Incentive stock options, or ISOs, are a type of employee stock option. Often considered the favorable employee stock option as compared to non-qualified stock options, they may present an opportunity to receive a preferential tax treatment when you exercise and sell the incentive stock option shares.
To obtain this preferential tax treatment, you must meet specific rules regarding the timeline between when the incentive stock option is granted, and when you sell your shares. The timeframe between when you exercise the option and when you sell the shares matters, too.
These two timelines help determine whether the profit you realize from selling you incentive stock option shares will be treated as a qualifying disposition or a disqualifying disposition. If you have qualifying disposition, the profit will be taxed at long-term capital gains. If you have a disqualifying disposition, the realized gain (if any) will likely be tax as a combination of ordinary income and capital asset tax rates.
There’s potentially a big difference between these two tax rates, with long-term capital gains being a lower rate than the rate on ordinary income — which is why many people who have incentive stock options want to achieve a qualifying disposition.
What Counts as a Qualifying Disposition of Incentive Stock Options?
To understand a disqualifying disposition, it actually helps to start by defining what a qualifying one is first. A qualifying disposition of incentive stock options is one that meets the following standards:
- The final sale of the incentive stock options shares occurs at least two years after the grant date, AND
- The finale sale of the incentive stock option shares occurs at least one year after the incentive stock option was exercised.
Let’s assume that you receive the following incentive stock option:
- Grant Date: January 1, 2019
- Exercise Price: $20/share
- Incentive Stock Options Granted: 1,000
Let’s also assume you exercised these options on February 1, 2020, when the fair market value was $80. The final sale happened on March 1, 2021, and the final sale price was $100.
Would this count as a qualifying disposition, giving you a better tax rate on your profit?
The Analysis of Qualifying Disposition of Incentive Stock Options
To determine that, you need to compare the timeline of activity to the rules for a qualifying disposition.
In this example, you met the standard for Rule 1, as you held the shares for twenty-six months from the grant date to the final sale date (January 2019 – March 2021). You also met the standard for Rule 2 in that you held the shares for a least one-year post-exercise prior to selling them (February 2020 – March 2021).
Because you achieved a qualifying disposition, your realized profit from the exercise price to the final sales price is eligible for long-term capital gains treatment. This amount is equal to the following:
(Final Sales Price – Exercise Price) * Shares Exercised = Long Term Capital Gain
($100 – $20) * 1,000 = $80,000
A Quick Note on Alternative Minimum Tax (AMT)
Unfortunately, the process for exercising, holding, and selling and incentive stock option may not be as easy as advertised above. The primary reason for the complication is the alternative minimum tax you may trigger.
The alternative minimum tax, or AMT, is a second tax calculation that occurs in every calendar year your file your taxes. If you’ve never owed AMT, you may have never heard of it either. Incentive stock options may possibly change both.
When you exercise and hold incentive stock options, the spread between the exercise price and the fair market value at exercise multiplied by the number of options exercised is known as the bargain element.
In the example above, the bargain element is calculated as:
(Fair Market Value at Exercise – Exercise Price) * Options Exercised = Bargain Element
($80 – $20) * 1,000 = $60,000
The bargain element is important because it’s a tax preference item included when you calculate the alternative minimum tax. If you have a large bargain element, it is possible that you will be subject to alternative minimum tax and may have a tax bill that is considerably larger than what you are used to paying in the year you exercise and hold your incentive stock options.
When you sell your incentive stock option shares as a qualifying disposition, it is possible you will get some of all of the alternative minimum tax back. This is commonly known as an AMT credit.
However, how quickly you receive the AMT credit is complicated and goes well beyond the scope of this article.
What Happens with a Disqualifying Disposition of Incentive Stock Options?
A disqualifying disposition is anything that doesn’t meet the standard for a qualified disposition. If your incentive stock option shares are exercised and sold as a disqualifying disposition, the gain will often be subject to a combination of ordinary income tax rates and capital gains tax rates.
We can use some of the same facts from our previous example, but changing the dates on when you took specific actions can radically alter the outcome. Assume the following:
- Grant Date: January 1, 2019
- Exercise Price: $20/share
- ISOs Granted: 1,000
Let’s also assume you exercised these incentive stock options on March 1, 2020, and the fair market value at exercise was $80. The final sale took place on February 1, 2021, and the final sale price was $100 per share.
In this example, you still meet the requirements set out by Rule 1 because the final sales of the shares occurred at least two years after the incentive stock options were granted (January 1, 2019 – February 1, 2021). You held the shares for a total of twenty-five months.
But you didn’t meet the requirements of Rule 2, because the final sale of the shares occurred less than twelve months after they were exercised (March 1, 2020 – February 1, 2021). Even though you could check the box next to Rule 1, failing to pass the second standard means this exercise and sale is a disqualified disposition.
As a result, the gain equal to the bargain element, $60,000, is taxed as ordinary income. The remaining gain from the market price at exercise to the final sales price will be taxed as a capital gain. In our scenario, it works out to be a short-term capital gain of $20,000. In the year you sell your shares, you’ll report $80,000 of income that is subject to tax for this disqualifying disposition.
Don’t Discount the Disqualifying Disposition on Your Incentive Stock Options Just Yet.
From a tax standpoint, a qualifying disposition at long-term capital gains treatment is better than a disqualifying disposition that results in ordinary income. This tax planning opportunity is one reason many will attempt to meet the qualifying disposition standard.
But you have to remember that meeting the qualifying standard means a longer holding period on your exercised incentive stock options.
You will need to buy the shares of stock via the option and pay the requisite AMT if any if you want to try and achieve a qualifying disposition. Then, you will need to hold (potentially volatile) stock for at least one year.
Holding company stock, or any single stock position, is a risk/reward tradeoff that should be considered in the scope of a larger financial plan — and depending on your situation, it may not be worth the risk in exchange for better tax treatment (especially if you need to diversify away from a large holding of a single stock, especially one tied to your company).
For those who value diversification over concentration risk or tax opportunity, trying to chase a qualifying disposition might not be a wise move. There’s the potential to get a preferential tax treatment — but that’s not the only factor in play when considering what’s best for you.
A disqualifying disposition may actually make more sense for you, depending on your goals and overall financial strategy.
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.