What it means
Some companies give employees stock options that carry special tax treatment, known as incentive stock options. An employee who exercises them, meaning buys the shares at the set price, does not usually owe ordinary income tax at that moment.
Tax treatment depends on when the shares are later sold. To make a qualifying disposition of incentive stock option shares, the employee must sell at least two years after the options were granted and at least one year after they were exercised.
If both periods have passed, the profit is generally taxed at the lower long-term capital gain rate. If the shares are sold sooner, the sale is a disqualifying disposition and part of the gain is taxed as ordinary income.
Similar logic applies to employee stock purchase plans, though the holding periods are counted from different dates and a portion of the gain may still be ordinary income. The details differ by plan, and the plan documents explain them.
Employers often provide a summary, and a tax adviser can check the dates. There is a catch worth knowing.
When incentive stock options are exercised, the difference between the market price and the exercise price may count towards the alternative minimum tax, a separate calculation that can create a tax bill even though no shares were sold. Employees who exercise a large number of options without selling can face a cash problem.
For employers, the type of disposition affects reporting duties and whether the company receives a tax deduction. In a qualifying disposition, the company generally does not claim a deduction, while in a disqualifying disposition it usually can.
Planning around the dates is therefore a matter of cash flow as well as tax. An employee may need to decide whether to pay for the shares with savings, borrow, or sell some shares early.
Because the share price can fall while the employee waits, the tax saving from patience is never guaranteed.
In practice
Real-world examples.
Example
A software engineer holds her incentive stock options for three years after the grant and 18 months after exercising. She sells the shares and reports the entire gain as a long-term capital gain.
Example
A sales director sells shares only eight months after exercising because he needs cash. His adviser explains that the sale is disqualifying, so part of the gain is taxed as ordinary income.
Example
A finance manager at a start-up helps staff understand the dates. She builds a simple tracker showing the grant date, exercise date and earliest date for a qualifying disposition for each employee. The tracker also flags the tax return line where the sale should be reported.
Formula
Calculation
Long-term capital gain on a qualifying disposition = (sale price - exercise price) x number of shares
Suppose an employee holds 1,000 options with an exercise price of $10, exercises them when the market price is $25, and sells at $40 after meeting both holding periods. The gain is (40 - 10) x 1,000 = $30,000. At an assumed long-term capital gain rate of 15% for illustration, the tax is 30,000 x 0.15 = $4,500, leaving $25,500 after tax before costs. If the same shares were sold too early, the $15,000 spread at exercise (25 - 10 = 15, x 1,000) would be taxed as ordinary income instead.Case study
Seen in the real world.
Pinecrest Software is an illustrative, fictional company that granted incentive stock options to its engineers. One engineer, Ravi, exercised 2,000 options at $5 when the shares were worth $20, and was excited about the profit.
His adviser reminded him to wait. If he sold before the second anniversary of the grant and the first anniversary of the exercise, the $30,000 spread at exercise, calculated as (20 - 5) x 2,000, would be taxed as ordinary income.
Ravi waited, sold at $30 and reported a long-term gain of (30 - 5) x 2,000 = $50,000. The illustrative lesson is that patience about dates can change the tax bill materially, but he also had to weigh the risk that the share price might fall while he waited. He also kept a reserve of cash so that he would not have to sell early if his personal expenses rose.
Watch out
Common mistakes.
- Counting both holding periods from the exercise date, when one runs from the grant date and the other from the exercise date.
- Ignoring the alternative minimum tax at exercise, which can create a bill even though no shares were sold.
- Selling just before the holding period ends, which turns a qualifying disposition into a disqualifying one.
Questions
People also ask.
What is a disqualifying disposition?
A sale made before the required holding periods have passed, where part of the gain is taxed as ordinary income.
Do the same rules apply to all stock options?
No, non-qualified options are taxed differently, usually as ordinary income at exercise.
Who decides whether a sale is qualifying?
The tax law sets the conditions, and the employee reports the result on the tax return, usually with help from the employer's records.
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