Qualifying Disposition

Qualifying disposition refers to a sale, transfer or exchange of stock that qualifies for favorable tax treatment. This type of stock is typically acquired through an incentive stock option (ISO) or a qualified employee stock purchase plan (ESPP). A qualified ESSP requires shareholder approval before it is implemented and all plan members must have equal rights in the plan.

To be a qualifying disposition, the employee must sell at least one year after exercising the stock, and two years after the incentive stock option (ISO) was granted, or the beginning of the ESPP offering period. For example, suppose Cathy’s ISO options were granted Nov. 20, 2017, and she exercises them Nov. 20, 2018. Cathy has to wait until Nov. 20, 2019, before she can report a long-term capital gain.

The capital gains treatment for a qualifying disposition applies to the amount of the sale represented by the difference between the exercise price of the option's stock and the market price at which the stock sold. For example, if Tim exercised 1,000 ISO options at $10 per share and sold them for $30 per share, he reports a capital gain of $20,000 ($20 x 1000 shares).

Non-statutory stock options (NSOs) do not qualify for capital gains tax treatment and get taxed at ordinary income rates. Issuing a compensation package that includes ISOs and a qualified ESPP helps a company attract and retain talented personnel. It also aligns company’s management and key employees with its shareholders as they both want the company to perform well and see its stock price increase. Some companies do not offer ISOs because, in contrast to non-statutory (or non-qualified) option plans, there is no tax deduction for the company when the options are exercised.

“Bargain element” refers to an option that can be exercised below the current market price, which provides the employee with an immediate profit. An employee who exercises a non-statutory option must report the bargain element as earned income which is subject to income tax. However, employees who hold ISOs do not do not have to report the bargain element until they sell their shares. The bargain element gets reported as ordinary income if the shares were immediately sold after they were exercised (a disqualifying disposition), or reported as a long-term capital gain if the sale was executed one year after exercising the options and two years after the grant date (qualifying disposition). To learn more about capital gains tax, see: What You Need to Know About Capital Gains and Taxes.)