These different rules have drastically different tax implications. Understanding the nuances can help you plan financially and save on taxes
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The below article is specifically geared towards the exercise and sale of Incentive Stock Options (ISOs) but can also be relevant for other potential workplace equity programs (i.e ESPP). It may help to brush up on the basics of ISO terminology
Quick Summary
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A Qualifying Disposition (QD) is the sale of an incentive stock option, after exercising, that was 2 years after the original equity grant date and 1 year after the exercise date
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Qualifying dispositions, for the most part allow for more favorable tax situations, as they will always be taxed at the long term capital gains rates of 0%, 15%, or 20%
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Although the long term gains from a QD are taxed more favorably, it can still affect your eligible exemption amount for the AMT! (read below)
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A Disqualifying Disposition (DD) is the sale of an incentive stock option, after exercising, that was less than 2 years after the original equity grant date or less than 1 year after the exercise date
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Disqualifying dispositions are taxed at normal marginal income rates. Assuming a gain, part of the sale will be categorized as income (typically showing up on your W2) while the other part will be a short term capital gain. This is important for tax planning!
Qualifying vs Disqualifying Dispositions - What’s the difference?
A ‘disposition’ simply refers to the classification of a sale of a stock. Simply think of it as way to describe the sale. Just as you would say “I sold my stock and it made money” you could also say “I sold my stock and it was a disqualifying disposition”. Each sale/transaction is classified on it’s own.
What I mean by this is you could sell the 100 of the same stock in two batches - one today, and one tomorrow - and each could have a different disposition depending on timing.
To put simply, to be a Qualifying Disposition, the sale of a stock has to satisfy both critera:
- Be at least 2 years after the original ISO grant/award date
- Be at least 1 year after the exercise date of the particular stock option
If at the sale of a stock, you only satisfied one (or none) of the above, the sale would be a Disqualifying Disposition
Pretty easy, huh? Let’s dive into an example. Please note, all of these terms such as ‘grant date’ or ‘exercise date’ should be made available and clear in the equity award center of whichever financial institution your company uses. This holds true even after you leave the company (although you should check for how long they keep the information).
Let’s walk through some examples
Ex: Multiple Dispositions for someone who recently left the company
Gary has been working at ‘Donate2Me’, a burgeoning fintech startup for 6 years until he recently left to pursue his love of painting. He first started on April 1st, 2014 and received 1,000 ISOs with a typical vesting schedule of 4 years and the grant date being his first day.
Note: your grant date may not always be the same as your first day!
Needless to say, all 1,000 stock options have since been vested and the company went public in 2019!
Since the options were now worth something, he decided to use this AMT Calculator AMT Calculator to see how to keep his taxes at a minimum. The calculator spit out that if he exercised just 500 of his options in 2019 and the other 500 in 2020, he would not have to pay any additional AMT!
As such, he exercised the first batch on May 1st, 2019 and the second on May 1st, 2020.
Let’s review Gary’s situation:
| Event | Date of Event |
|---|---|
| Award Grant (1,000 ISO) | April 1st, 2014 |
| Exercise Batch #1 (500 shares) | May 1st, 2019 |
| Exercise Batch #2 (500 shares) | May 1st, 2020 |
With the economy taking a turn for the better, Gary considers liquidating and selling his stock so he can buy the world’s largest oil canvas. Assuming today is April 1st, 2021, what will happen if he sells all 1,000 shares of ‘Donate2Me’ today?
For Exercise Batch #1 - he will have sold for a qualifying disposition because:
- His original grant date was over 2 years ago (April 1st, 2014)
- The exercise date for batch #1 was over 1 year ago (May 1st, 2019)
For Exercise Batch #2 - he will have sold for a disqualifying disposition because:
- Although his original grant date was over 2 years ago (April 1st, 2014)
- The exercise date for batch #2 is less than 1 year ago (May 1st, 2020 - 11 months ago)
Should Gary Wait To Sell Batch #2?
Conventional wisdom states that he should wait 1 more month. However, everyone has a different situation and Gary should consult with a financial advisor if he wants a tailored answer. There are some things he can at least first consider:
- The bargain element of a disqualifying disposition (difference between strike price and fair market value of stock at time of exercise) will be classified as Income. As in, Gary’s company will include this number on his W2 as part of box 1. In most circumstances this is a less favorable situation as you likely can’t offset all of these gains with any capital losses, whereas you could have if this was a qualifying disposition.
- If he waited a month to sell, his proceeds would all be counted as ‘long term capital gains’ which are subject to much more favorable taxes!
- However, the risk Gary takes in holding out for one more month is the same risk anyone takes holding stock. What if the stock falls in the next month, making whatever he would have saved on taxes irrelevant because the decline in stock price was more?
Ex: Disqualifying Disposition Corner Case
It’s most common to have a disqualifying disposition because you waited to exercise your stock options, forcing you to either have to wait many months for that 1 year mark to pass or sell now at a higher tax rate.
This makes sense as you probably had no idea a ‘disposition’ was even a thing until your company started getting close to going public and your HR/advisors starting presenting on these topics. In addition, you didn’t think to exercise your options before your company was going public as that’s a big risk.
Well one corner case that is rarely talked about is a Disqualifying Disposition due to not satisfying the other criteria - having the award date being less than 2 years from the sale date.
Many companies offer additional equity grants during promotion / review cycles. And oftentimes, these grants actually have a more fluid stock option vesting schedule (i.e. instead of having to wait a full one year cliff for the first 25%, options will vest every paycheck, month, or quarter). This is meant to award long tenured folks who’ve already ‘proven loyalty’.
As such, this actually gives you the option to very quickly exercise an option close to the original award date. If we take the above example with Gary, let’s say he stayed at the company and got a promotion in 2019 which came with a new equity package. His award date was May 1st, 2019 and his first options vested on June 1st, 2019. Due to his calculations, he decided that on every vesting date, he would immediately exercise the options.
Fast forward to today, April 1st, 2021. What would happen if he sold today?
| Event | Date of Event |
|---|---|
| Award Grant (Promotion) | May 1st, 2019 |
| Exercise first options (as they vest) | June 1st, 2019 |
If Gary sold these stocks today, his sale would be a disqualifying disposition because:
- His award grant date is less than 2 years ago (May 1st, 2019 - 23 months ago)
- Despite his exercise date being far past 1 year from today (June 1st, 2019 - 22 months ago)
With ISOs, Tax Planning = Tax Saving
Whether you are finding out about this for the first time, or a seasoned veteran, it never hurts to understand your tax liability and plan out how many options you can exercise without having to pay additional taxes. For that, utilize our AMT Calculator AMT Calculator to find out how to save today!