What is Disqualifying Disposition of Incentive Stock Options
In this article, we will explain the concept of disqualifying disposition in incentive stock options.
Stock options, one of the most popular forms of equity compensation, are usually granted by privately held companies for the purpose of motivating and retaining employees. It is basically a form of stock, a share of company ownership, that can be purchased for a predetermined price after a certain period of time. ISOs or Incentive Stock Options in this regard, are one of the types of stock options that are widely used. Probably you might wonder what disqualifying disposition in incentive stock options mean? In this article, we will explain the concept of disqualifying disposition in incentive stock options.
Disqualifying disposition and Incentive stock options
Before we jump into the concept of disqualifying disposition, it is important to understand the basic definition of incentive stock options and disqualifying disposition. Incentive Stock Options or ISOs, are a form of stock-based compensation that gives the employee the right to purchase a predetermined number of shares at a predetermined price after a particular period of time. Disqualifying disposition is a stock option transaction wherein the sale, transfer, or exchange of stock is carried out before the required holding period. Thus, disqualifying disposition in relation to ISOs refers to any transaction that results in unfavorable tax treatment to the holder of those options.
What are incentive stock options?
Incentive stock options also referred to as ISOs, are a type of equity incentive plan that a company provides to its employee. These stock options are used to attract and retain employees by giving them an opportunity to acquire a share in the company at a predetermined price (strike price). This benefit is given to the employee after a certain period of time which is also known as the vesting period. The purpose of an ISO, or any stock option, is to align the employee’s interest with the company by providing an ownership stake in the company.
How does incentive stock options work?
A company grants incentive stock options to its employees on a vesting schedule, which means that the employee is required to stay with the company in order to gain ownership of the options which are granted. While exercising ISOs is a process whereby the employee actually obtains the stock by paying the strike price after the vesting period or before the expiry date of that option. Generally, the mechanism of incentive stock options works on the basis of the vesting period and strike price, which are the key factors that govern this process. Therefore, the working of an incentive stock option is similar to that of a regular stock option. However, ISOs have different tax treatment as compared to other stock options.
What is AMT?
AMT or Alternative Minimum Tax, is a tax system in the United States that is imposed to collect taxes that are evaded by means of other tax breaks. In regard to incentive stock options, AMT tax treatment is applied in the case where the fair market value of the stock is higher than the strike or exercise price at the time of exercise. Usually, under ISOs, AMT is applicable instead of regular income tax at the time of exercising the option. The purpose of AMT is to ensure that high-income individuals pay their fair share of taxes. As a result, AMT tax treatments are generally used in determining when indulging in avoidance tax action by exercising ISOs.
How does AMT get triggered?
Now that you know the basics of AMT, you need to know the factors that trigger AMT tax treatment. These triggers are crucial in determining whether your exercise of an incentive stock options results in regular income tax or AMT. The following are the key factors that trigger AMT tax treatment:
- If the fair market value (FMV) of the shares is higher than the strike price at the time of exercise, the option holder would be subject to AMT. Thus, it is essential to know the FMV of the shares when the option holder exercises ISO.
- In the case of the option holder exercising and subsequently selling the shares and earning large amounts of capital gains, AMT is applicable due to the fact the selling price exceeds the price paid by the option holder, which is treated as a capital gain.
- When the household income is above a certain level, the option holder will be subject to AMT. In particular, an individual whose household income is above $81,300 is likely to trigger AMT when exercising ISOs.
What is disqualifying disposition?
A disqualifying disposition refers to a stock option transaction that results in unfavorable tax treatment for the option holder. In other words, a disqualifying disposition occurs when the sale, transfer, or exchange leads to unfavorable tax treatment for the option holder. Basically, when the shares are sold before one year of exercising the option or before two years of granting the option, this would trigger a disqualifying disposition. While under disqualifying disposition, incentive stock options are typically converted into nonqualified options, resulting in regular income tax treatment.
How does disqualifying disposition work?
A disqualifying disposition for incentive stock options is triggered when the option holder sells the shares before one year of exercising ISOs or before two years of granting the option. In this case, when such stock is sold and holding requirements are not met, it triggers a disqualifying disposition. Once the option holder is under a disqualifying disposition, the ISO would be converted into nonqualified stock options. As such nonqualified stock options are subject to regular income tax treatment instead of AMT. To simply put, the disqualifying disposition would result in the conversion of an ISO into a nonqualified stock option which increases the tax liability.
Special consideration of disqualifying disposition
In the case of disqualifying disposition, there are certain special considerations that need to be taken into consideration. Before we look into these special considerations, it is essential to understand what the bargain element means? Well, the bargain element refers to the option transaction where stock options are exercised at a price lower than the share’s fair market value. Below mentioned is the special consideration for disqualifying disposition:
- The option holder is not required to report the bargain element as long as the option is held for a specific time. After the shares are sold, the option holder must report the bargain element in their taxable income.
- When the shares are sold after one year of exercising and two years of granting the option, the bargain element is typically considered as a long-term capital gain. As such, it must be reported as a capital gain for tax purposes.
Difference between disqualifying disposition and qualifying disposition
Now that you have a fair understanding of disqualifying disposition, it is essential to know the difference between disqualifying disposition and qualifying disposition. The difference between disqualifying disposition vs qualifying disposition are listed below:
- Qualifying disposition is a stock option transaction when the holding requirements are met by the holder and the shares are sold after completing the holding requirement. On the other hand, disqualifying disposition occurs when the shares are sold prior to the holding requirement.
- In the case of qualifying disposition under ISOs, capital gains tax or regular income tax is applicable, whereas disqualifying disposition leads to regular income tax instead and capital gains tax is levied. As such, there is one taxable event under qualifying disposition and two taxable events under disqualifying disposition.
What is a qualifying disposition of incentive stock options?
Qualifying disposition of incentive stock options takes place when the option holder does not realize any gains in connection with the selling of shares. This happens when the holding requirements are met and the option holder executes the transaction after holding the shares for more than a year after exercising and two years after the grant. It is important to note that if the shares are sold right after exercising, the disqualifying disposition will take place. Thus, a qualifying disposition is considered as more beneficial compared to disqualifying disposition in terms of taxation.
Calculation of qualifying disposition of incentive stock options
To better understand how qualifying disposition is calculated, let us look at an example of calculation of disqualifying disposition of incentive stock options. Assume that Christine exercises her incentive stock options on September 20, 2022, after they were granted on September 20, 2021. In this case, Christine would have to wait until September 20, 2023, to report a long-term capital gain. This is because of the fact that Christine held the exercised options for more than a year after the exercise date and two years after the grant date.
How does qualifying disposition work for incentive stock options?
When the option holder exercises their shares and holds them for more than a year after the exercise or two years after the grant, the qualifying disposition occurs. It results in a long-term capital gain tax or regular income, depending on the holding period of the shares and other factors. In the above example of Christine, in order to fall under qualifying disposition, she must wait until September 20, 2023, to sell the shares, which is one year after the exercise and two years after the grant date.
When to discount disqualifying disposition on your incentive stock options
You know that under qualifying disposition, the holder must wait for a long time for selling the shares before realizing a taxable event. The pursuit of a qualifying disposition might not be a prudent course of action for individuals who place a higher value on diversification than on concentration risk or tax opportunity. The possibility of receiving advantageous tax treatment exists, but there are other considerations when determining what is suitable for the option holder. As such, discounting disqualifying disposition solely depends on individual preference, financial resources and other factors.
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