What is a Qualifying Disposition?
A qualifying disposition is the sale, transfer or exchange of stock that an investor acquires from an incentive stock option (ISO) or employee stock purchase plan (ESPP) and is taxed at the capital gains rate.
How Does a Qualifying Disposition Work?
For example, let's assume that John Doe works as a financial analyst in Company XYZ. Over the years, he's been granted 1,000 options to purchase Company XYZ stock at $10 per share under the company's incentive stock plan.
John leaves his job two years later but exercises his ISOs and pays $10,000 for his 1,000 shares. Three years later, he finds a buyer for his shares at $25 per share and thus sells his shares, netting a tidy $15,000 profit. Because John sold his shares at least one year after receiving the stock and two years after receiving his ISOs, John pays long-term capital gains tax (15%) on the $15,000 rather than paying taxes at his marginal tax rate (say, 30%). If John sells, transfers, gives away, or shorts his Company XYZ stock too soon, he'll lose the tax benefit and have to pay ordinary income tax on the gain.
Why Does a Qualifying Disposition Matter?
Making sure that a qualifying disposition is indeed "qualifying" is crucial to investors who have stock options because the tax implications are severe. In John Doe's case, had he sold the shares earlier, he may have had to pay $4,500 in taxes instead of $2,250. Because the long-term capital gains tax is generally low compared to ordinary income tax rates, investors in high tax brackets are more affected by not having a qualifying disposition.
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