
The cash required to buy the shares of stock is equal to:
“Exercise Price” X “Number of Shares Exercised”
In our example below this is equal to $10,000. If you have a greater number of options or a higher exercise price (or both), your cash call could be higher.
The cash required to pay the alternative minimum tax is more complicated because it’s based on a number of personal tax return inputs. One of those inputs is related to the bargain element of your ISOs. The bargain element is equal to:
(“Fair Market Value at Exercise” – “Exercise Price”) X “Number of ISOs Exercised”
The larger the bargain element, the greater the potential for the AMT. The greater the AMT, the greater the potential for cash flow issues when it’s time to pay that tax bill.
We can use a couple of scenarios to show this. For the first, assume that you have the following grant of incentive stock options:
- ISOs: 10,000
- Exercise price: $1.00/share
- Fair Market Value at Exercise: $50
- AMT Rate: 28%
If you exercise and hold all 10,000 incentive stock options shares, the bargain element and subsequent AMT due, in our hypothetical example, is::
(“Fair Market Value at Exercise” – “Exercise Price”) X “Number of ISOs Exercised”
($50 – $1) x 10,000 = $490,000
“Bargain Element” X “AMT Rate” = “AMT Due”
$490,000 x .28 = $137,200
That means you need $137,200 additional in cash to pay that tax bill. Herein lies the issue: where does the money come from to pay for the AMT due?
One way to cover the $137,200 cost of the AMT is to write a check from your other personal assets if you have that type of cash available. Not everyone does (or if they do, they don’t want to use it to pay taxes), so a second option might be to do a disqualifying disposition of the incentive stock option shares.
Let’s look at a second scenario in which, instead of exercising and holding 10,000 incentive stock option shares, you exercise and hold 7,000 shares and exercise and immediately sell 3,000 shares.
When you sell the shares, you’ll immediately capture the profit from the sale:
(“Market Price at Exercise – Exercise Price) x “Shares Exercised and Sold”
($50 – $1) x 3,000 = $147,000
If you exercise and hold 10,000 shares, you need to come up with enough cash to pay the AMT. In this scenario when you exercise and hold 7,000 shares — but also an exercise and sell 3,000 — you’ve created a positive inflow of $147,000 that can be used to pay the tax bill.
You Might Owe the Same in Taxes Regardless of Disposition Type
Many people don’t want to end up with a disqualifying disposition because they believe they’ll pay more income tax this way. But that’s not always the case.
The way your taxes are calculated is different depending on whether you have a qualifying or disqualifying disposition. But in some cases, the amount of taxes owed can be very close.
When you exercise and sell as a disqualifying disposition, your income tax calculation will likely include two parts. The first part is the profit from the exercise and sale.
This profit will likely be subject to ordinary income tax. If we follow scenario 2 above with 3,000 shares as a disqualifying disposition, the profit of $147,000 will be subject to ordinary income. If we assume a 32% income tax rate, the total tax due will be $47,040.
A disqualifying disposition of some of the shares also means that the AMT adjustment for the remaining exercised and held shares will be lower than had you exercised and held all the shares.
In scenario 1 above, the bargain element when you held 10,000 shares is $490,000. In scenario 2, only 7,000 shares were exercised and held. These make up part 2 of the tax calculation.
The bargain element is:
(“Market Price at Exercise” – “Exercise Price”) x “Shares Exercised and Held”
($50 – $1) x 7,000
Assuming a flat 28% flat AMT tax rate, the AMT due (our part 2) will be $96,040. If we add these two taxes together, the total tax from the original 10,000 shares will be $143,080.
Compare that to the example above when you exercised and held 10,000 shares and the total tax due was $137,200.
The difference in total tax due for this calendar year is under $6,000, which is a relatively small amount compared to all the numbers we’re using here. A key difference, however, is that with a qualified sale of stock, the tax paid due to an AMT adjustment may come back as a credit in future years.
When you owe a similar amount in taxes either way, a disqualifying disposition may make more sense because you don’t subject yourself to the risks of holding a single concentrated stock position.
That being said, you may want to work with an accountant or an advisor who can model the two for you to see what it may look like in your specific situation before making a decision.
A Disqualifying Disposition Could Lead to a Reduced Position in Company Stock
If you are seeking to reduce your position in company stock, an intentional disqualifying disposition is one way to do so.
Looking back at the examples above, the end result of scenario 1 is owning 10,000 shares of company stock valued at $500,000. The end result of scenario 2 is owning 7,000 shares valued at $350,000. That’s a 30% reduction in exposure to the company stock by using a disqualifying disposition.
This could be an important consideration if you have a large portion of your net worth already tied up in one company stock, you want to retire and need to diversify, or you otherwise feel as though the stock price has peaked.
But if you are bullish on the stock, adequately understand the risk/reward tradeoff, and/or have other assets or means on which to survive, you might deliberately choose to own a large position in the stock.
You need to determine how much concentration risk is appropriate for you to take on, which should be considered in the larger context of your comprehensive financial plan.
You May Still Be Able to Participate in the Upside of the Company Stock
Many people feel influenced to act one way or another because they fear missing out. As this pertains to owning company stock, you might feel the fear of selling your stock shares too soon (even if it’s a profit) and missing out on being part of a potential meteoric rise if the company becomes “the next Apple.”
This isn’t a reason to avoid a disqualifying disposition, though. Using this strategy to sell some of your shares may still allow you to participate in the upside of the company.
Again, using our example, in scenario 1 you retain 10,000 shares and in scenario 2 you retain 7,000 shares. If the stock price quadruples from $50 per share to $200 per share, the value of your 10,000 shares will be $2,000,000 and the value of your 7,000 will be $1,400,000.
Clearly, there is a meaningful difference between these two figures (30%). But even in scenario 2, you very much benefitted from and participated in the growth of the value of the company and did not miss out on much.
Is a Disqualifying Disposition A Good Idea?
A disqualifying disposition may be a good technique to implement a part of a liquidation strategy for your incentive stock options.
It could help you create positive cash flow that can be used to offset the tax liability, manage your position in one stock while still allowing for participation in the upside, or capture profits immediately (instead of leaving that to chance) along the way.
These reasons are why it may make sense to explore how exercising and selling shares from ISOs as a disqualifying disposition fits into your overall plan, as compared to blindly seeking a qualifying disposition in an effort to pay long-term capital gains rates instead of a potentially higher ordinary income tax rate.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.