Disqualifying vs Qualifying: ISOs

April 03, 2024

Tax qualified awards such as ISOs and qualified section 423 ESPPs, are those that offer the opportunity for employees to gain the most favorable possible outcome as it relates to the taxation of their awards. However, in order to obtain these benefits, there are rules that must be followed.

In this article we’ll be discussing at a high level, what a qualifying and disqualifying disposition is, as well as the tax implications of both types as it relates to incentive stock options.

Preferential Tax Treatment

Before beginning, let’s first explain what “preferential tax treatment” is and why in 99% of situations, award holders of a tax qualified award would prefer to dispose of their shares in a qualifying disposition.

Preferential tax treatment essentially means that if the shares are disposed of in a qualifying disposition, award holders can have a large portion on the gain of their awards or all in the case of ISOs, treated at long term capital gains rates.

For those of you unfamiliar with why participants would want to have their awards taxed at long term capital gains rates, it is because long term capital gains rates max out at 20% as opposed to the 37% rate that ordinary income and short-term capital gains rates max out at. So, when we say “preferential tax treatment” what we mean is essentially the opportunity to have your tax qualified award taxed at long term capital gains rates, as opposed to the two alternatives mentioned above.

Incentive Stock Options

ISOs are awards that can only be granted to employees and have quite a few requirements that must be understood from the company side to even qualify for preferential tax treatment.

Some of those requirements are as follows:

Shareholder Approval
Employee Only
Exercise Price Limitations
Contractual Term Limitations
100k Limit
Etc.

In this article we will be discussing only the impact of disqualifying and qualifying dispositions, but linked below are additional resources that can be used to thoroughly understand this form of equity compensation.

NASPP | Guide to Incentive Stock Options
NASPP | Protecting Employees From the Alternative Minimum Tax Trap
NASPP | Stock Plan Fundamentals

Qualifying Disposition

A qualifying disposition is one where the employee holds their shares for more than two years after the date of grant and one year after the date of exercise (please note that the holding period for the property you acquire when you exercise an option begins on the day after you exercise the option). If both requirements are met in relation to the disposition of shares acquired from the exercise of an incentive stock option, then the holder qualifies for what we call “preferential tax treatment”.

Qualifying Disposition

Grant Date: June 1st, 2021
Exercise Price: $10
Shares: 4000
Date of Exercise: June 1st, 2022
FMV at Exercise: $30
Shares Exercised: 1000
Date of Disposition: June 2nd, 2023
FMV at Sale: $45
Shares Sold: 1000

In this scenario, the award satisfies the requirements of a qualified disposition. This is because the ISO was granted on June 1st, 2021, which means that the two years from grant date requirement was met due to the sale occurring two years later on June 2nd, 2023.

Remember though, there is more to a qualifying disposition than just the two years from grant date requirement, there is also the one year from exercise requirement that needs to be met, which is also satisfied in this scenario, because the shares were exercised on June 1st, 2022, and then sold exactly one year later on June 2nd, 2023.

What this means for the participant is that the gain on their award, which would be the spread between the strike price and FMV at date of sale, will not be taxed at a rate higher than 20%.

Long Term Capital Gains = $35,000

$45 (FMV at date of sale) - $10 (FMV at date of exercise) = $35 (Spread)
Shares = 1000
Tax Rate = Max of 20%

Company Obligations: Reporting

“But what does this mean for the company and their reporting obligations?”

Well, because this was a qualifying disposition nothing would be reported on Form W-2 due to there not being compensation income recorded from the qualifying disposition.

The only reporting requirement would be that of section 6039 which does go beyond the scope of this article, but can be learned about at the link below:

NASPP | Understanding Compliance Under Section 6039

Disqualifying Disposition

To break it down rather simply, a disqualifying disposition is essentially one where either the one year from date of exercise and or two years from date of grant holding period, has not been satisfied.

Using the same example as before, let’s talk about what changes when a disqualifying disposition occurs.

Grant Date: June 1st, 2021
Exercise Price: $10
Shares: 4000
Date of Exercise: May 30th, 2022
FMV at Exercise: $30
Shares Exercised: 1000
Date of Disposition: May 31st, 2023
FMV at Sale: $45
Shares Sold: 1000

This scenario is a disqualifying disposition solely because the award holder did not wait the additional day to satisfy the two years from date of grant requirement, despite holding the award for the required one year from date of exercise.

What does this mean for the award holder though? Well, it isn’t as simple as just being the reverse of a qualifying disposition, the award is now no longer one that qualifies for preferential tax treatment, which means that the award for all intents and purposes, will now be treated as an NQSO, which you can learn more about at the links below:

NASPP | Guide to Nonqualified Stock Options
NASPP | Stock Plan Fundamentals

This scenario means that the award is no longer being taxed on only the spread between the strike price and FMV at date of sale. Instead, the calculation will go as follows:

Compensation Income = $20,000

$30 (FMV at date of exercise) - $10 (Strike Price) = $20 (Spread)
Shares = 1000
Tax Rate = Max of 37%

Long Term Capital Gains = $15,000

$45 (FMV at date of sale) - $30 (FMV at date of exercise) = $15 (Spread)
Shares = 1000
Tax Rate = Max of 20%

As you can see the overall gain of $35,000 remains the same, however, the breakdown is now segmented into two parts: compensation income and long term capital gains, which the employee was lucky enough to qualify for, due to the holder retaining ownership of the shares for the required year needed for long term capital gains rates, which any capital asset can qualify for if held for a full year before disposition.

IRS | Topic no. 409, Capital gains and losses

Company Obligations: Reporting

“But what does this mean for the company and their reporting obligations?”

Well, because this was a disqualifying disposition there would be a compensatory element to the award which would need to be reported on the employees W-2.

This also means that because there was compensation income, the company would be entitled to a tax deduction equal to the compensatory element of the award, which in the above example, is $20,000. This tax deduction by the company is something that wouldn’t normally be possible if the disposition was a qualifying one.

A great tip to remember is that a company can only take a tax deduction if there is a compensatory element to the award, which in relation to ISOs will not be known until the actual sale of the award.

The reporting requirements under section 6039 are also still in effect, which does go beyond the scope of this article, but can be learned about at the link below:

NASPP | Understanding Compliance Under Section 6039

Ask the Equity Expert

The more you discuss equity compensation the more questions that tend to arise, for this reason we want to make sure that our readers are aware that we do have resources available for you to gain further clarification on your most pressing issues, and one such resource is our live Ask the Equity Expert sessions, where attendees can ask the one and only Barbara Baksa any of their most pressing questions in relation to equity comp.

Follow us on LinkedIn to stay updated on upcoming sessions, which typically occur on the last Thursday of every month!

NASPP | LinkedIn

By Jason Mann
Content Director

NASPP