Disqualifying disposition: Overview, definition, and example
What is a disqualifying disposition?
A disqualifying disposition refers to the sale or transfer of stock acquired through an employee stock option plan or stock purchase plan that does not meet the required holding period set by the Internal Revenue Service (IRS) to qualify for favorable tax treatment. In particular, this term is commonly used in relation to Incentive Stock Options (ISOs) or Employee Stock Purchase Plans (ESPPs), which allow employees to purchase company stock at a discounted price.
To receive favorable tax treatment under these plans, the employee must hold the shares for a minimum period. If the shares are sold or transferred before meeting the required holding period (typically one year after the stock is transferred and two years from the option grant date), the sale is considered a disqualifying disposition, and the tax benefits are lost. Instead, the sale is taxed as ordinary income, potentially subjecting the employee to a higher tax rate.
Why is a disqualifying disposition important?
A disqualifying disposition is important because it impacts the tax treatment of the gain on the sale of stock obtained through employee stock options or purchase plans. Normally, when the holding requirements are met, any profit from the sale of stock under these plans may be taxed at more favorable capital gains rates. However, if the stock is sold too soon and the sale qualifies as a disqualifying disposition, the tax treatment is less favorable, as the gain is taxed as ordinary income.
For employees, understanding the implications of a disqualifying disposition is crucial to managing taxes efficiently and making informed decisions about when to sell company stock. For employers, ensuring that employees are aware of these tax consequences is key to helping them take full advantage of their stock options or stock purchase plans.
Understanding disqualifying disposition through an example
Imagine an employee is granted stock options through an Incentive Stock Option (ISO) plan and purchases shares at a discounted price. The stock’s fair market value increases over time, providing the employee with a potential profit.
If the employee decides to sell the stock within one year of purchasing it or within two years of the grant date, the sale would be considered a disqualifying disposition. As a result, any profit from the sale would be taxed as ordinary income, instead of the lower capital gains tax rate.
In another example, an employee participates in an Employee Stock Purchase Plan (ESPP) that allows them to buy company stock at a 15% discount. The employee holds the stock for less than one year and sells it shortly after purchasing it. This action would qualify as a disqualifying disposition, and the employee would be taxed on the discount as ordinary income, rather than receiving the more favorable capital gains treatment.
An example of a disqualifying disposition clause
Here’s how a disqualifying disposition clause might appear in a stock option agreement:
“If the Employee disposes of the shares acquired through this Option before satisfying the holding period requirements for a qualifying disposition under the applicable tax laws (i.e., within one year after the transfer of the stock and two years from the date the Option was granted), the disposition shall be considered a disqualifying disposition. The Employee will be required to recognize ordinary income on the sale, and the Company will withhold the applicable taxes accordingly.”
Conclusion
A disqualifying disposition occurs when stock acquired through an employee stock option plan or employee stock purchase plan is sold or transferred before meeting the necessary holding period, leading to less favorable tax treatment. Understanding the rules around disqualifying dispositions is important for employees to avoid unexpected tax consequences and maximize the benefits of stock options or stock purchase plans. By planning when to sell stock and ensuring the holding periods are met, employees can minimize the tax impact and make more informed financial decisions.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.